John Bogle has a great formula for describing total investment returns:
Total Return = Dividend Yield + Investment Return + Speculative Return
He defined investment returns as earnings growth/contraction plus dividend yield and speculative returns as the increase/decrease in the respective stock’s P/E ratio. The first two (DY+IR) are direct actions taken or achieved by your investment. The third (SR) is driven purely by the whims of the market. This combination of all three drive both the short and long term returns of your investment portfolio.
To put it in the context of Benjamin Graham’s eponymous phrase, the speculative return is the voting machine while the dividend yield and earnings growth is the weighing machine. Or put in our boxer’s parlance, one happens in the ring and the other outside of it.
We strongly believe our investment selection process that focuses on companies with little/no debt, high free cash flow, high capital returns and deep competitive moats will – over the long term – assure our investment returns. Theoretically, purchasing our investment at a discount to fair value will mitigate risk in the speculative return.
All of this seems quite reasonable until we recognize that a vast majority of our short-term returns and a substantial part of our long-term returns are directly linked to Bogle’s speculative returns. John Maynard Keynes wrote, “In one of the greatest investment markets in the world, namely New York, the influence of speculation is enormous. It is rare for an American to ‘invest for income,’ and he will not readily purchase an investment except in the hope of capital appreciation. This is only another way of saying that he is attaching his hopes to a favorable change in the conventional basis of valuation, i.e., that he is a speculator.” Things have changed very little since Keynes penned these words in the throes of the Great Depression.
At Nintai we keep a close watch on both investment returns and speculative returns within our individual holdings and how that impacts the portfolio in total. As seen below, since 2005 over half of our returns have come from speculative returns – meaning over 50% of the returns of the Nintai portfolio have come from P/E expansion rather than dividend rates or earnings growth.
Much like a state of equilibrium in physics, this simply cannot go on in perpetuity. Over the next decade we would expect to see overall returns decrease in scope as P/E ratios return to a more normalized level. As the Nintai portfolio’s average P/E is roughly 28% below the S&P500, we would expect this correction to affect the portfolio significantly less than the general markets thereby leading to outperformance in the long term. We believe the financial strength of our portfolio holdings – in combination with lower P/E ratios – provides us significant protection in the case of a market correction similar to 2000 or 2008/2009.
[An "ideal" stock might have all three components. A decent dividend. Earnings growth. And a stock out of favor which would swing back to favor (multiple expansion). AAPL used to fit the latter two criteria. Now it fits the first two criteria.]