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Consistent Profitability

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.

Diversification – A Balancing Act

Diversification is quite simply the spreading of one’s investment across a range of assets, the goal being to reduce investment risk. Contrary to popular belief, diversification is a balancing act rather than a free lunch.

To understand our approach to diversification, one first has to understand what drives investment return:

return

The goal of investment is to earn a good return. Return = Yield + Capital Appreciation (what you receive in dividends plus the change in share price). Capital Appreciation = Growth + Revaluation, i.e. the fundamental growth of the business (measured in terms of revenue, profit, book value, etc.) and the change in the share price relative to the fundamental value of the business. Therefor Return = Yield + Growth + Revaluation. This is a mathematical identity that always has to be true. Yield and Growth are driven by business fundamentals – a good business can pay dividends and grow its revenues and profits year after year. This is a sustainable source of return, and is driven by business quality: Quality -> Sustainable Return = Yield + Growth. Revaluation on the other hand is driven by investor sentiment. As investor sentiment swings between optimism and pessimism, so the share price of a company relative to its fundamental value also swings. While investor sentiment tends to cancel itself out over very long periods of time, it is still a very significant driver of return over 5 – 10 year periods.

In a nutshell, the causality of return is business quality and price paid. To earn a good return over the long-term, we must invest in high quality businesses at attractive prices – nothing less, and nothing more.

So where does diversification come into this?

Unfortunately even the best quality businesses can fail (though they are far less likely to do so than inferior businesses) because of unpredictable events beyond their control: Natural disaster, fraud, expropriation, war, economic depression, etc. Alternatively, a once great business can deteriorate if it fails to remain competitive and adapt over time.

Fortunately, as often as things can go wrong, or businesses can disappoint, so too things can go right and businesses can exceed expectations. A company can be the subject of a buyout at a large premium, or can have a run of success beyond all expectations.

In contrast with the predictable direct causality that Quality and Price have on return, these positive and negative surprises are highly unpredictable. This means that in a completely undiversified portfolio, success or failure may have more to do with luck and randomness than quality or price. In a diversified portfolio, these surprises are more likely to cancel out to a degree, meaning that the outcome is more likely to be a result of quality and price – the things that a good investment process should focus on.

Rather than allowing luck to have an undue influence on our portfolios, we prefer to minimize the role of randomness and maximize the role of our investment process over time through a reasonable degree of diversification. The goal is to diversify away as many sources of randomness as possible (i.e. geography, industry, company, currency, etc.) without diversifying away the causality of superior long-term return (i.e. high quality at an attractive price). The second part of that last sentence is critically important and often forgotten. The best portfolio is probably one where the only common thread is quality and price. When this balance is not possible, it usually isn’t worth pursuing diversification at the expense of expected return.

All too often investors diversify so extensively, without any consideration for quality or price, that the long-term expected return of a portfolio declines rapidly as the two fundamental causes of superior return are diversified away completely. Sadly, this is the approach taken by many investment advisors: They neglect the fundamental causes of superior return by spreading their clients’ investments across a wide range of costly strategies in the pursuit of diversification, only to end up with an expensive index tracker. This is certainly not our approach.

It is worth noting that insofar as achieving healthy diversification whilst maintaining expected return is concerned, it is better to have a broad investment universe rather than a narrow one. While 25 – 40 stocks might sound like a lot, a portfolio of 40 stocks from an investment universe of 5 000 + stocks listed across the globe is likely to be far superior (better diversified, with a higher expected return) when compared to a more concentrated portfolio selected from a narrower universe of stocks. This is why we take a global view: We can achieve wide diversification, but still only invest in the top 1% of companies ranked by quality and price.