Monday, June 29, 2015

What drives future investment returns?

There are several factors that drive future investment returns. The important drivers behind future returns on equity investments include:

1) Dividend Yield
2) Growth in Earnings Per Share
3) Change in valuation
4) Impact of reinvested dividends

As an investor, I try to take full advantage of those factors by focusing on:

1) Attractive Entry Price
2) Adequate growth in earnings
3) Dividend Safety
4) Strategic dividend reinvestment

While these are important drivers of future returns, it is equally important to keep as much of any returns as possible. In order to do that, investors need to be mindful of all costs. In order to reduce taxes, it is advisable to place as much shares as possible in a tax-deferred account such as a Roth IRA for example. In taxable accounts, it is advisable to refrain from too much trading, in order to let the power of tax-deferred capital gains on long-term holdings do its magic. The other way to keep costs low is by putting money in the lowest cost broker. In my situation, this is Interactive Brokers, which charges me 35 cents/investment. It feels like a steal.

Let's illustrate the concept with an example from the real life. For example, PepsiCo (PEP) sold at $52.20/share at the end of 2004. The company earned $2.41/share in 2004, and earned $2.39/share in 2005. Therefore, it sold at a trailing P/E ratio of 21.70. The quarterly dividend was increased to 23 cents/share in June 2004, up significantly from the previous rate of 16 cents/share. The stock yielded 1.76%.


Fast forward to the end of 2014, the stock closed at $94.56/share. The company earned $4.27/share in 2014, and is expected to earn $4.70/share in 2015. Therefore, the stock is selling at a trailing P/E ratio of 22.15 and a forward P/E ratio of 20.10. The quarterly dividend was increased to 65.50 cents/share in June 2014, up 15.40% from the previous rate of 56.75 cents/share. The stock yielded 2.77%.

Had the P/E ratio from 2004 remained constant at 21.70, the share price would have sold at $92.66/share, which is fairly close to what it actually sold for at the end of December 2014. The $1.90 difference to $94.56/share was due to expansion in the valuation multiple –aka increase in the P/E ratio.

The difference from $52.20/share to $92.66/share was driven by the increase in intrinsic value that arrived from growth in earnings per share. As you can see, an increase in earnings per share results in increase in the intrinsic value of the business.

An investor who put $52.20 at the end of 2004 would have purchased one share of PepsiCo. If they reinvested their dividends, they would have ended up with 1.2635 shares worth $119.48 by the end of 2014. Those shares would have been generating $3.31/share in annual dividend income, which is a cool 6.30% on the original cost.

Investment Growth
Intrinsic Value
 $ 92.66
Change in Valuation
 $ 94.56
 $  1.90
Reinv Dividends

This exercise does not take into effect taxes. If the investor purchased PepsiCo shares in a Roth IRA account, they would not have to pay any taxes on any gains or dividends. If our investor had purchased shares of PepsiCo in a taxable account however, they would have had to pay taxes on each dividend payment. In the accumulation phase of saving for retirement, taxes are a drag on your nest egg. Had our investor been paying a 15% tax on dividends, their $52.20 investment in 2004 would have grown to $117.79. The blow was softened by the low initial yield on PepsiCo. If our investor had their money in a company which pays a higher than average dividend like AT&T (T) or Verizon (VZ), they would have lost a greater proportion of wealth generation to taxes. If the investor had used a regular IRA or 401 (k) however, they would have been able to effectively purchase the shares at a 25% discount.

The actual valuation multiple applied by Mr Market would depend on the mood of participants, overall level of interest rates, expectations for further growth in the business, etc. As long-term business owners, our goal is to select quality companies selling at attractive prices, and then hold on to those quality companies for decades.

When I discuss quality companies, I am looking for a company with a dominant position in an industry without too much expected change. When changes occur slowly, the company will be able to adapt better. When you do not have a lot of changes, it is much easier to compound shareholder wealth. This is because the product you sell will not change much over time, which means you do not need to constantly invest money in re-tooling factories, spending heavily on new product promotions etc. Slow changes in industry allow reinvestment of profits at high rates of return, without the negative effects of technological or other disruptions. It is no wonder that consumer staples with their strong recognizable brand names, pricing power, and unique products have been able to compound earnings and dividends for decades. In PepsiCo’s case, when you sell the same type of product for decades, you end up earning a lot of money over time, as you reinvest profits at high rates of returns, which translates into earnings growth and the ability to generate more excess free cash flow every year.

Full Disclosure: Long PEP and VZ

Relevant Articles:

Taxable versus Tax-Deferred Accounts for Dividend Investing
Let dividends do the heavy lifting for your retirement
Rising Earnings – The Source of Future Dividend Growth
Will the dividend grow?
Reinvest Dividends Selectively

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