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.

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Investing: 3 part harmony

Think winning the lottery is the key to happiness?

Contrary to fact, many believe winning the lottery would bring them happiness.

Want an anecdotal example of why this isn’t the case? Read a tragic story here: http://abcnews.go.com/2020/story?id=3012631&page=1

Want further proof? A presentation by GMO highlighted that “2 out of 3 winners spend or lose ALL of their winnings within five years.” Also, “1 out of 3 winners declares bankruptcy!”

So, why do so many people still play the lottery? It’s the triumph of hope over reason, in my opinion. Many people want a short cut to happiness.

I believe the path to happiness is doing what you love for a living. Financial success is a result, not a cause.

To achieve happiness and success, you need to work hard, add value for others, be honest and have integrity. It’s simple to say, but hard to do. Most seem to know this deep down, but are too lazy to do it.

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.

Failure = quitting

My father worked hard to convince me how important attitude is, but I didn’t do a very good job of listening. I’ve spent most of my life thinking attitude was a result, not a cause. But, now I know otherwise.

My dad is one of those really optimistic people. He expects good outcomes, and so they frequently happen. He’s one of the happiest people I know. He laughs easily, has strong relationships with family and friends, and has a good time doing even the mundane things.

When he had knee surgery last year, he was worried but also optimistic about the outcome. What happened? He’s taken to his new knee very well. This outcome is a result of his attitude, which led him to do the things he needed for the operation to be a success. He was a model patient and a model during physical therapy afterward. His outcome was assured because of his attitude.

You see, I’ve discovered that failure is not the result of things going poorly, it’s the result of quitting. No one can make you quit. You have to chose to quit. When things don’t work out the way you would like, it’s only feedback. You use this feedback to change your thinking and action, and that leads to success. As long as you keep trying, you can’t fail. As long as you keep taking that feedback and trying new approaches, you will eventually succeed.

It took me a long time to realize this, but now I see it clearly. Success happens because people go into things with the right attitude. The right attitude allows them to do the things necessary to succeed. If things don’t work out, they modify their thoughts and actions to get the outcomes they want. They don’t stop trying until they get the results they want. The only way to fail is to stop trying or to never try. The only person who fails is the one who quits.

Or, as more succinctly put by Napoleon Hill in Think and Grow Rich: ” A quitter never wins–and a winner never quits.”

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.