Tag Archives: investing

The Two Sides Of Total Investment Return

By Quan Hoang I spend about 10-15% of my time crunching data. That sounds tedious but I actually enjoy this task. It forces me to pay attention to details, checking any irregularity I see in the numbers and trying to tell a story out of the numbers. My recent work on Commerce Bancshares (NASDAQ: CBSH ) led me to ponder the relationship between ROIC and long-term return. Over the last 25 years, Commerce Bancshares averaged about a 13-14% after-tax ROE, and grew deposits by about 5.6% annually. Over the period, share count declined by about 1.9% annually, and dividend yield was about 2-2.5%. Assuming no change in multiple, a shareholder who bought and held Commerce throughout the period would receive a total return of about 9.5-10%, which is lower than its ROE. Why is that? Chuck Akre once talked about this topic: ” Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at (what) the average return on all classes of assets are and then I (discovered) that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that? Audience A: Reinvestment of earnings. Audience B: GDP plus inflation. Audience C: Growing population. Audience D: GDP plus inflation plus dividend yield. Audience E: Wealth creation. Audience F: Continuity of business. Akre: …what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that (the) return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.” The restriction in Akre’s explanation is ” absent any distributions. ” In general, there are two sides of total return: the management side, and the investor side. Management can affect total return through ROIC, reinvestment, and acquisitions. Investors can affect total return through the price they pay and the return they can achieve on cash distributions. The Problem of Free Cash Flow Reinvestment into the business usually has the highest return (this post discusses only high quality businesses that have high ROIC). Problems arise when there’s free cash flow. Management must choose either to return cash to shareholders or to invest the cash themselves. Both options tend to have lower return than ROIC. Cash distributions don’t seem to give investors a great return. Stocks often trade above 10x earnings so distributions give lower than 10% yield. In my example, Commerce Bancshares wasn’t able to reinvest all of its earnings. It retained about 40% of earnings to support 5.6% growth and returned 60% of earnings in the form of dividends and share buyback. The stock usually trades at about a 15x P/E, which is equivalent to a 6.67% yield. The retained earnings had good return, but the cash distributions had low underlying yield. The average return was just about 10%. Unfortunately, many times returning cash to shareholders is the best choice. Hoarding cash without a true plan on using it destroys value. Expanding into an unrelated business for the sake of fully reinvesting doesn’t make sense. Similarly, acquisitions often don’t create a good return. The problem with acquisitions is that they’re usually made at a premium so the underlying yield is likely lower than the yield that would result from share buybacks. The lower underlying yield can be offset by either sales growth or cost synergies. Studies show that assumptions about cost synergies are quite reliable while sales growth usually fails to justify the acquisition premium. To illustrate this point,let’s take a look at 3 of the biggest marketing services providers: WPP, Omnicom, and Publicis. Omnicom is a cautious acquirer. It spends less and makes smaller acquisitions than peers. Its average acquisition size is about $25 million. Over the last 10 years, Omnicom spent only 16% of its cash flow in acquisitions while WPP and Publicis spent about 44% of their cash flow in acquisitions. Publicis is a stupid acquirer. It makes big acquisitions and usually pays 14-17x EBITDA. WPP is a smart acquirer. Like Omnicom, it prefers small acquisitions. When it did make big acquisitions, it paid a low P/S and took advantage of cost synergies. For example, it paid $1.75 billion or a 1.2x P/S ratio for Grey Global in 2005. That was a fair price as WPP was able to integrate Grey and achieve WPP’s normal EBIT margin of about 14%. To compare value creation of these companies over the last 15 years, I looked at return on retained earnings, a measure of how much intrinsic value per share growth created by each percent of retained earnings. As these advertising companies have stable margins, sales per share is a good measure of intrinsic value. Retained earnings in this case is cash used for acquisitions and share buyback, but not for dividends. As expected, Publicis created the least value: It’s interesting that the smart acquirer WPP didn’t create more value than Omnicom. That’s understandable because acquisitions aren’t always available at good prices. So, it’s very difficult for management to generate a great return on free cash flow. Therefore, the value of a high-ROIC business is limited by the capacity to reinvest organically. Free cash flow tends to drag down total return to low double-digit or single-digit return. The Investor Side of Total Return It’s very difficult to make a high-teen return by simply