When patience doesn’t pay

Last quarter we wrote about active share and how our portfolios are very different from the index. The strength (both relative and absolute) that we saw in September continued through the end of the year, as our portfolios rose 13.1% in aggregate during the last quarter, bringing our total net USD return for 2019 to 23.5%, while holding roughly 15% in cash.

If in the previous quarter we were reminded of the importance of active share, then this quarter we were reminded of something equally important: Equity returns don’t come smoothly! As of end-August our year-to-date return was only 3.5%.

It’s very easy to lose patience with a stock, an investment strategy or even the whole stock market when returns don’t quickly materialize. So how do we counter this? Is it simply a matter of being patient in every instance? Turns out there’s more to it than that.

Lesson #1: Patience doesn’t pay when you invest in a bad business.

Let’s consider a tale of two stocks – Johnson & Johnson (JNJ) and Ford – two American heavyweights. Between 2002 and 2012, JNJ’s share price changed by… 0%. A decade of no real return. The same was true for Ford. Since 2012 JNJ’s share price has more than doubled, while Ford’s has languished for almost another decade. Following those 10 years of no return, how could an investor distinguish between these two companies? The answer is to break down those returns into their components: Sustainable return and revaluation. Sustainable return is a persistent source of return, while revaluation tends to cancel itself out over long periods of time.

Between 2002 and 2012, JNJ’s real sustainable return was 165%, while its valuation had dropped 60%. Ford on the other hand had delivered negative sustainable return, and its valuation had more than doubled over the same period. To an investor looking back at 10 year total returns in 2012, these two stocks would have looked the same. To an investor looking at sustainable returns and valuations, these two stocks couldn’t have been more different. JNJ is a high quality business with a proven track record of profitability and a healthy balance sheet, both of which drive strong sustainable return. Ford has always been the opposite.

Lesson #2: Patience doesn’t pay when you overpay, even for a good business.

So now we know we must invest in good businesses. But 10 years is a very long time to earn nothing from a good business like JNJ. So how can we avoid waiting 10 years to earn a positive return? Don’t overpay! In 2002, JNJ was on a 32x PE ratio. In 2012 it was 13.7x. Once you’ve determined that something is a good business, you still need to pay a good price for it to ensure good returns.

There are countless examples of high quality businesses that have delivered fantastic sustainable returns since 2000, but have only recently reached breakeven for their investors that were paying ridiculous prices during the tech bubble. It took 15 years for Microsoft investors (who paid 70x PE in 2000) to breakeven, despite the business delivering 430% real sustainable return over the same period.

Interestingly, Ford has traded on a single-digit PE for most of the last 20 years. Valuation on its own isn’t enough – you still need to buy a good business – remember lesson #1.


But what about the medium term? In 2010, JNJ traded on a 14x PE. It was cheap, it was a good business, but two years later it had delivered no return. This is when patience is required. This is when patience pays.


How can we apply these lessons today?

So let’s come back to 2020 and see how things are set up: The US stock market continues to make new highs. Over the last 10 years the S&P 500 has returned 256%. Why not simply buy the S&P 500 today and be patient?

If we adjust for the abnormally low margins of 2009/10 the S&P 500 traded at a PE of 13.5x a decade ago, vs 22x today. Roughly half of the total return of the last decade has come from revaluation from historical lows to the highest PE since the tech bubble – a non-persistent source of return. If valuations revert to anything near their long-term averages, and sustainable returns remain roughly the same for the next decade, this implies low-single-digit real returns from the S&P 500. Furthermore, these returns aren’t likely to come smoothly! Don’t expect the last decade to repeat itself. Remember lesson #2.

We’re far more comfortable holding a globally diversified portfolio of high quality businesses trading at historically low valuations, with 95% active share relative to the global benchmark index.

Investment Case: Apple

We sold out of our position in Apple in the 4th quarter of 2019. We bought most of our shares in 2016 between $90 and $120 for a total return of roughly 140% in just over 3 years. While Apple has been a phenomenal investment for us, and it remains an excellent business by our estimation, we think the valuation has raced ahead of the underlying business fundamentals.

In this Investment Case post we put Apple through our process and demonstrate why we bought in 2016, and why we sold at the end of 2019.1

The Causality of Return

While many investments are made on the basis of predictions, narratives, or statistical correlations, our process is based on the causality of return, which is defined by the following mathematical identity:

Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation

This identity forms the foundation of our investment philosophy and process, so we’ve written about it on several occasions here, here, here and here.

Sustainable Return

The iPhone has been one of the most successful and profitable consumer products in history. Over the last 20 years Apple has delivered real sustainable returns of >20% p.a. driven primarily by rapid growth in revenues, but as the company has matured sustainable return has become less growth oriented and increasingly driven by return of capital to shareholders.

