Where do company and market returns come from? After all, cutting to the heart of the matter, returns on the the assets in our portfolios – ideally, positive ones – are the whole reason we are investing in the first place. That being so, it is surprising how unexamined the question of just what makes up the returns we have seen from our investments tends to be – not to mention what we may reasonably expect from them in the future.
It is, however, something that has been occupying the mind of Jake Taylor, who recently made a second appearance on The Value Perspective podcast. The versatile Taylor is not only CEO of value manager Farnam Street Investments but also co-host of the ‘Value: After Hours’ podcast and author of novel The Rebel Allocator, whose plot he enticingly likens to “The Karate Kid but where Mr Miyagi is Warren Buffett”.
Making clear from the start that he is leaning heavily on the number-crunching of Semper Augustus Investments Group chief investment officer Chris Bloomstran, Taylor runs through the five individual components of a company or market return – simplifying matters by asking us to imagine the 500 businesses that comprise benchmark US index the S&P500 are rolled up into a single entity.
“What is the total change in sales at the top line?” he lists. “What is the change in margin? What is the change in the share count – as it were, the number of ‘claim tickets’ chasing the ownership of this business? What is the change in the multiple – which is really a factor of sentiment? And then the dividend yield – you know, what was paid out to the owners?”
Looking at the annualised returns generated by the S&P500 over the 10 years to 31 December 2021, then, Taylor notes: “Sales grew by 3.1% a year, which sort of jives with our notion of GDP growing at 3%, while an expansion in margins contributed 4%. And share count reduced over the decade – in other words, a lot of buybacks occurred – to give seven-tenths of a percent attribution to return.
“On top of that, the multiple expanded to contribute 6.4%. That is a huge number – like, the 6%-ish range is pretty much the entirety of the return you would normally expect from the ownership of a business, right? And then dividend yield was 2.4%, which is about where it lives most of the time. And when we add all those together, we end up with a 16.6% annualised return over a 10-year period, which is absolutely phenomenal.”
That of course begs the question as to what the next decade could look like. “We know the number for the last 10 years – can we do it again?” asks Taylor. “That is what I have been trying to answer in my last two quarterly client letters and, at the risk of spoiling the punchline to the April one, if the returns are not going to come from, say, top-line growth or multiple expansion, what other ways to win might we be looking for?
“Now, everyone could come up with their own numbers but what I felt comfortable underwriting for the next 10 years is, for sales growth, let’s call it 3% again – so it kind of stays with GDP. Margin is a tough one – Jeremy Grantham describes that as one of the most mean-reverting data-sets in finance while Warren Buffett has said only a fool would believe profit margins for corporate America can be much more than 6%.
“And yet they have been above 6% for a long time – currently they are at 13% – so either Buffett has lost it or we should expect some mean-reversion here, whether from inflation or deglobalisation or one of many other reasons corporate America may not be as profitable as it has been – but I am fading that by 3% contribution. I am open to arguments against 3% but, over the next 10 years, margin will be lower for sure.
“As for share count, which was a contributor in the last decade, I would probably put it flat for the next 10 years. All those buybacks that lowered the share count in the last 10 years involved a lot of leverage so I would not be surprised if, at some point, companies actually had to issue equity for survival – as we saw in 2008. So let’s just put that as a wash at zero and let’s put yield at the typical 2% it has always lived around.”
Turning to valuation and a price/earnings multiple, Taylor argues there is no good metric when it comes to timing an investment. “Whether it is market cap-to-GDP or CAPE or Tobin’s Q, all valuation metrics stink for timing,” he says. “They do not tell you anything although they do all sort of rhyme and suggest the same thing – that markets are pretty expensive, even with the corrections we have seen so far.
“So I am fading that multiple – even if that does not get us all the way back to any long-run average. Still, let’s say it is a 4% reduction – I mean, we saw 6.5% for 10 years on the way up so is it not possible we might see 4% in the other direction for the next 10 years, just to get back to normal? Then you add all that up and you end up with minus 2% annualised, which is almost minus 20% total over a 10-year period.”
Taylor acknowledges such a prospect could prove shocking to a lot of investors but, as we point out ourselves on the podcast, the S&P500 has not needed 10 years to drop by a fifth – it has essentially managed that feat in the space of the last seven or eight months. “Sure,” Taylor laughs hollowly. “Who knew that, around three months from me writing all this, we would see all of that number?
“I guess the question now is – are we done? Or is there more pain before we can get to the next bull market? That is a great question but one I do not have a lot of good answers for.” Where he does have some good answers, however, is how analysing these different components of return can inform investors’ thinking and help them to make better decisions on where to set their money to work.
“I just wrote up a case study of a company that was able to do well – even without a lot of top-line growth or multiple expansion,” says Taylor. “Both of those – big top line, big multiple change – are hallmarks of a bull market so, if we are not going to have them for the next 10 years, what are some other ways we can win? And, in my case study, this particular company grew at a 6% annualised growth rate from 2005 to 2021.
Capital allocation firehose
“Profit margins hovered around 17% to 20% – so reasonable, if nothing spectacular – but the big thing was the share count dropped from 80 million to 23 million shares, which is a 7.5% CAGR [compound annual growth rate] reduction in the share count. In fact, the company spent $22bn – about 85% of its cashflow from operations – basically pointing the capital allocation firehose at buying back shares.
“Now, buying back shares is not an unalloyed good – it has to be done at the right price. Otherwise, value is basically walking out the door. But this business was blessed with a relatively low EV-to-EBIT [enterprise value/earnings before income and tax] multiple for most of that time period so, on average, it was retiring shares at about 11x to 12x EV-to-EBIT – pretty cheap, then.
“And naturally, if you did not sell back to the company – if you held on for that entire period – you ended up with a 20% CAGR over that time period, which ended up being like a 2,100% return. You absolutely crushed it for almost 20 years. Of course, it is a lot easier said than done, right? The first four years of that time period, the stock went nowhere – it was maybe an 8% cumulative return– so you looked like a bozo.
“And, at the same time, there were multiple 30% drawdowns and lots of just dead doldrums where nothing was happening. Yet, behind the scenes, the company was growing a little bit; the margins stayed steady; it was retiring share count like a beast; and, in the end, lots of accretion was happening under the surface. You just had to be patient and ride it out.
“My takeaway here is, if you are not going to see huge top-line growth or multiple expansion for the next 10 years, how can you win in a down-market? And the answer is – find a steady, boring, reasonably profitable business that has good capital allocation and is retiring shares when it is cheap to do so. That way, you wake up every morning hoping to see the price is down because that means they are buying back at a lower valuation, which is even better for you as a remaining shareholder. Certainly, if markets are not going to be giving you this big tailwind, it is one pattern you might be looking for as a way to win over the next decade.”
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