An Investing Metaphor

I don’t know how productive this will be to anyone’s understanding of investment, but I personally found the following to be a very simple and helpful thought experiment:

Generally speaking, I believe most investors would benefit dramatically from viewing their investments in the belief that their ownership is completely illiquid and that the only source of returns will be dividends. Owners therefore would only generate returns from the receipt of dividends accruing from operating cash flows or from the liquidation of assets. In this thought experiment, the market price with all its fluctuation will be forgotten, and any terminal sale will also be forgotten- they will consider themselves owners until complete liquidation leading to dissolution. You can simplify further and imagine a Coinstar type machine whereby you insert cash and receive coins on an annual basis in an amount which may be stable, rapidly increasing, rapidly declining, or anything in between, with essentially infinite options.

For simplicity, we will assume market cap is always equal to enterprise value and that earnings are indicative of distributable cash flows. This will make things quite a bit easier, as there will be no need to differentiate between net income and the various cash flows you generally need to assess to estimate the equivalent of owner earnings. The discounting of the future to the present will also be ignored. All investments in this scenario cost $100 but deliver differing earnings results.

Returns would therefore be equal to net income / price paid, whether the net income was distributed as a dividend or not, as all net income is potentially distributable.

Clearly we can see that by owning a no-growth company that generates $10 in net income on an investment of $100, one would receive returns of 10% per year in perpetuity. If net income is growing, then returns will be higher- if net income is declining, then returns will be lower than 10%. Very simple- and I believe there is significant value in keeping things simple.

We can see that ignoring the time value of money, it is possible to achieve better returns by purchasing a lower-yielding company that is growing at a higher rate. For example, if one purchases company A for $100 producing $5 a year for a current return of 5%, but which will grow at 20% over the next 10 years, you will do better in total than the investor who owns no-growth company B which also costs $100 but produces $10 forever for a current return of 10%. By year 5, company A will produce $12 a year, and by year 10 it will produce $31 a year. It should be clear that company A should be more attractive to the investor (whether you call yourself a “value” investor or not), as you are receiving much more in future earnings relative to what you are paying.

You can also see that the lower the current yield, the quicker the company must grow, and it must do so for longer and longer periods of time to achieve at minimum average results.

There will be some typical “value” picks which will produce $30 forever on a purchase of $100, and of course the investor would achieve 30% perpetual returns. For every one of those however, there will be many more which currently produce $30 but in 5 or 10 years will produce maybe $10, $5, or $0.

There will be others which have no earnings, but assets valuable enough to eventually deliver high liquidating dividends. So the investor may receive $0 in the first 5 years, then $300 at the end of the sixth year, for a $33 or 33% annual profit, again, excluding the time value of money.

This framework hopefully helps explain both the expectations and potential returns embedded in the prices of investments.

Using the numbers from a current example of a popular stock shed some light on the potential future returns and growth required to achieve favorable returns for a private owner who has no interest in ever selling.

Company G grows at a high rate but also produces a disproportionately low current return. It has a price of $100 and current net income of $0.31. As of right now, a private owner is achieving 1/3 of 1% in annual return. To get a 10% annual return, net income will eventually have to rise to $10. This means that until net income reaches $10, the private owner will obviously achieve returns below 10%. Let’s say that the owner is very patient, and will wait 10 years to achieve a 10% annual return. This means that net income will have to grow at around 41% a year for a decade, and once net income finally hits $10, the owner will then achieve average returns similar to those of the investor who purchased the no-growth firm B producing a perpetual 10% a year. To get total annual returns above 10%, the net income of company G will have to keep growing at a similarly high rate for years after the 10th, given that the investor has received returns far below average in the first 10.

As can easily be seen, the investor in company G needs extraordinary growth for a decade and will at that point be achieving market-average returns. The investor in company G is basically counting on at least 15+ years of constant high-rate growth to best the market. This is a very generous base case given that we are excluding the time value of money, which would discount each year by 10%, as that is the market average and the investor’s cost of capital here.

When prices are embedded with magnificent expectations of future growth, the investor must assess and essentially predict the future, then the company must outperform those expectations to achieve above-average returns. This is why delivering long-run outperformance by purchasing great and popular companies is so difficult. One must: 1. Properly assess the very-long term, in many cases 1-2 decades in the future 2. Purchase these companies at prices at which they will outperform expectations unless if you would like sub-average returns.

Meanwhile, if you purchase the 30% perpetual yielder, you can analyze the present and think about the probability of things remaining as they currently are. If there is no cause for things to rapidly change, and if they do remain constant, the investor will do very well- and they are receiving the cash flows immediately, instead of years from now. Again, in reality the timing of the cash flows will create an enormous difference, because as the high-growing firm needs to compound at 41% a year, a good investor will discount those earnings by 10% a year which will cut an enormous amount from the future yield on those earnings and therefore the present value of the company. Not to mention the fact that in reality many fast-growers are issuing shares and diluting owners, taking on debt, and generating negative cash flows to equity which all need to be accounted for.

With some tinkering with discount rates, you can quickly see that with a 10% annual discount rate, every $1 of earnings in year 10 discounted to the present will be worth only about 38% of earnings in year 1, or about $0.38. This means that it is much, much easier to achieve the equivalent of a 10% return per year in the present if the company is achieving a 10% yield in year 1. This gives the companies generating large earnings relative to price in year 1 a very big advantage, both in potential returns and in ease of choice/estimation for the vast majority of investors.