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Two Simple Things To Help You Do Well At Investing

Nate Silver is a statistician and political forecaster with The New York Times. To describe his ability in political forecasting as top-notch would be a severe understatement.

In 2012, he cemented his reputation by accurately predicting the outcomes of the presidential election in the USA in 50 out of 50 states.

He wrote a book titled The Signal and the Noise: The Art and Science of Prediction. It’s a book that describes the inherent difficulties in making accurate forecasts, why humans – as a group – are so bad at forecasting, and what we can do to improve.

While that certainly makes for an engaging read (in my opinion, at least), that’s not the point here.

In his book, Silver showed some charts depicting the relationships between the S&P 500 Index’s (an American stock market benchmark) average annual returns and its starting valuation – using the Cyclically Adjusted Price Earnings ratio – since 1871.

I’ve recreated them below, and they show something remarkable.

Over the short-term (1 year), stocks’ returns have basically no correlation with their starting valuations. Cheap stocks could just as easily do well or falter, as could expensive stocks. Over a period of 12 months, it’s really as good as saying we have no idea what stocks will do.

SandP1yr

Source: Robert Shiller’s data; Author’s calculations

But, stretch the holding period out to 10 years, and the chart becomes much neater. The relationship between the S&P 500’s average annual return and its starting valuation is now apparent. Buying stocks when they have low valuations would likely give higher returns compared to buying stocks when they’re expensive.

SandP10yr

Source: Robert Shiller’s data; Author’s calculations

If we lengthen the holding period to 20 years, the chart becomes even neater.

SandP20Yr

Source: Robert Shiller’s data; Author’s calculations

Turns out, to do well at investing, one might need only do two simple things: 1) Buy stocks at low valuations in relation to underlying fundamentals, and 2) Hold them for the long-term.

Sadly, that’s not what many are doing. Some might buy stocks cheap, but when the going gets tough momentarily, they throw in the towel and bail. That’s certainly not going to work! Over the short-term, a coin-flip might even do better in telling us whether a stock’s going to go up or down as compared to its starting valuation.

Some, on the other hand, might point to the S&P500’s flat performance over the last 13 years and wrongly conclude that holding stocks for the long term doesn’t work; the index was at 1,500 points on March 2000, only to find itself back at 1,500 on Jan 2013.

What they might not realise is that back in March 2000, during the dot-com bubble, the index carried a sky-high CAPE of 43. At such valuations, the chances of a favourable outcome over the long-term are miniscule, to say the least.

In Singapore, over the past six years, we have seen shares such as Super Group (SGX: S10), Vicom (SGX: V01), and Jardine Cycle & Carriage (SGX: C07) outperform the Straits Times Index (SGX: ^STI) dramatically, as seen below.

11 Oct   2007 10 Oct   2013 Change   in price
Super Group S$0.88 S$4.03 358%
Vicom S$1.78 S$4.82 171%
Jardine C&C S$20.20 S$35.60 76%
STI 3,876 3,170 -18.2%

Those three shares carried a PE ratio of 15.5, 11.2 and 16.1 respectively, back on 11 Oct 2007. From 2003 to 2006, net income had more than doubled at Super Group and increased 25% at Vicom, while sales at Jardine C&C grew 365%.

With that backdrop in mind, the valuations carried by those shares six years ago were, arguably, decent at the very least. But what happened a year after 11 Oct 2007? Super fell 43%, Vicom lost 10%, and Jardine C&C’s share price had halved. Buying those shares on the cheap in Oct 2007 didn’t help their investors much.

Yes, it was the Great Financial Crisis at work during those times, but it didn’t change the fact that decent valuations on those shares couldn’t save them from declines as well. It was only after some time had passed that they began to pick up the pace and do well for their investors.

Foolish Bottom Line

Buying shares based on their fundamentals needs time to work, as Silver’s charts show. In his book, Silver actually questioned, “How could stock prices be so predictable in the long run if they are so unpredictable in the short run?”

As investors, we don’t have to answer that. We only have to recognise that we are likely to do well if we do only two things (as mentioned earlier): 1) Buy stocks at low valuations in relation to underlying fundamentals, and 2) Hold them for the long-term.

The real question is, will you?

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing owns shares in Super Group.