In terms of a somewhat succint summary, it is good to think in terms of trade-offs in the full picture. The expected returns formula I use really summarizes things neatly, and makes you think about how changes in the different variables impact overall results over a given time period.
The expected returns formula is a function of:
1. Dividends
2. Earnings Per Share Growth
3. Changes in valuation
I am using this additional step in the exercise, because quite often I see folks whose whole analysis stems from looking at a price chart and making up their mind from it. This is dangerous in my opinion, because you need to understand the context and reasons of why what happened happened. And from them to determine if it can happen further in the future, or not. All probabilistically speaking of course.
One needs to look at these three items together, rather than in isolation, when it comes to understanding where returns come from.
But in general, the first two items, dividends and earnings per share growth are the fundamental sources of returns. Over long periods of time, of at least 10 - 20 years, these items generate the lions portion of returns. The percentage increases the further out in time you go.
The last time, change in valuation, is part of the speculative returns. This can ebb and flow wildly in the short run, from month to month, year to year and even 5 - 10 years. Changes in valuation can push down returns or really accelerate returns in the short-run, but those are very hard to predict. The longer your timeframe however, the lower the importance of the changes in valuation on returns. Unless of course you really really overpaid at the start - think investing at 100 times earnings in Nikkei in 1989 or buying tech stocks at 100 times earnings in 1999.
As a long-term investor, I focus on fundamental returns (dividends and earnings). I do try to ensure I am not overpaying for a security. Other than that, valuation is a range that is accepted or not. My goal is to find a good company I can hold for decades first. Valuation is important, but in reality it only affects a portion of my returns.
For example, if I invest in a stock it does matter if I pay 15 or 25 times earnings for it in the first decade of ownership. After all, if growth in earnings per share is the same under each scenario, you are better off buying at 15 times earnings. Buying low also means obtaining a higher starting yield today. In an ideal world, you would buy low, then be able to reinvest dividends at a higher yield, and then ultimately the stock price would be revalued higher. This is how many of the greatest investors have done it.
However, you do not always have the option of either buying low or buying high. In many cases, you may have to "buy high" because you may also miss out on buying at all. There is an opportunity cost associated with waiting for too long for the perfect set-up that never comes.
After all, the real wealth for a long-term investor is not if you bought at 15 or 25 times earnings, but identifying a company that can grow those earnings at a steady clip over time, and pay a growing dividends along the way. It took me a long while to realize this lesson.
I really love this chart from the late Jack Bogle, which illustrated the interplay between the sources of return on S&P 500 between 1946 and 2015. It really puts things in perspective.
This type of thought process works on individual companies, indices and other assets such as bonds for example.
I have posted several articles in the past, discussing the sources of investment returns, and applying the concepts to real-world situations. You can read and enjoy below:
