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

Process versus results

One of the hardest things to do when investing is to keep my focus on process instead of results.

Does that mean that results are unimportant? No. But, it does mean that an over-emphasis on short term results can prevent me from achieving truly unique investing performance.

I find that an analogy, here, helps me grasp this difference. I believe that being honest is necessary to achieving happiness. But, being honest at any particular time does not mean that happiness will instantaneously follow. Honesty is a virtue–like all others–that yields results over the fullness of time.

It seems that everyone has heard of an unscrupulous salesperson that has made a fortune while being less than honest. Such salespeople may do very well in the short term, but over the long term they’re going to pay the price for treating others poorly. It may take decades for this price to be paid, but rest assured that it’s always paid.

The same is true with investing. Those who focus on short term results seem to always be chasing the latest hot thing. They inevitably end up buying high and selling low because they are too focused on results and not enough on process.

Generating truly excellent investment results over the fullness of time requires an intense focus on process: the process of researching, analyzing, valuing, purchasing and selling partial ownership of businesses. Any focus on short term results that distracts an investor from this process will lead to sub par results. An intense focus on short term results will lead to disastrous decisions. Trust me, I’ve made them myself.

It’s hard to focus on process at times. Sometime an investment’s price will go down as business value goes up. Sometimes price will go up much faster than underlying value. Price is important, but it can distract you from underlying value.

The key is to have a process and discipline that you know will work, and to make sure you don’t get distracted by short term results when you know long term results are what’s important.

Even after 11 years of investing, I still find myself getting distracted by short term results. What do I do? I realize I’m letting it happen, then promptly and none too gently refocus myself back on the process. And, so far, that works.

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.