This form of sustainable return is constrained by a combination of profitability and valuation. At current prices Apple yields 1%, but repurchases about 5% of their shares each year. We think it is unlikely that Apple will be able to sustain this rate of share buybacks for very long at the current price.

Our future expectations for overall sustainable return are ~9% in real terms – still very healthy.

In 2016 we had a slightly more conservative sustainable return assumption at ~8%, owing mostly to lower Growth assumptions.


Since we’re measuring Sustainable Return in terms of revenues, we need to do the same with Revaluation. To this end we need to determine a “fair” Price/Sales ratio and compare it to the current multiple.

Price/Sales = Net Margin x Price/Earnings

According to Bloomberg, analysts expect Apple’s net margins to be around 19%. We think this is a reasonable base-case assumption.

Apple currently trades at 27x earnings, a high multiple that requires healthy growth to be justified. Over the last decade Apple’s median PE has been 15.5x, though we’re happy to work on an exit PE of 18.5x as reasonable.

18.5 PE x 19% Margin = 3.5 Price/Sales which is 34% below Apple’s current 5.3x revenue multiple. If we annualize this over 7 years, our Revaluation assumption becomes -6.4% p.a.2

In 2016 our fair Price/Sales estimate was 3.1x, primarily owing to a more conservative exit PE multiple. This compared favourably to the prevailing multiple of 2.4x at the time, implying Revaluation of +3.8% p.a. annualized over 7 years.

Total Return

The following graph shows how Apple’s Sustainable Return (blue) and Total Return (green) have developed over time. The dotted blue line shows where Sustainable Return would go at a rate 9% p.a. (real) for 7 years:

The yellow circle indicates where we originally bought Apple, while the red indicates where we sold.

Total Return = Sustainable Return + Revaluation

In 2016, our conservative Total Return expectation was 8% + 3.8% = 11.8% p.a. in real terms (~14% p.a. in nominal USD terms).

Actual Sustainable Return was slightly higher than our expectations (9.5% p.a. vs 8% in real terms). Revaluation, on the other hand, completely overshot, as is often the case since valuations are so volatile and unpredictable in the short-term. This provided us with an opportunity to earn what we would have been satisfied to earn over 7 years, in just more than 3.

Today, our base-case Total Return expectation is 9% – 6.4% = 2.6% p.a. in real terms (~4.8% p.a. in nominal USD terms).

Good Quality

Apple remains a high quality business. It is consistently profitable, and though it has raised some debt in recent years it still has very strong financials and cash flows.

Profitability is a most important driver of sustainable return over time – it determines the trajectory. A profit can be returned to shareholders in the form of Yield or reinvested in the business for organic per-share Growth. Yield and Growth are the two constituents of Sustainable Return. Absent consistent profits, few businesses can deliver high Sustainable Return over long periods of time. No problems here for Apple.

Financial Strength is the second most important driver of Sustainable Return over time. It doesn’t say much about the trajectory, but it says a lot about the riskiness of the business and the probability of a sudden, steep decline in Sustainable Return should the business run into financial difficulty.

Apple has raised $100bn in debt since 2012 when it had none. This represents <10% of the market cap of Apple and doesn’t present much risk at this stage.

What is more of an issue is that the valuation of Apple at 27x earnings places a constraint on the sustainability of Apple’s share repurchase program. Apple’s balance sheet will come under pressure if buybacks continue at a rate of 5% p.a. at these valuations. This wasn’t an issue in 2016 when the stock traded at 12x PE. This means less Sustainable Return potential from Yield.

Probabilities vs Possibilities

In 2016 Apple traded on a 12x PE. It subsequently returned 140%, well beyond our expectations and trades on a PE of 27x. This valuation is expensive in absolute terms and relative to Apple’s own history. This valuation also constrains Apple’s ability to generate Sustainable Return through return of capital to shareholders, making future returns heavily dependent on Growth.

While higher returns are obviously possible for Apple, we believe our inputs to be a reasonable base-case. Anything is possible, and there is a range of likely outcomes rather than one specific outcome set in stone. But investors should be concerned with probabilities, not possibilities. In the case of Apple, the probabilities favour low returns over the next 5 to 10 years.

As always, the way to think about this is not to try and predict the future for this one stock, but to ask whether you would invest in a portfolio of 50 stocks with the same preconditions. If the answer is no for the 50, it should be no for the one too.


1 Note that this is just a high-level overview of a more thorough analysis.

2 Technically, Return = Growth + Yield + Revaluation x (1 + Growth), but since the Growth interaction with the Revaluation term is usually quite small, we just group it into Revaluation for the sake of simplicity. Our calculations always factor this interaction in though.