Investors face an abundance of choice when deciding which shares, ETFs and funds to include in a portfolio. Choice is a good thing but it can be overwhelming. Many investors turn to the experts for ideas. Responding to this the financial media follows a familiar formula:

  1. Find a fund manager
  2. Get a couple high level quotes on opportunities that he or she currently likes
  3. Add some fluff about how brilliant the fund manager is and some interesting personal hobbies that usually involve a $16,000 titanium bike or an extensive collection of first growth Bordeaux

No context is provided to these stock picks. We don’t know if they are a significant holding or an irrelevant percentage of the fund. Since this is a one time interview we have no idea when the position is sold. We don’t even know the real hypothesis of the fund manager because their view is generally expressed in a short quote. It is up to each of us to decide if this stock aligns to our investment strategy and do further research to validate the idea.

It is also confusing to dissect the brief rationale professional investors provide when recommending the purchase of a particular share. The rationale is often filled with jargon, confusing terminology, and financial metrics that many everyday investors may only narrowly grasp the meaning of.

I won’t speak for other people but when I was younger this ‘financial speak’ impressed me. I would read up on any terms I didn’t understand and as my knowledge grew I felt like I was getting the key to an exclusive club. I’m not impressed anymore. I think the smartest people are the ones that explain complex terms simply. Explaining things in a straightforward way shows confidence and humility.

But ‘financial speak’ is not going away. And every profession does it. I’ve come up with my own secret decoder. It allows me to place a stock pitch within a simple model based on where returns come from.

Where do returns come from?

Following commentary on the share market can be confusing. We are inundated with data, financial metrics, and esoteric approaches to finding shares to buy. Some investors swear that if you stare at charts long enough you can unlock the secrets of future share price movements.

This is not an article about the relative merits of different investment approaches. It is not about predicting which shares will do well and which won’t. It is simply looking at the three drivers of returns and applying them to examples of share picks from fund managers that often appear in the media.

The drivers of returns

The first is dividends. This one should be obvious. A dividend is cash in your pocket and an important component of returns. Dividends are a by product of earnings. You need to earn money to return it to shareholders. You need to grow earnings to grow dividends.

The second driver is changes in valuation. As a partial owner of a company a shareholder is interested in how much that company earns. If what we want as investors is earnings, we can view the price we pay for a share in relation to earnings. That is why there is so much commentary about the price to earnings or P/E ratio. That is how much an investor is willing to pay for earnings.

The amount an investor is willing to pay for earnings can change over time. If investors expect a company to grow earnings faster in the future it makes rational sense to pay more for current earnings. The contrast is true as well. If investors think the prospects for earnings growth are poor they will pay less for current earnings.

Sometimes what investors will pay for earnings are a result of a less than rational assessment of the prospects of a company. Investors can get overly excited and fall victim to greed. This is when bubbles form and individual shares and the market trade at higher valuations. Sometimes investors get irrationally fearful and valuation levels of certain shares and and the market get lower.

The third driver is earnings growth. If we are willing to pay 20 times earnings for a share earning $1 and are still willing to pay 20 times earnings when the company makes $2 the share price will double.

Those are the three places that returns come from. There is a myriad of reasons that factor into dividend levels, the valuation investors are willing to pay and earnings. But we can’t lose sight of the foundational drivers of returns.

Understanding the three factors that drive returns is not some magic formula that identifies which shares to buy and which to avoid. But it does inject some common sense when hearing a sales pitch for a share.

Going through examples is illustrative. I am writing this article on July 11th and took a look through some major financial publications to find commentary on attractive opportunities for investors. To be clear I am not saying that investors should follow any of these recommendations. And I’m not criticising them or saying they are wrong. I am simply trying to place the pitches within the context of where returns come from.

Example 1: Buy REITs

The AFR wrote an article titled “Macquarie says it’s time to buy real estate stocks before rate cuts”.

The article quotes a report put out by Macquire. Here is the rationale quoted in the article for Macquire’s view that the time is right to buy real estate investment trusts. And to be clear I have not read the report. I could probably get access to it but this exercise is for everyday investors that read the financial media and try and make decisions based on what they read.

And below is what I read in the AFR.

“With the [US Federal Reserve] expected to cut in September, we would look past the risk of an RBA hike, and are now overweight REITs,”

“We expected a hawkish shift from the RBA, and it has happened. With the shift to slowdown and global banks easing, there is reason to think the RBA will hold so as not to risk pushing the $A up too far.”