relying on management. The capacity to reinvest will dissipate over time and free cash flow will drag total return down to single digit. However, there are two ways investors can improve total return. First, investors can shrewdly invest cash distributions. When looking at capital allocation, I usually calculate the weighted average return. For example, if a company invests 1/3 of earnings in organic growth with 20% ROIC and 1/3 in acquisitions with 7% return on investment, and returns 1/3 to shareholders, how much is the total return? It depends on how well shareholders reinvest the money. If we shareholders can reinvest our dividends for a 15% return, the weighted average return is 20% * 1/3 + 7% * 1/3 + 15% * 1/3 = 14%. This number approximates the rate at which we and the management “together” can grow earnings (actually if payout rate is high, combined earnings growth will over time converge to our investment return on cash distributions.) Second, an investor can buy stocks at a low multiple. The benefit of buying at a low multiple is two-fold. It can help improve yield of earnings on the initial purchase price. It also creates chance of capital gains from selling at a higher multiple in the future. Warren Buffett managed to make 20% annual return for decades because he was able to buy great businesses at great prices and then profitably reinvest cash flow of these businesses. Small investors can mimic Buffett’s strategy as long as the stock they buy distributes all excess cash. They can reinvest dividends for a great return. In the case of share buybacks, they can take and reinvest the cash distribution by selling their shares proportionately to their ownership. That’s how Artal Group monetizes Weight Watchers (NYSE: WTW ). Share Repurchase at Whatever Price This discussion leads us to the topic of share repurchases. I think many investors overestimate the importance of share buyback timing. It’s nice if management buys back shares at 10x P/E instead of 20x P/E. But what if share prices are high for several years? Would investors want management to wait for years – effectively hoarding cash – to buy back stock at a low price? Good share buyback timing can help build a good record of EPS growth but EPS growth doesn’t tell everything about value creation. It’s just one side of total return. What investors do with cash distributions is as important. So, I think management should focus more on running and making wise investments in the business and care less about how to return excess cash. I would prefer them to repurchase shares at whatever price. By doing so, management effectively shares with investors some of the responsibilities to maximize total return. Share buyback gives investors more options. Investors must automatically pay tax on dividends but they can delay paying tax by not selling any shares at all. If they want to get some dividends, they can sell some shares and pay tax only on the capital gain from selling these shares instead of on the whole amount of dividends. Or they can simply sell all their shares and put all the proceeds into better investments if they think the stock is expensive. Conclusion I do not believe in buying a good business at a fair price. If the management does the right things, holding a good business at a fair price can give us 10% long-term return. But great investment returns require a good job of capital allocation on the investor’s part: buying at good prices and reinvesting cash distributions wisely.

Simple Investing Strategies Cannot Remain Entirely Simple For Long

By Rob Bennett Simple investing strategies are sound investing strategies. The key to success is sticking with a strategy long enough for it to pay off. Complex strategies cause investors to lose focus. Unfocused investors have a hard time sticking with their strategies through dramatic changes in circumstances. The greatest virtue of Buy-and-Hold is its simplicity. However, Buy-and-Hold purists take the desire for simplicity too far. Buy-and-Holders have told me that one big reason why the strategy was not changed following Robert Shiller’s “revolutionary” (his word) finding that valuations affect long-term returns is that it would complicate it to add a requirement that investors adjust their stock allocations in response to big valuation shifts in an effort to keep their risk profiles roughly constant. If that’s so, they made a terrible mistake. Buy-and-Hold does not call for allocation adjustments to be made in response to valuation shifts because the research showing the need for them did not exist at the time the Buy-and-Hiold strategy was being developed. Once the strategy was set up in the way that it was, changing allocations came to be seen as a complication. Isn’t it more simple to stick with one allocation at all times? I don’t think so. Buy-and-Hold seemed simple in the days when we did not realize how much the long-term value proposition of stocks is altered by the valuation level that applies at the time the purchase is made. We now know that the investor who fails to make allocation adjustments is thereby permitting his risk profile to swing wildly about as valuations move from low levels to moderate levels to high levels. In the long