Where Do Investment Returns Come From? Understanding the 3 Key Drivers
Where do investment returns come from? I had an interesting conversation about an investment with a friend. Through the conversation it became clear that they were not aware where their potential investment returns were coming from. It’s a simple question but what’s driving investment returns?
Investment Return irregardless of asset class (e.g. bonds, stocks, real estate) are generated from:
Return of Cash
Growth
Multiple Expansion
That’s it! It’s these 3 items that drive all investment returns, regardless if it's a bond, stocks, real estate, your small business, or a multinational company. The investment return is the product of the rate of return of each of these 3 items. In the context of this article we will be talking about stocks (i.e. common equity of companies). It’s important to understand when you make an investment where your potential returns are coming from. You want to go into an investment with eyes wide open!
Return of Cash
Return of cash are actions where cash is returned to the shareholder/owner of the asset. These can include dividends, share repurchases, distributions etc... In the context of a bond, it would simply be the interest distribution you would receive. This is the simplest concept to understand and most people instinctively understand it. Dividends and distributions are something investors can see and hold. Buybacks are less obvious but are the same as dividends and are generally more tax efficient than dividends for investors. Buybacks increase your proportional overall ownership of the business.
Let's create a company called ColdBerry Industries. ColdBerry Industries trades at $100 per share, has earnings of $10 per share, and ROC of 40%. The company has no extra cash and no debt on its balance sheet. ColdBerry Industries is returning $4 per share in dividends and $3 per share in buybacks per annum. The return of cash to investors would be 7% per annum.
It boils down to what the shareholder actually receives out of the asset, not what is retained by the asset. You should ask, how much cash is being returned to shareholders? How much net stock is being bought back? How much is being paid via dividends? Is the cash being returned coming from income or debt?
Growth
Growth, as the name suggests, is the asset growing (or shrinking) its per share earning power (i.e. this is important to account for dilutive actions). This encompasses all the earnings the asset retains, use of debt and equity, and the subsequent (or lack of) growth in per share earning power.
The higher the return on capital (ROC) a business can achieve the better the returns will be for the investor. A company that can achieve extremely high rates of returns on capital only needs to invest a small amount of cash to achieve high growth rates. The opposite is also true, a company with a low ROC needs to invest a large amount of cash to achieve low growth rates.
Let continue the ColdBerry Industries example above. ColdBerry Industries returns $7 per share to investors every year leaving $3 per share to be retained by the company. The company reinvest those earnings back into the business at a ROC of 40%. This would achieve a growth rate of 12% or $1.20 increase in per share earnings.
It's important to always look at the growth in per share earning power. There are many companies that will issue equity to grow the business or acquire a business only for the overall earnings power of the business to grow, but per share earnings power remains flat or even shrinks. Companies will extol the benefits of said growth or acquisition, but who benefits? Usually it’s not the shareholders but managers whose empire grows ever larger. If the business grows but your share of said business shrinks you are not the beneficiary.
Multiple Expansion
Multiple Expansion is the change in valuation from the purchase price to the eventual sale price (or current price). All companies and assets are valued at some kind of valuation (or multiple). If the multiple changes (i.e. expands or contracts) the value of the company or asset changes.
Continuing the ColdBerry Industries example, in 5 years the market is valuing the company at 20x earnings instead of 10x. The valuation or multiple has doubled and is now twice as expensive. Some may chalk this up to their exquisite investing acumen but chances are it was just dumb luck. The annualized rate of return for the multiple expansions is nearly 15%! If the reverse happened and the multiple went from 10x to 5x, the rate of return would be nearly -13% annualized.
Multiples can change for a variety of reasons but primarily revolve around changing investor sentiment. A multiple may increase due to positive sentiment about future growth prospects. Or a multiple may contract in the face of an existential threat to the company.
Certainly, some assets' earnings are worth more than others but it is speculative to try to predict the change in multiples to drive your returns. If you buy assets cheap enough and the multiple re-rates higher, that’s great, but it is not guaranteed or even warranted. What is even more interesting, multiples can contract. Pay a too high price and you may see your investment returns evaporate!
Bringing It Together
Investment returns irregardless of asset class (e.g. bonds, stocks, real estate) are generated from return of cash, growth, and multiple expansion. Finishing the ColdBerry Industries example we have:
Return of Cash - 7%
Growth - 12%
Multiple Expansion - 15%
An investor's annualized rate of return would be nearly 20% excluding multiple expansion. When including multiple expansions we get nearly 38% annualized rate of return.
Depending on investment style investors gravitate towards different criteria. Growth investors will almost always prioritize growth. Momentum investors are usually focusing on multiple expansions. While traditional value investors tend to prioritize return of cash.
What we focus on is what we can know and control. We can reasonably know the businesses we are investing in; the quality of the business and management, the industry, and the competitive forces in the business and industry. What we cannot know is what someone else will be willing to pay for the business or asset in the future. So long as we buy a business or asset cheap enough, return of cash and growth will drive your investment returns. If you buy a good business cheap enough and the market realizes a few years down the line and re-rates the business that’s great!
Investment Returns are derived solely from return of cash, growth in earnings power, and multiple expansions. With this mental framework you can look at any investment to know where your returns will come from.
ColdBerry Capital is a global value investment fund whose investment philosophy is inspired by Warren Buffett and Charlie Munger. To find out more you can contact us here.
Disclaimer
This article is for educational purposes only and is not a recommendation. This article and other articles we write are our own opinions and thoughts. The article expressed above contains forward-looking statements and is intended for informational purposes. It is not a recommendation to buy, sell, hold, or otherwise trade the securities of the referenced issuer.
