This article was posted on Wednesday, Jan 01, 2020

Continued from Part 7 . . . The widow’s advantage was that she saw “when” not as a fixed point in the future but as a trend line. “Over time,” she thought, “the line will go up. This investment will compound better than the available alternatives”. While she seldom bought individual companies anymore, sometimes she bought shares of the two or three top companies in a given sector. As an example only, years ago when it became clear that computization was the future, she bought both Microsoft and Apple. 

After the Great Recession of 2008-09, when it became obvious that the Federal Reserve would save the economy almost no matter what, she bought shares in each of the largest three or four domestic banks. She could not imagine an economy without banking services, so she thought her purchase was a safe investment. And when she had investible funds but no individual stocks were particularly compelling, she bought a S&P Index Fund when she thought it was favorably priced. 

The S&P 500 is an index of the largest publically held companies in America, and is a simulacrum of the market as a whole. Over the last forty-five years or so, the Price / Earnings Ratio of the S&P 500 has run from 7.22 (Oct-Dec 1976) to 122.14 (Apr-Jun 2009), and back to 13.72 in the third quarter of 2011.

Some of this extraordinary spread was for cause. In the Apr-Jun period, 2009, the market’s P/E ratio was an unusual 122.14 due to the housing crash and consequently low corporate earnings while share prices remained elevated. By 2011 the ratio of stock prices to corporate earnings had recovered to 13.72. 

Parsing the historical data offered by the S&P, a grid can be developed that reflects a relationship between the P/E ratio of the S&P and annualized returns for the following 10 years: the lower the P/E Ratio, the higher the returns (example below). This relationship, being consistent, is probably more robust than the actual numbers, which are unlikely to be repeated.  NOTE: The past is no indication of future performance.

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Excluding the second quarter of 2009, which was unusual due to the housing crash (a P/E of 122!), assets historically purchased when the S&P 500 Price/Earnings ratio is over 19 tend to appreciate very little over the following decade. Assets purchased at a P/E below 15 historically generate a 10 year annualized return of 9% or thereabouts.

Uber-low P/Es across the entire market don’t happen very often. They are seen with individual stocks, of course, but individual stocks could be priced low for a reason. Even sectors could be priced low for a reason. But it is unusual to find entire markets priced well below their mean for very long.

The widow liked to add to her S&P 500 Index fund when the market was less than 15 P/E. When that happened, she expected an annual return over the following decade of 10% or so. Ten percent per year means that portion of her portfolio invested in the S&P 500 Index would double every 7 years. Twenty-eight years would provide for four doublings: $100,000 invested for the first 7 years would grow to $200,000; after 14 years it would be $400,000, 21 years equals $800,000, and twenty-eight years along the initial investment of $100,000 could be projected to grow to $1,600,000. 

What is important here is that she stopped investing for herself a long time ago. For the last few decades she’s been investing for her posterity. She wished her own grandparents had been as thoughtful.

Judging the affordability of the stock market as a whole from its P/E ratio tends to work best for people who buy market-wide index funds. There’s nothing opaque about it: buy when the market P/E ratio is low. When it’s high, don’t buy. While you’re waiting to be proven right, feed the cat.

Things become more nuanced when buying individual stocks, where barriers to entry are important. Barriers to entry are the obstacles that make it difficult for a new provider to compete in that specific market. They come in several flavors:


(Brand image, patents, copyrights.) A brand image is created over time. It is reinforced each time the customer finds that what she bought this time is the same as she bought last time. She had learned to associate that product with a certain bundle of hopes, and once again the product delivered. There were no unwanted surprises.

Coca-Cola and Pepsi have been cola competitors for a long time. At the end of WWII Coca-Cola had a 60% market share. Forty years later Coke was down to 24%. Taste tests in the early 1980s revealed that consumers generally preferred the sweeter flavor of Pepsi over the more astringent Coke. Coca-Cola (the company) responded by taking “Old” Coke off the market and replacing it, early in the second quarter of 1985, with “New” Coke. New Coke was indeed sweeter, and in blind taste tests was preferred over both “Old” Coke and Pepsi. But the replacement proved a massive failure, especially in the southern states, and within three or four months the original formula was reintroduced nationwide as “Coke Classic”. Since then both companies have become less cola focused and more oriented towards a spectrum of non-alcoholic drinks. Coca-Cola, for example, now sells over 500 brands in over 200 countries. Pepsi’s operations have expanded similarly. With more options available overall, total drink sales have increased while overall cola sales have declined. Coke now sells significantly more cola than Pepsi. “New” Coke was a self-inflicted wound corrected by the return of Coke Classic.

And that brings us to Gillette, who recently surprised their customers by associating their razors with toxic masculinity. Gillette promptly lost $8 billion in sales.

These two examples illustrate the power of brand expectations. Coca-Cola customers didn’t care what Coke tasted like, as long as it was what they were used to. Gillette customers felt valued by the company until the Good Idea Fairy got involved. Gillette concluded that associating their customers with toxic masculinity was somehow a good idea. That surely wasn’t what their customers were expecting, and the Good Idea Fairy followed the $8 billion out the window. 

The takeaway is that Coca-Cola (traditional taste) and Gillette (traditional masculinity) own their lanes through intangible barriers to entry. People like Coke and used to like Gillette. In both cases, there are plenty of competitors on the other side of the moat.

There have been many cola companies, and some survive. RC cola, for example, is still around. Every southern boy, with flecks of toilet paper still stuck to their shaving nicks, has offered his date a RC Cola and a moon pie. That combination is known for ending in a platonic kiss on the cheek, and thus RC Cola is a regional success. But most of the cola companies that challenged Coke or Pepsi have gone down the memory hole.