term, there is more complexity in a strategy that calls for wild risk profile shifts than in one that requires the investor to check valuation levels once per year and to change his stock allocation once every ten years or so. That’s all that is required for investors seeking to keep their risk profiles roughly stable. That extra one hour or so of work performed every decade reduces the risk of stock investing by 70 percent and saves the investor a lot of emotional angst during price crashes. It is the losses suffered in price crashes that cause investors to abandon Buy-and-Hold strategies (at the worst possible time!). Devoting an additional one hour of work to the investing project renders price crashes virtually painless for investors following the updated Buy-and-Hold approach (Valuation-Informed Indexing). It’s not only engaging in transactions that adds complexity. Figuring out how to respond when large losses of accumulated wealth are experienced is a huge complication, one that Buy-and-Holders did not consider when devising the first-draft version of the strategy. There are other ways in which Buy-and-Hold has become more complicated over the years. In the early days, there were few types of index funds available. Investors were generally advised to go with a Total Stock Market Index Fund. That’s still a good choice. But today’s investor has dozens of options available to him. He can invest only in small caps or only in mid caps or only in large caps or can mix or match in all sorts of ways. Traditionalist Buy-and-Holders often express dismay at the number of choices available, bemoaning the added complexity that comes with added options. I am sympathetic to those feelings. The core Buy-and-Hold idea – that it is by keeping it simple that investors avoid falling into emotional traps and confusions – is an idea of great power. Purchasing a Total Stock Market Index Fund still makes a great deal of sense for the typical, average investor. But I don’t believe that dogmatism on this question is justified. It adds only a limited amount of complexity for an investor to focus on small caps or large caps or mid caps. And some investors find appeal in focusing their investing dollars in the ways that new types of index funds permit. Some investors don’t feel safe investing in anything other than large caps. Some like the excitement of small caps and would be inclined to try to pick individual stocks rather than to index if investing in a Total Stock Market Index Fund were the only available option. In relative terms, an investor who purchases a large cap index fund or a small cap index fund or a mid cap index fund might thereby be avoiding more complex options that would draw him in if he were to try to follow a purist path. And of course many investors like to invest in different segments of the market. Investing in a high-tech index fund is riskier than investing in a broad index fund. But it is less risky than investing in any one high-tech company. Buy-and-Hold dogmatics would argue that only the investor who chooses a broad index fund is a true Buy-and-Holder. My take is that the success of the Buy-and-Hold strategy inevitably created demand for a greater variety of investing options and that there is no way to keep the Buy-and-Hold concept from becoming a bit more complicated over time. Another big change since the early days of Buy-and-Hold is that many investors no longer limit themselves to broad U.S. indexes but seek participation in the global marketplace. That makes sense, doesn’t it? Our economy is gradually becoming a global economy. There are numerous complexities that come into play as the transition proceeds. The U.S. has long had a stable economic system. So going global adds risk. However, that might be true only historically and not on a going-forward basis. It might be that the risky thing on a going-forward basis is to continue to invest solely in the U.S. market. The Buy-and-Hold Pioneers did not anticipate having to make decisions re such questions. They thought they had solved the complexity problems once and for all. These questions just turned up as time passed. The full reality is that they always do! Simple investing strategies cannot remain entirely simple for long. Valuation-Informed Indexing will become more complex over time too. We have 145 years of U.S. stock market data available to us today to determine when valuations have changed enough to require an allocation adjustment and how big a allocation adjustment is required. As more years of data are recorded, our understanding of what sorts of allocation adjustments are either needed or desired will become sharpened and refined. That’s good. We want to have as much historical data available to us for guiding our allocation shifts as possible. But it cannot be denied that the decision-making process will become somewhat more complex as more considerations are taken into account. That’s just the way of the world. Humankind’s understanding of the world about it improves over time and those improvements undermine our ability to keep things simple. Simple is good. But a purist stance is not realistic in the fast-changing (because it is fast improving!) world in which we live today.