I think this is a good example to start with because we are dealing with all three of the factors that drive returns. A REIT (or real estate investment trust) owns real estate, rents it out and profits off the difference between the cost of maintaining and holding that real estate and the rents taken in. It is an intuitive business model.

To buy or build real estate is expensive. And many REITs use debt to fund the purchase or construction of property. The cost of that debt is impacted by interest rates. And Macquire is saying investors should ignore the talk of short-term RBA interest rate increases and focus on the fact that they will come down eventually. If interest rates come down it can be cheaper to service the debt. Lower costs mean more profits. Growing earnings is one of our factors of returns. We can check that box.

The valatuion of REITs are often correlated to the value of the real estate that they hold. It is an asset heavy business, and it makes sense that investors pay attention to the value of those assets. An investor in a REIT cares about changes in the value of the real estate holdings.

The reason a REIT spends lots of money and / or takes on debt to buy expensive real estate is because of the predictability and long-life of income that can be generated from renting it out. Valuation levels of any asset are based on the cash flows the asset can generate in the future. No sane person would pay the same amount of money for a building that could be rented out for two years at a $50,000 profit and one that could be rented out for twenty years at $100,000 profit per year. The cash flows impact the valuation.

If interest rates go down and it costs less to service debt, the proft on each building goes up. That increases future cash flows and the building is worth more. This is another factor in where returns come from – changes in valuation.

A REIT is a simple business model. Higher earnings for the overall REIT come from increased cash flows from the properties owned by the REIT. Properties with higher cash flows are worth more. That makes the valution go up. In this case an investor could get higher earnings and investors would likely to be willing to pay more for those earnings. That is a double win for investors.

Dividends are the third driver of returns. Dividends come from earnings and you need growing earnings to support higher dividends. But they are also a choice by management. Management does not have to increase dividends if earnings go up and they do not have to decrease dividends if earnings go down unless the drop is so profound it puts the dividend in jeopardy.

But a REIT is different. They are required to pay out 90% of earnings in dividends. In this case the board has less of choice. We’ve been through each of the drivers of returns. If Macquarie is right earnings will go up, dividends will increase and valuation levels will likely increase. That would be great for investors who buy REITs.

This exercise doesn’t mean Macquire is right or wrong. But it does give us a jumping off point for further research and to inject our own opinion into any decision we make. The first thing is to assess their call to look past the short-term interest rate environment. Think that through. Will the RBA cut rates anytime soon even if interest rates still go up this year? That is what you should ponder.

This is complicated. Macquire is essentially saying that no matter what happens in Australia the RBA will be forced to act because the Federal Reserve is going to cut interest rates which will put upward pressure on the Aussie dollar. To validate Macquire’s opinion you have to consider the following:

  • Will the Federal Reserve cut interest rates in September?
  • Will a cut in US interest rates push the Australian dollar up?
  • Will the RBA respond to a higher Australian dollar with a cut of interest rates no matter what is happening with the economy and inflation?

If you agree with Macquire’s logic you next have to decide if REITs will benefit from this environment and which REITs will benefit the most from lower interest rates. That will likely take an analysis of the propotion of debt on each property that is fixed rate (and for how long) and floating rate. You can’t stop there. It is one thing to benefit from lower rates but the REIT still needs to make revenue. You need to analyse factors that may impact occupancy rates.

I assume in the actual report Macquire spells a lot of this out for us but since most people reading the AFR don’t have access to the report a potential investor will have dive into the details of each REITs financial statements. The alternative is to buy an ETF that holds lots of REITs. As John Bogle said why search for a needle in a haystack when you can buy the haystack.

Example 2: Buy global consumer staples shares

My next example is also from the AFR in an article published on July 1st titled “GQG slashes tech exposure, here’s where it’s buying next”. I’m going to focus on the ‘buying next’ part.

The article has several quotes from GQG’s Brian Kersmanc. Brian was described in the article as the protégé of “star stockpicker Rajiv Jain”. I like this part. I’ve never had a protégé. I’m imaging the AFR called Rajiv but he was busy riding his titanium bike and he told the reporter to speak to his protégé. I hope one day to ask someone to speak to my protégé.

Back to the good stuff. Brian said the following:

“We’re seeing staples stocks trading at 52-week lows because they had a multiple de-rating, falling from around 29 times earnings as people realised they didn’t want to pay a premium for safety because a recession wasn’t happening,”

This is a good example of how financial jargon evolves. People didn’t use to say “de-rating”. Probably because it isn’t a word. You can tell something is jargon if you can’t use it in any other setting. Nobody is sitting around the pub tell their mate they are putting a bet on because the Rabbitohs line was excessively de-rated. Anyway, what Brian is saying is that shares have fallen in price because the valuation levels went down and they are now at their low for the last year.

