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Not all returns are equal

During my recent European trip at a dinner with friends, someone asked me if the market was up that day. It’s a question I often get from anyone who knows that I’m an investment advisor and a stock-picker. I often disappoint them saying that I don’t know because I haven’t looked.

Are all up days or years in the stock market the same, though? From the outside, a gain of 10% of the entire stock market’s performance seems to be identical with a 10% increase in price, and thus good news for stockholders. In actual fact, not all 10% annual returns are equal.

How do we make money in stocks?

At Sicart, we like to keep things simple. There are three ways to make money in stocks: 1/ cheap stocks become expensive, 2/ small companies become big, and 3/ troubled companies recover. We usually define value investing as paying less than we believe a business is worth. Once the stock price reaches the price target we had in mind, a disciplined investor may feel compelled to sell, and look for another undervalued company. It is a bit of limiting approach, though, that rules out capturing the growth potential of a small company. That’s why, when pressured to label our style of investing, we like to say that we are value buyers, and growth holders. (Once we’ve bought a stock at a great price, why would we not hold it and benefit from the long-term expansion of the business?) The third way to make money – buying troubled companies that recover — overlaps the others as well. On the whole, we find that stocks are fairly valued or even overvalued most of the time, so to have an advantage, we need to see a major mispricing. Such a mispricing is usually most likely caused by some real or perceived trouble that a company is facing. In response to that, investors often panic, and the stock price drops to an attractive level.

What is a total return on investment?

ROI is a concept that may sound simple, but is not necessarily intuitive. If we buy a stock at $10, and it is at $20 after 5 years, we have an unrealized gain of $20 less $10: that is, $10. However, we will also have collected $0.50 per year (or $2.50) in 5 years of dividends. Thus, we have 100% appreciation in the stock, and another 25% return in dividends received. The total return is 125% over that 5-year period. The dividends are ours to keep, but the appreciation or unrealized gain is really a paper gain until we sell the stock and realize the gain. Thus, timing a sale is just as difficult a decision as buying the stock in the first place.

Not all returns are equal though…

We know that our stock price went up from $10 to $20, but that’s not the whole story. We’d like to know why this happened. Has the business grown? Has it recovered from some missteps?

If the stock was formerly trading at 10x earnings (meaning that we had to pay $10 for each dollar of earnings) and now trades at 20x earnings, that would indicate the first scenario: the stock has become more expensive. If the stock is still trading at 10x earnings, but earnings grew from $1 to $2, growth would usually be the cause. Finally, if the stock had depressed earnings of $0.50, and recovered to $2, it has likely recovered from some trouble. Notice how in the recovery case, the stock’s earnings multiple changed from $10 divided by $0.50 or 20x to $20 divided by $2 or 10x.

Ideally, in our stock purchases we’d like to capture all three of these improvements:  a stock that gets more expensive, that grows and benefits from a business recovery, and enjoys a cyclical upswing.

We don’t know though that the stock performance that came from a lasting growth and recovery in the business will likely endure, while if the stock has just gotten more expensive or captured a cyclical tailwind, the stock may not able to hold its gains in the long run…

Why does it matter?

Though as we are in the business of making money, we are first of all in the business of keeping it. Depending on when you buy a stock, you always run the risk of losing money. Let’s invert our three scenarios. If you buy an expensive stock, it may get cheaper as its prospects diminish. If you buy shares in a big company, it may shrink in size. If you buy a company that’s doing perfectly well, one big misstep could prompt a 50% drop or more. The history of the market is littered with such examples.

Hence, being contrarians, rather than buying the high-flying, pricey, hot stocks in the market, we seek out the struggling, lower-priced, stumbling ones. This approach has served us well over many years and many market cycles.

Today’s markets – lasting gains or not?

What gets everyone’s attention is when the stock market – at least the major indices that represent it — is up 10%, 20%, 30% for the year. Few investors stop to wonder about the cause. Is a cheap market getting expensive? Are the total earnings potential of businesses expanding?  Or is an economic recovery helping all companies?

Much as we enjoy celebrating gains in our investments, we always wonder if they are truly durable. There is nothing wrong with benefitting from investor enthusiasm and seeing your stock rise many times higher than you ever expected. But we must grasp that not all returns are equal, not all are lasting, and not all are deserved. If they aren’t, the unavoidable law of reversal to the mean will correct that over time.

Easy come easy go…

Unrealized gain is a paper gain that the market can quickly reclaim as investors lose their confidence, commitment, and excitement about a particular stock or the market as a whole. The first gains to evaporate are usually those that came from stocks going from cheap to very expensive. The price investors are willing to pay for each dollar of earnings fluctuates wildly over the decades. The S&P 500’s cyclically adjusted 10-year price-to-earnings ratio since the late 1800s has been as low as under 5x and as high as 45x, with 15-16 being both the average and median. Today we are at 33x, a touch higher than on Black Tuesday in 1929. The stock market gains of the last few years have been driven by an expansion in the earnings multiple.  Stocks went from cheap to expensive. The S&P 500 peaked in the 1500s in 2007, which is comparable to the dotcom bubble only 7 years earlier. Today, the index is approaching 2,900. How much of that almost 100% increase over the last market peak is deserved and durable is a multi-billion-dollar question that we ask ourselves as we remember that the first rule of making money is not losing it in the first place.

Happy Investing!

Bogumil Baranowski

Disclosure:

This article is not intended to be a client‐specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.