The following is an extract from last week's regular feature in the Personal Finance section of the Independent On Sunday. Be sure to pick up your copy this Sunday.
Abbey Windfall
Have you sat down and really thought about how the stock market works? People who've been following this column for a while know that the Foolish philosophy is all about buying and holding shares in good companies. And by holding, we don't just mean 6 months or a year. We're talking 3, 5, 10 years and more. Anne Scheiber, a humble New Yorker, died in 1995, leaving a fortune of over $20 million to charity. This fortune accumulated from an initial investment of $5000 in 1994 and was made entirely from investing in the stock market. She bought shares in great companies like Coca-Cola and Gillette and then just sat on them. And sat, and sat, and sat....
Abbey National, synonymous with the term "windfall gain," is a classic example of the sort of wealth you can accumulate by investing in a household name company. Abbey is now a bank, having left its mutual building society roots long behind, but banks are hardly known as your typical growth company. The mortgage market is extremely competitive, with lots of different players offering a wide range of products.
Five years ago, suppose you had bought shares in Abbey at 485p. Six months later, you may have been a little worried as the shares had steadily fallen to 388p -- a 20% loss in the space of a few months is not supposed to be in the script. In fact, it took the shares over a year just to get back to the price you'd paid for them.
During that dim and dark first year, your faith in the company and the stock market was probably tested. When the shares were falling, you felt you were losing money. Worse, you didn't know where and when the bottom was going come. Your 20% losses conceivably could have turned into 40% and more. In the worst case scenario, you can lose your whole investment. The temptation is to sell out, not being able to handle the paper losses, and cap your losses. No-one likes losing money, and it is not a nice feeling. However, although they didn't know it at the time, good news was just around the corner for Abbey National shareholders.
From the low point of 388p, the Abbey share price never again looked back. A year after your purchase, the shares finally got back to the 485p you paid for them. That moment would have been greeted with some relief, because many people can't bear to sell a share at a loss.
As of today, the shares hover around the 1300p mark, meaning your initial investment would have appreciated by about 170%. To put that into some context, that's the equivalent of compounding annual returns of 21.8%. If you had left your money in the bank, rather than buying shares in it, you'd have earned compounded annual returns of about 7%. Quite a difference. And the Abbey return doesn't include dividends, which have grown at an average rate of 20% per annum over that period.
Shell is one of the very biggest companies in the world and a household name. Yet in recent times, the company and its share price have been going through a rough patch. The share price peaked at 485p in October 1997 and now hovers around the 400p mark. Shell have been struggling to generate a decent return on their assets, and the oil price has been in the doldrums for well over a year. Yet if you'd bought the shares five years ago and held them all the way through to now, you'd have achieved a 12.1% compounded annual growth rate -- again, not including dividends. That is way above the returns you get from a bank account and almost bang in line with the returns the London market has generated over the past 80 years.
You can hopefully see from these examples why we Fools advocate long-term buying and holding of shares. We're not talking about any old companies, either, because many destroy value over a period of time. Those are usually companies with poor management, operating in extremely competitive industries and not generating high returns on their assets. You should look to invest in quality companies -- those with the exact opposite characteristics.
World stock markets are at all time high levels, and this has been highlighted this week by the Dow Jones breaking the psychologically relevant 10,000 barrier. Now the time factor is more critical than ever. The value of compounding returns really comes as the years roll by. Long-term stock market investors should never forget that.
Ask the Fool
Dear Fool,
Can you explain what a "stop loss" trigger is in the context of equity investments, and how it might work? -- A.M., London
Some people set stop losses for their investments, saying that if the share price falls below that level, they will sell. The theory goes that you can cap your losses at a certain level, say 20% below your original purchase price. This arbitrary stop loss limit supposedly imposes a discipline on you and stops you from idly sitting there and watching the loss get bigger and bigger. That's the theory. In practise, such events as a company issuing a shock profit warning will cause the share price immediately to halve. Unfortunately, the share price doesn't conveniently stop at 20% when it's on its way down so you can sell out at your stop loss level. Also, as you will see from the Abbey National example in our main article, a stop loss may see you selling shares in a perfectly sound company missing out on the years of upside. If you feel comfortable with them, by all means use stop loss triggers. But be aware of the pitfalls.
My Smartest Investment
On starting work in 1988 I decided to buy a house and let a room in it rather than contribute to somebody else's mortgage. I also saw it as a chance to make some capital gain, as the housing boom had not yet reached the area where I was living. I paid £15,250 for the house (on a 100% mortgage) and sold it 9 months later for £33,000 on leaving the area. After expenses I was left with a profit of approx £15,000. Had I followed the advice of the herd and merely rented, my profit would have been zero! -- A.G, Inverurie
The Fool responds: Congratulations. You must have made a very canny purchase. The housing market is notoriously difficult to time, but on this occasion you seem to have done it rather successfully. A straight property investment is just like buying shares -- over time, its value will appreciate, but that time period will vary depending on the investment. In your case, the appreciation occurred over a very short period of time, but this is not probably the norm.
Trivia Quiz
This company was the former owner of Pizza-Hut and currently owns brand names like 7Up and Walker's Crisp. It is American and its name is associated with one of the best known beverage brands in the world. Name the company.