A company can earn the same amount of money and pay the same dividends but if investors decide to pay less for those earnngs the share price will drop. Sometimes this happens because investors expect growth in the future to be slower. Sometimes it happens because investors are trying to position their portfolio based on what they expect to happen in the economy.

That is what Brian is saying happened. Nothing has really changed about the prospects of the companies but investors have just collectively been willing to pay less for their earnings. And he gave the reason. Investors didn’t want to “pay a premum for safety because a recession wasn’t happening.”

To understand Brian’s statement we need to know a little bit about different types of companies. Companies in the consumer staple sector sell staples to consumers. And I’m not trying to be cute here. A staple is something you need no matter what is happening with the economy.

Companies that sell staples are thought to be safe because they can continue to sell their products in any economic environment. This contrasts with companes that do well when the economy is soaring and poorly when it isn’t. Those are cyclical companies. When the economy does poorly some investors will rotate into safe companies because they know their earnings won’t be impacted much be worsening conditions.

Brian continues:

“Now these companies are priced more attractively, with their multiples in the mid-teens, and so a basket of these stocks looks like they’re at some of the lowest premiums to the market that we’ve seen in a very long time.”

Brian’s hypothesis is focused on a single driver of returns. These companies have gotten too cheap. He mentioned a recession but that was in reference to overall investor expectations changing from thinking a recession is imminent to the view that we will avoid one. Brian isn’t making any predicton about the economy. He is just saying that investors have done something they do countless times. Overshooting the appropriate response to changing views of the economic environment. We see this all the time. When times are good investors get too optimistic. When times are bad investors get too pessimistic.

Brian didn’t say it, but I think his expectation is that since valuations are so low they will naturally go up even without a catalyst. This is a much easier opinion to do further research on since he has isolated his call to one factor and isn’t offering any sort of marcoeconomic directional call.

GQG is a global equity fund. I would do a quick check of global consumer staple shares and see how much valuation levels have fallen. Then you need to start going through a list and doing research. Even though Brian is only focused on valuation levels something going wrong with one of the other two drivers could derail an investment in an individual share. The valuation level isn’t going to go up if you pick the wrong company and earnings drop or the dividend is cut.

My take on both of these prediction

There is a difference in the way I invest and how many fund managers invest. Most fund managers are more short-term focused despite their pleas to the contrary. This largely isn’t their fault as they are responding to the manic reaction from investors if there is any short-term shortfall in performance. The managers don’t want assets to flow out of their funds so they can’t afford to underperform significantly over even a short period.

I am a long-term investor and don’t care if my portfolio underperforms at different times. As an income investor focused on dividend paying companies I know that in tmes of investor euphoria I will underperform as investors chase growth.

In some ways both of these calls are similar. Both Macquarie and GQG think that investors are too focused on short-term factors and that eventually there will be a rotation back into ‘safer’ shares. Since both REITs and consumer staples generally pay healthy dividends these are the types of investments I favour.

I don’t play the rotation game. This means that I don’t rotate my portfolio based on my view or the consensus view of economic activity or interest rate moves. There are several reasons for this. The first is that I don’t think I have any competitive advantage in predicting what the economy will do or what central banks will do.

I also don’t generally listen to the consensus view because it is normally wrong. If you need evidence of that look at the last couple years. Inflation was going to be transitory. Interest rates were going to be cut in late 2023. Then early 2024. Now apparently, they are going up in Australia. We were going to have a recession. Now we aren’t.

Not only do you have to be right about market reactions to a particular change in the economic environment, but you also have to get the timing right to beat other investors who are also rotating their portfolios. This is very hard. That is why fund managers get generiously paid when they are good. This comes in handy when stocking a wine cellar.

The other reason that I don’t rotate my portfolio is because it is short-term investing with all the requisite poor tax outcomes and transaction costs. But that doesn’t mean this analysis is worthless for me. I want to hold shares for the long-term but I also want to buy them at attractive prices. Changing market conditions can provide this opportunity.

I tend to gravitate to consumer stamples shares and the second article is catalyst for me to do some more research. And that is the value of hearing what professional investors think. They spend a lot more time monitoring markets than the average investor. It is their job afterall. Their insights can be valuable for everyday investors like you and me. Just make sure you understand what they are saying and how their view will impact the drivers of returns. And of course…do your own research.

I hope this exploration was helpful. Please email me at mark.lamonica1@morningstar.com if you have any thoughts or want to volunteer as my protégé.

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