Using Momentum And Hedge Funds To Build A Better Portfolio

Welles Wilder revolutionized the investment world in 1978 when he developed the Relative Strength Indicator (“RSI”). RSI was one of several new technical indicators that helped individual investors move away from static “60/40” or “70/30” stock/bond asset allocations as trading commissions plummeted in the wake of discount brokerages displacing more expensive “full-service” offerings. Now, nearly forty years later, Berkeley Square Capital Management has a new take on RSI – and the traditional “70/30” allocation. The firm combines the two concepts, while adjusting RSI from a short-term indicator based on the past 14 days to a longer-term momentum indicator based on the past 12 months , and also adding hedge funds to the allocation mix – “50/30/20.” What’s more, Berkeley Square’s momentum strategy differentiates between the best and worst sectors within each asset class, taking advantage of reduced commission charges by rebalancing its portfolios as frequently as warranted to maximize risk-adjusted returns. Sector Breakdowns Rather than allocating 50% to the S&P 500, 30% to the Barclays Aggregate, and 20% to the HFRI Hedge Fund-Weighted Composite (“FWC”), Berkeley Square breaks each of the broad indices down into its composite sectors, and then assigns RSI rankings to each. The top five sectors from each asset class are then weighted to comprise the total “50/30/20” portfolio. Among equities, Berkeley Square looks at the S&P 500’s ten composite sectors: Energy Materials Industrials Consumer discretionary Consumer staples Health care Financials Information technology Telecommunications Utilities For fixed-income, Berkeley Square looks at the following Barclays Total Return indices: S. Corporate Investment Grade Intermediate Corporate Long U.S. Corporate S. MBS GNMA S. Long Credit S. Aggregate Government/ Credit And for hedge funds, the following HFRI strategy style indices are considered: ED: Merger Arbitrage EH: Equity Market Neutral EH: Short Bias Emerging Markets (Total) Equity Hedge (Total) Event-Driven (Total) Fund of Funds Composite Macro (Total) Frequency of Rebalancing The frequency of portfolio rebalancing should always be scaled to maximize risk-adjusted returns. According to Berkeley Square’s findings, equity holdings are best rebalanced monthly, which has historically yielded a return per unit of risk of 0.76 – compared to risk-adjusted returns of 0.56 for annual rebalancing, 0.59 for semi-annual, and 0.66 for quarterly. By contrast, bond holdings perform best when rebalanced annually, and hedge-fund holdings when rebalanced quarterly. Independent Returns Adding hedge funds to the asset allocation has slightly improved returns, historically, but more greatly improved risk-adjusted returns. As Modern Portfolio Theorist Harry Markowitz said, “Expected return is a desirable thing and variance of a return is an undesirable thing” – so rational investors should prefer more stable returns to more volatile returns, all other things being equal. From 1991 through 2014, the S&P 500 Total Return Index generated compound annualized returns of 10.18%, compared to the HFRI FWC’s 10.81%. But the S&P’s annualized standard deviation of 18.39% yielded a return per risk unit of 0.55, while the HFRI FWC’s much lower 12.11% annualized standard deviation yielded a 0.89 return per unit of risk. The Barclays Aggregate Index of bonds, by contrast, yielded much lower annualized returns of 6.39%, but with even lower annualized volatility of 4.97%, its return per unit of risk was the highest at 1.29. Putting it all Together What’s important, of course, is how the three asset classes act together, within a single portfolio: According to Berkeley Square’s research, the “50/30/20” portfolio – even without rebalancing – outperformed “70/30” with annualized returns of 9.58% from 1991 through 2014, compared to the “70/30” portfolio’s returns of 9.48% over that same time. More importantly, “50/30/20” outperformed on a risk-adjusted basis, with a return per unit of risk of 0.85 compared to the “70/30” portfolio’s 0.72. But what about when Berkeley Square’s dynamic reallocation system was followed? In this case, the “50/30/20” portfolio’s annualized returns were boosted to 10.92% with return per unit of risk of 1.16, besting even the long-only S&P 500 Total Return Index’s 10.18% returns, and with much less volatility. For more information, download a pdf copy of the white paper . Jason Seagraves contributed to this article.