Investing: 3 part harmony

Investment returns seem mysterious to most. You buy one investment and it takes off; you buy another and it tanks; you buy a third and it goes nowhere. Why? It seems more random and unpredictable than the weather at times.  

The underlying reality is more simple than that, though.  Investment returns can be broken into three parts and analyzed individually. Understanding that three part harmony makes investing seems much less mysterious and more practical–and so it is.

Investment returns consist of:

  1. dividends relative to price paid
  2. underlying earnings growth
  3. change in the multiple to underlying earnings

The dividend seems like the most straightforward part of investing returns, but many people seem to overlook the importance of it. What matters is the dividend relative to the price paid over the full period of investment. If that dividend is eliminated (like banks in 2009), shrinks (Real Estate Investment Trusts) or grows (Johnson and Johnson), that can have a big impact on your return. It’s important to understand the dividend yield as well as the sustainability of that dividend (whether it will grow or shrink).

The second element, earnings growth, is (in my experience) the hardest to predict, and has  the second largest impact on returns. If earnings grow while you hold an investment, then you have a nice tailwind that can allow you to generate good results (Apple). If earnings shrink (Best Buy), or even tank (Citigroup), it probably won’t matter what price you paid or dividend yield you start with, your investment results are likely to be unsatisfactory.  

Earnings consist of underlying sales and profit margins (or book value and return on equity in the case of banks, insurance companies, etc.). If sales grow and margins are stable (Wal-Mart), then earning will most likely grow. If margins grow and sales are stable (IBM), you’ll likely experience earnings growth. If margins and sales tank because technology has become obsolete (Blackberry, anyone?), earnings shrinkage will be a big headwind to your results.

The third element, change in multiple to earnings, is the most difficult for people to grasp and is likely to have the biggest impact on return. The multiple people are willing to pay for earnings, which is frequently expressed as price to earnings ($10 per share stock price, $1 per share in earnings, 10x price to earnings multiple), is a reflection of how market participants think of a company and its future prospects. If people think very highly of a company (Amazon), they may be willing to pay 20x or more on earnings; if they think poorly of a company and its prospects (Xerox), they may be willing to pay only 5x earnings.

Market sentiment towards companies changes a lot over time. When people become despondent with a company, it can trade very low to fundamentals; when people become euphoric, a company can trade at very high multiples. Whereas one can analyze and predict dividends and earnings based on underlying evidence, multiples are more likely to be a result that must be judged and reacted to rather than predicted. Buying at a low multiple and selling at a high one gives a tremendous tailwind to investing results.

When you put together multiple change, earnings growth and dividend yield over the life of an investment, you have the three parts of investment return. By analyzing those three parts, you can understand why your investments do well or poorly, and then make adjustments to your investment process. The three part harmony of good returns requires a keen understanding and mastery of all three parts.  

Investment results can be clearly understood if you take the time to do so. Such an effort removes the mystery and reveals an understandable system that can be used to produce good results. This may not sound as exciting as shooting from the hip in hopes of a big win, but good results over time create great wealth, and that’s as exciting as can be.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Investing: 3 part harmony

Contrary to popular belief, firms that pay return on capital to investors are better investments than those that reinvest capital back into the business

A recent paper by James Montier brilliantly highlighted this issue.

For example, a recent McKinsey paper showed that corporate executives know 17% of their invested capital went toward underperforming investments that should have been terminated and 16% of their investments were a mistake to have financed in the first place.

Many corporate managements do a terrible job of investing corporate capital.

When asked how accurately such executives could forecast corporate investments, 70% of managers said they were too optimistic about the time to complete a project, 50% said they were too optimistic about the impact an investment would have, and 40% were too optimistic about the costs involved.

It’s not surprising that management is overly optimistic about their pet projects.

Even worse, 40% of managers admitted that they “hide, restrict, or misrepresent information” when submitting capital investment proposals, and 50% of subordinates working on such capital investment projects said it was important to avoid contradicting superiors.

No wonder most companies are bad capital allocators–managers are rarely honest with themselves about their pet projects, and they discourage dissent when discussing potential results.

In other words, companies that retain capital instead of paying dividends or buying back stock and debt tend to be worse investments than those that tend to pay out return on capital to shareholders. Here’s the proof:

A study by Anderson and Garcia-Feijoo showed that low capital expenditure companies outperformed high capital expenditure companies by up to 10% per year.

The companies that returned capital to shareholders beat the companies that pumped capital back into the business.

Another way to look at it was highlighted in a study by Cooper, Gulen and Schill, who showed that companies with low asset growth, in terms of cash, property, plant, equipment, etc. returned as much as 20% per year more than companies with high asset growth.

I think these findings are counter-intuitive to what most investors believe, and certainly to what many professional investors think, too.

It’s a rare company that can allocate capital effectively, and the proof is clear that companies, on average, that retain capital for investing aren’t necessarily good investments. It’s important to realize, too, that not all companies are bad capital allocators.

This is why I pay so much attention to return on incremental capital invested when I research businesses to invest in.

I stay away from any company that rewards management for retaining capital, especially when management has a bad track record of effectively reinvesting those dollars.

But, I love to see a management that wisely returns capital to investors when they don’t have opportunities and have great track records for adding value when capital is retained.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.