The Alchemy of Stock Market Performance - Total Returns to Shareholders

Total Returns to Shareholders

Decomposing total returns to shareholders (TSR) can give better insights into a company's true performance and in setting new targets.

The traditional method decomposes TRS into three parts:

1. percent change in earnings
2. percent change in P/E, and, 
3. dividend yield.

A clearer picture can be found from breaking TRS into four parts:

1. the value generated from revenue growth net of the capital required to grow
2. the growth in TRS that would have taken place without the measure in (1),
3. changes in shareholder's expectations about the company's performance as reflected in a measure such as P/E, and
4. the effect of leverage.

A good company and a good investment may not be the same.

Example:

Comparing the company and stock performance of Reckitt Benckiser Group (RB) and Henkel from 2008 to 2013

Revenue growth and ROIC:   RB outperformed Henkel in both

Annualised TRS:  RB 19% and Henkel 932%)

Explaination:  Henkel's low starting multiple in 2008 reflected difficulties with its adhesives business, which experienced significant declines in sales volume in 2008 and 2009.




Expectation treadmill

This is the name for a problem faced by high-performing managers who try to meet market expectations that result from the high level of performance in recent periods.

RB above, illustrates the reason that, in the short term, extraordinary managers may deliver only mediocre total returns to shareholders.

Lesson derived (for investors and managers):  A small decline in TRS in the short run to adjust expectations (P/E) may be preferable to desperately trying to maintain TRS through acquisitions and ill-advised ventures.



Summary:

For periods of 10 - 15 years or more, it is true that if managers focus on improving TRS to win performance bonuses, then their interests and the interests of shareholders should be aligned.

The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TRS performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ill-advised acquisitions or new ventures.

A company should measure management performance in terms of the company's performance, not its share price.

Three areas of focus should be its performance relative to its peers in its::

• growth,
• ROIC, and 
• TRS,

To Buy or Not to Buy: Quality first, then Potential Return at an Acceptable Risk.

To buy or not to buy - the bottom line is the potential reward and the amount of risk that you must accept to achieve it.

Always assuming you have done your due diligence concerning the quality issues, look to see if the hypothetical total return is sufficient to warrant adding the stock to your portfolio.  If the stock appears to be capable of doubling its value in five years, it's probably a good buy.

If you have been cautious enough in your estimates of earnings growth and future PEs, and if the potential reward is at least 3x the risk of loss, you'll have no qualms about buying the stock.



Use Your Common Sense

Investing is far from a precise science.

What you lose in accuracy because you are building one estimate upon another, you gain by being conservative in your estimates.

If you are careful to take the more cautious choice at every opportunity, you are rarely going to be disappointed at the outcome.

A small difference - a 1% difference in the risk would translate into only a small difference in the share price - is not enough to warrant waiting for the price to be just right.

If the price is more than just a little too high for the value parameters to satisfy you, however, you'll want to complete your study and wait for the price to come down to a more reasonable figure.



Summary:

1.  Always the Quality criteria must be met first
2.  Then look at the Total Return - this must be >15% per year.
3.  Only buy when the Risk is acceptable, that is, the potential reward must be at least 3x the risk of loss.
4.  Don't squabble over pennies when you are buying.

REMEMBER:  Prices can fluctuate by as much as 50% on either side of their averages during the course of the year; so you might be pleasantly surprised when a price you thought beyond hope just happens to materialize one day.

Total Returns vs Total Wealth vs Total Real Returns

Total Returns

Total returns means that all returns, such as interest and dividends and capital gains, are automatically reinvested in the asset and allowed to accumulate over time.

A graph depicting the total return indexes for stocks, long- and short-term bonds, gold, and commodities from 1802 through 2001, showed that the total return on equities dominates all other assets. Even the cataclysmic stock crash of 1929, which caused a generation of investors to shun stocks, appears as a mere blip in the stock return index. Bear markets, which so frighten investors, pale in the context of the upward thrust of total stock returns.

Total Returns vs Total Wealth

However, the total wealth in the stock market, or in the economy, does not accumulate as fast as the total return index. This is so because investors consume most of their dividends and capital gains, enjoying the fruits of their past saving.

It is rare for anyone to accumulate wealth for long periods of time without consuming part of his or her return.

• The longest period of time investors typically plan to hold assets without touching principal and income is when they are accumulating wealth in pension plans for their retirement or in insurance policies that are passed on to their heirs.
• Even those who bequeath fortunes untouched during their lifetimes must realize that these accumulations often are dissipate in the next generation.

The stock market has the power to turn a single dollar into millions by the forbearance of generations - but few will have the patience or desire to let this happen.

Total Returns vs Total Real Returns

The focus of every long-term investor should be growth of purchasing power - monetary wealth adjusted for the effect of inflation. The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0 percent per year after inflation in all major subperiods.

The wiggles on the stock return line represent the bull and bear markets that equities have suffered throughout history. The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to invetors when they occur, are insignificant when compared with the upward movement of equity values over time.

In contrast to the remarkable stability of stock returns, real returns on fixed-income assets have declined markedly over time. From 1802 to 1926, the annual real returns on bonds and bills, although less than those on equities, were significantly positive. However, since 1926, and especially since World War II, fixed-income assets have returned little after inflation.