There are alternative razor companies (Schick, Personna, Bic, etc.), but none of them have Gillette’s name recognition or associations: the Marlboro Man probably shaved with a Gillette razor. Companies can soil their own nests, Coke with “New Coke!” and Gillette with their “Toxic masculinity”, but self-inflicted wounds are largely correctable. The company has only to return to meeting its customer’s expectations.

Warren Buffett has owned Coca-Cola stock for decades. He owned Gillette, too, before P&G bought it.

Economies of Scale 

(Walmart, Costco.) Richard Warren Sears (later of Sears, Roebuck & Co.) began his eponymous business in the early 1890s as a mail-order watch company. He was joined by Alvah Roebuck, and soon thereafter the company began adding products (“Hey, as long as you’re buying a watch, how ‘bout a little chewing tobacco for the missus?”) and pretty soon Sears, Roebuck & Co. was selling a raft of things (toys, farm equipment, eye glasses, needles, seeds, kitchen stoves, mucking forks, etc.) all ordered and delivered by mail. In 1895 Julius Rosenwald bought out Alva Roebuck, and a year later Rural Free Delivery (RFD) was introduced in the United States. Customers no longer had to hitch Ol’ Dobbin to the wagon and spend a day getting to their nearest pick up station and back. With RFD anything Sears, Roebuck sold could be delivered directly to their customer’s front door. Talk about a fortuitous purchase! Mr. Rosenwald must have been quite pleased with the improvement to Sears’ bottom line.

Switching Costs 

(Banks, computer operating systems, mortgage servicing companies.) Excluding credit cards and checking accounts, both of which can be changed as easily as one’s hair color, most banking relationships are sticky. It’s time consuming and sometimes costly to change banks. Even for something as common as refinancing one’s home loan there are costs, both salient (appraisal, credit check, title services, etc.) and subtle (amortization resets). There can be charges for lines of credit, merchant services, standby funding, etc. All of these are sources of income for the bank, and it has been found that the more services a customer is signed up for the less likely he is to switch banks. That brings us to Wells Fargo. Not too long ago Wells Fargo was fined by their regulators for enrolling their customers in services never asked for, and then charging for the services. The genesis was that low ranking employees were assigned unrealistic sales quotas and, probably to save their jobs, used unethical ways – perhaps with the knowledge of supervisorial staff – to meet these quotas. It appears that Wells Fargo’s institutional experience was that people having (perhaps not even using, just “having”) multiple bank services were less likely to change banks, and Wells sought to monetize that knowledge.

Network Effects  

(Google, Facebook, Twitter) When a company’s profit margin expands nonlinearly as the customer base grows, the company benefits from “network effects”. If young Melissa was the company’s sole customer, Facebook would have little value. But once enough people joined and the customer base reached a critical mass, Facebook became a prime mover. The corporate infrastructure was in place and the costs of servicing the next customer became vanishingly small, approaching zero. This business model means there does not have to be a subscription cost to the consumer. There is only the quiet selling of personal data accumulated by the network. Partially because the data can be sold again and again, successful businesses that provide network effects are wildly popular (Free!) and potentially unspeakably profitable (there is no shelf life to personal data). 

Control of a Limited Market 

(Railroads, pipelines, etc.) Imagine a little village of a dozen or so families who await their RFD package from Sears, Roebuck. How did they manage their waste? At one time, while they were putting up the cabin, there may have been a slit trench somewhere. When the first or maybe the second family moved into the cabin, the facilities were probably upgraded to an outhouse.  Eventually a sewer was constructed, flushing into the local creek. That would work out pretty well, except maybe for the folks living downstream. But then a seed company bought the old Baker homestead and put a series of greenhouses up. Workers were hired.

Sensing a windfall, Asoghik Artsuni & Sons, Land Development and Car Repairs, immediately began constructing condos on the creek-side lot they bought at a tax sale 11 years earlier. They called the development of 24 condos and a hot tub “Riverside Estates”.

Learning of the pending condos, the downstream health authorities demanded something more sophisticated than dumping human waste into “their” creek and AA&S was required to provide septic tanks. That system was the only one within a two-week drive, thus no pumper trucks serviced the new condos. Asoghik Artsruni & Sons had to provide a way to pump out the tank(s) when necessary. They bought a used pumper truck and started a Municipal Services division. Although that division had absolute control of a limited market, it did not turn out to be a very good investment. The population base was inadequate to support the new business. 

On the other hand, if the market is large enough, control of even a minority piece can be a splendid opportunity. Shares in Union Pacific Railroad sold for $60.97 (dividend 1.8%) on 04 Sept 2009. They recently sold at $ 161.50 (dividend 2.4%). Union Pacific, while having competitors, shares oligarchic control over a much larger market than Asoghik Artsuni Municipal Services. That makes a material difference. AA&S Municipal Services had total control of waste disposal for 24 condo units. Union Pacific provides railroad service to most of the United States west of the Mississippi River, and the population therein. While both businesses control (fully or partially) a limited market, the difference between the prospects of a business serving 24 condos and a business serving most of the major population centers in the western United States is pretty significant.

The value of unambiguous barriers to entry is unquestionable. They reduce the risk of loss as well as potentially increasing the returns. Their presence means the investor does not have to be the low cost provider to have a successful purchase. These five barriers to entry are applicable to both stock and real estate investments. 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. Klarise Yahya is a Commercial Mortgage Broker specializing in difficult-to-place mortgages for any kind of property. If you are thinking of refinancing or purchasing real estate Klarise Yahya can help. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]