Return = Yield + Growth + Revaluation = Sustainable Return + Revaluation
This understanding of return is central to our investment philosophy and process. We’ve written about this on numerous occasions. Those who have followed our writing will recall that revaluation, though dominant in the short-term, tends to cancel itself out over long periods of time.
The result is that over very long periods of time, Return ≈ Sustainable Return.
This makes sustainable return incredibly important as it is the underlying fundamental source of value creation to all investors in aggregate. Businesses with low or negative sustainable returns might deliver high returns at times when revaluation is strong, but because this isn’t a persistent source of return, these businesses ultimately fail to create value for their shareholders over time.
Revaluation acts as a transfer of wealth between investors, rather than wealth generated by the business itself. This doesn’t mean that revaluation isn’t worth pursuing, but because of its unpredictability it makes sense to own strong businesses that are likely to generate high sustainable returns, and to approach revaluation more opportunistically over and above this.
What causes high sustainable return?
So, what causes sustainable return to be better for some companies than others? The most important factor is profitability. If a business makes a profit it can reinvest it in the business to drive growth, or it can return it to shareholders as yield. Since Sustainable Return = Yield + Growth, it stands to reason that the base rates for sustainable return of consistently profitable businesses should be superior.
To demonstrate the fundamental relationship, we calculated the annualized sustainable returns of nearly 1 200 of the largest US-listed companies with at least 10 years of financial data history (as of June 2018), and categorized them by consistency of profits:
The base rates for those that were profitable 10 years out of 10 were significantly higher, whether measured in terms of earnings, sales or book value. Less consistent profitability was associated with lower annualized sustainable return, as we would expect from the causal relationship.
While this is quite a simplistic way of assessing profitability (because it doesn’t account for capital employed, cash flow, leverage or cyclicality), it nevertheless demonstrates just how powerful consistent profitability is in driving the base rates for long-term sustainable returns.