What to Expect from a Good Portfolio

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To draw reasonable long-term expectations for the market or a portfolio, one has to understand and assess the fundamental drivers of return. Total return comes from two sources: Sustainable return and revaluation.

Sustainable return is the fundamental growth of a business (i.e. revenue growth, profit growth, etc.), including the capital returned to shareholders by way of dividends/buybacks. This fundamental growth is ultimately driven by business quality, the main determinant of which is profitability: A profitable business can reinvest its profit to grow the business or distribute it to shareholders, both of which amount to sustainable return.

Revaluation is the change in the price of the business relative to its fundamental growth. This is driven by investor sentiment rather than the underlying business. While sentiment is highly unpredictable in the short term, positive revaluation over long periods of time generally occurs from periods of undue pessimism and vice versa.

The difference between total return and sustainable return over any period is revaluation – i.e. sentiment. Because sentiment tends to swing between optimism and pessimism, it is ultimately sustainable return which dictates the direction in which total return moves over long periods of time.

A good portfolio is one with superior sustainable return, preferably acquired at an attractive price – i.e. when sentiment towards the companies in that portfolio is weak.

With that in mind, consider the following real-world portfolios: Portfolio A (a good portfolio) & Portfolio B (an average portfolio):

IndexPortUSD

At first glance the above chart may seem a bit busy, but if we consider it one element at a time, it paints a very useful picture:

  1. The solid blue line represents the value of $1 invested in the sustainable return of Portfolio A 20 years ago until the end of June 2017, after inflation. Note that this line has grown more than 20x since 1997 – a fantastic history of shareholder value creation;
  2. The green line represents the real market value of Portfolio A over the same period – i.e. the total return. While the green line follows the blue line over time (i.e. total return follows sustainable return), it overshoots to the upside and downside as investor sentiment swings between optimism and pessimism. As per the earlier explanation, the difference between these two lines is sentiment;
  3. The dashed blue line shows our expectation for Portfolio A’s sustainable return over the next 7 years. This estimate is based on what we believe is a conservative combination of 3rd party analyst estimates and history;
  4. The solid dark grey line represents the sustainable return of Portfolio B, but rebased so that it ends at the same point as the solid blue line (for the purpose of making forward-looking comparisons). Note that the dark grey line starts at roughly $12, meaning one would’ve needed to invest 12x as much in the sustainable return of Portfolio B to end up at the same point as the blue line of Portfolio A;
  5.  The light grey line represents the real market value of Portfolio B, which has tracked the dark grey line over time;
  6. The dashed grey line shows our expectation of Portfolio B’s sustainable return over the next 7 years.

With an understanding of what this chart represents, we can draw some conclusions/inferences:

  1. Portfolio A has a vastly superior long-term track record of both sustainable return and total return relative to Portfolio B, not only in terms of growth, but also in terms of stability. There is a degree of survivorship bias in this (Portfolio A was selected by a process where one element of the quality analysis favours companies with a strong track record of sustainable return), but this bias is countered by a combination of conservatism (the forward looking sustainable return is roughly half of what it was historically) and forward-looking quality analysis/independent 3rd party estimates that have little to do with history. Our expectation is that Portfolio A will continue to deliver superior sustainable return over the next 7 years, as per the dashed blue line;
  2. Portfolio A is about as undervalued as it has ever been;
  3. Portfolio B has climbed significantly over the last year, but this return has been driven almost entirely by revaluation to a level last seen in 2000, despite an environment in which its sustainable return has stagnated. From this valuation it is likely that returns over the next 7 years will be disappointing for Portfolio B;
  4. While we believe that Portfolio A is significantly better than Portfolio B, it has nevertheless underperformed Portfolio B recently, even though its sustainable return has been better. This underperformance has been revaluation driven.

Clearly Portfolio A has been vastly superior vs Portfolio B over the last 20 years – any long-term investor in Portfolio A would be satisfied with the results. What is less obvious is that along the way to achieving these vastly superior results, the investor in Portfolio A frequently underperformed the investor in Portfolio B by significant amounts. Consider the following chart:

DDUSD

Each bar on this chart (including the blue) represents the most that Portfolio A has underperformed Portfolio B in total from a specific point in time. Where Portfolio A never dipped below Portfolio B from a specific starting point, there is no red bar (note that there aren’t too many empty spaces).

Example: Let’s assume we’d invested in Portfolio A in October 2005. By August 2006 (almost a year after our initial investment) Portfolio B would have returned 13.4% after inflation, while our Portfolio A would have returned only 3.3% – we’d have been 9% behind Portfolio B. This was the worst cumulative underperformance of Portfolio A vs Portfolio B from that starting point, which is what the blue bar in the above graph represents. Each red bar represents a similar calculation from a different starting point.

What is staggering is that despite outperforming Portfolio B significantly over any long-term period, Portfolio A has experienced cumulative drawdowns averaging -7% from nearly 70% (!) of all potential starting points. In some cases the cumulative underperformance was as much as 20%!

In the above examples Portfolio A is a static snapshot of the aggregate of all our clients’ portfolios as of 30 June 2017, excluding cash*. Portfolio B is the MSCI World Index, our benchmark.

* This snapshot doesn’t include stocks bought and sold in the past and is in no way representative of the historic performance of our clients’ portfolios, which a) haven’t been around for 20 years, and b) have changed over time.

Telling an investor to expect good long-term returns from a good portfolio is hardly ground-breaking analysis. Very few people, however, would expect the same portfolio to experience relative drawdowns averaging 7% from 70% of potential starting points, vs the benchmark index (i.e. an average portfolio). In reality, this is exactly what investors should expect from short-term returns!

What this analysis demonstrates is that short-term returns are driven almost entirely by sentiment and that they are random. Chasing short-term returns is an exercise in futility, yet this is exactly what many investors (including professionals) do.

Our goal is to achieve good returns over a 5 to 10 year investment horizon. As the first chart in this commentary demonstrates, we believe that we are well positioned to achieve this goal: We hold good quality stocks that are currently undervalued. Along the way to achieving our long-term goal we fully expect to experience periods of short-term underperformance. These two apparently conflicting expectations are entirely consistent with a good portfolio – this is one of the great paradoxes of equity investment.