LONG TERM INVESTING—My North Star
First up this post is about LT investing not speculating or trading. Secondly, as I have stated before, my share portfolio is significant in terms of my net wealth and by far represents my largest asset. The upshot of this is that I must get it right and that means being aware of where I sit on the risk/return spectrum. IMO that means focusing on quality growth names as they can offer the best LT returns if acquired well. Since it is a lull before results season, I thought I would look at long-term returns for a group of quality /growth stocks and compare them to a bunch of what I call go-nowhere stocks, being those stocks that in the LT return around their cost of capital. Is my North Star worthwhile?
Thirdly, if I had the data, time and computer firepower I would do an extensive quant-style study but I don’t, so in this case I have taken a big shortcut but have no incentive to doctor the numbers, far from it.
What I have done I pick a dozen stocks that (sort of) sit comfortably in each group. Then look at SP returns over 10 years. Look at the RoE’s and come to some conclusions. Then I comment on issues with the sample and what can go wrong with the execution.
For the stocks I chose for each sample, I tried to spread the sectoral concentration. Secondly, I also tried to exclude the huge winners or losers in each category. Each stock must have been listed for 10 years or very close.
For the quality growth stocks I choose, CSL, RMD, ALL, TNE, CAR, REA, JHX, DMP, CHC, BRG, AUB, and JBH. I left out the exciting WAAX stocks, WTC, XRO, ALU and also PME. The reason for this is that I think 10 years ago these companies would not have had the record to be quality growth but were on their way there, so inclusion would have biased the results too much. I could have gone mad in health but only included two and tried to spread the rest across various sectors. This was done not to bias the sample. The average Roe for this group is 26% (range 12-35%) but that is a hodge podge of varying duration but includes at least the last 5 years for all.
For the “go nowhere” stocks I again tried to spread the sector selection but found a lot of finance and property so tried to cap them. Secondly, I did not include some of the big disasters such as HLS, SGR, IFL and AMP. The stocks I decided on are all institutional-grade holdings and would be a part of many insto portfolios especially 10 years ago. Those stocks are, WBC, ANZ, SUN, SGP, ABC, BAP, GUD, ORG, ORI, PPT, IPL and LLC. I have been kind including BAP, since it was mainly regarded as a growth stock for much of the last 10 years and its inclusion notably assists returns. The ROE for this group is about 7% but probably around 8% if the Org losses are excluded. 8% puts them right around the usual cost of capital. The range was 5-11%, quite tight.
For each group, I then indexed the 10-year share prices and made an equally weighted index of each, growth and go nowhere. The two charts are below.
Over the 10 years, the growth stocks returned 15% pa before dividends and the “go nowhere” stocks returned 1%. Adding approximate dividends of 1% for growth and 4% for “go nowhere” brings them slightly closer but not much. The usual cycle in economics is regarded as 5 years but I have doubled this to reduce macro noise on these results, such as the big move up and then down post-C19 in growth stocks
What are we looking at here?
To me, this speaks to the difference between growth and value investing. Both are valuation-based but quite different. The LT value of the stock is equity*spread above cost of capital*change in equity deployed. In other words, real value comes from adding assets that return above the cost of capital. For companies that return the cost of capital, book value is their LT valuation, it doesn’t matter what assets they add or subtract, if they don’t change the returns no value is added. That is seen by grouping the stocks and looking at the long term. Generating returns from these styles of stocks is then reliant on buying at a discount to book or attempting to trade the cyclical trends that push earnings above CoC. The big returns are made when you can successfully pick a cost of capital returner that sustainably moves to a positive spread type of business. They do occur but rarely and usually entail a changed business. Value investing is based on the company doing stuff it has done before whereas in growth investing the company must do something extra, and keep compounding.
For growth stocks, the valuation is based on accurately assessing the spread over the cost of capital and the growth in equity. In other words, how much (volume) and at what rates (spread) can the company deploy capital? That is a bit more complicated than value investing.
Usually, a reasonable guess can be made at spread and growth scenarios and with an appropriate margin of safety when buying these stocks a pleasing return can be generated at relatively low risk.
What can go wrong?
The critical assumptions here are knowing what drives the positive spread above the cost of capital and how large the opportunity is for these stocks. The world is a dynamic place and sustainable advantages can disappear and the result can be frightful for returns of growth stocks. An example was A2 milk. A2 was a growth company that had built a reasonably long record of attractive returns, so could be regarded as a quality growth stock. What was probably not appreciated by the market was that despite a lot of theories for how its returns were made, in hindsight, they were based on a low-cost distribution model with the help of some good branding that produced great returns. When that low-cost model disappeared so did A2’s differentiation. Either its spread or growth or both were now threatened. I am not trying to get into a discussion on the ins and outs of A2 but to point out that all business models have an Achilles heel and knowing that, or discovering it quickly, is very important in growth investing as you are usually paying up.
In summary, this short study is an affirmation that the theory does measure up over the long term and evens out over a bunch of stocks. The real message to me is the investing approach for “no growth” and growth stocks are quite different, but knowing your companies in detail, especially their weaknesses is critical. Let the compounding take place but have an idea of what is driving it and a broad idea of what it is worth.
Hope that is of interest to some.
disc I hold 9/12 high roe, none of the low roe at this stage.