Reader Question: The Source of Stock Market Returns

by JT McGee

I got a reader question about this sentence:

There are really only three limits to stock performance: the PE ratio, the potential size of the firm in the future, or the return on the businesses’ retained earnings.

It’s from an article on misguided management, but it’s probably the most important thing to understand about investing.

Where Stock Market Returns Come From

I think the confusion about stock market returns comes from the number of people who seek to paint broadly where stock returns come from. I’ve seen statistics about the relative importance of dividends, share repurchases, and simple stock appreciation. I think they miss the forest for the trees.

Here’s what I was trying to say in the article: stock returns have three limits. How much you can make from any given company is the lowest of these three limits:

  1. How big the company can ultimately become. This is most important for businesses that require very little capital. One example is MasterCard (MA), which is a cash cow and requires little to no capital expenditures to grow. MasterCard is driven by its network. It can use an existing network twice and earn more than twice as much without building out some factory to produce twice as much earnings. Thus, how big it can grow is more important than what it gets on its capital investment, since there are little to no capital investments to be made.
  2. The return on retained earnings, or returns on capital. This is most important for businesses that require huge amounts of capital expenditures. Think railroads or utilities which require that the company build and replace railways or electricity generation facilities to stay in business. If to make $60 more each year you need to put up $1,000 then you’re not going to grow your company very quickly.
  3. The price to earnings ratio. The third point is most important to businesses that also fall into businesses that require significant capital investments and/or working capital. Occasionally you can get these businesses cheap. Think of a business that carries $100 million in inventory, sells it once per year, and makes $5 million in after-tax profits. If you pay a PE multiple of 5 for the company, you would only pay $25 million for it. That would be one forth of book value, assuming it carried no debt. You would earn $5 million on a $25 million purchase price for a 20% return each year.

Start with the end!

You have to start with the end in mind to see why the sources for returns are so important.

For the asset light business, your long-run returns are limited to a multiple of earnings times future earnings potential. There is nothing holding this kind of business back from years upon years of double digit earnings growth except having the potential to sell that many more units. Likewise, there’s nothing to drain the business if it has to cut back during periods of economic weakness. That’s the good thing about businesses that don’t require a lot of capital. They can grow uncontrolled by any real limit on growth with the exception of the market size.

For the asset heavy business, the limit on returns is the return on capital. If you can make 6% per year building out railroads, you can grow your earnings 6% per year assuming no granularity in making new investments and the demand is there. Of course, this business also thrives on leverage. If you can borrow at 2% and double your capital investment each year, you can grow earnings at something like 11% per year (6% x 2 – (2%*.5)). Real estate rentals fit here.

For the low price to earnings businesses, your long-run returns are limited to the owner earnings. If owner earnings are $5 million and you pay $25 million for the business, the most you’ll ever make in the long run is 20% per year (assuming no multiple expansion.) In the short-run, the limit for returns is infinite. If you buy it, liquidate the inventory, and shut it down (as you should do!), you can run away with $100 million from a $25 million investment in less than one year. Of course, every year you refrain from liquidation, your annual returns drop exponentially from infinity to a limit at 20%.

Laughing at Efficient Markets

The above is why I think the idea of efficient markets are silly.

Let’s take the case of airlines, which trade at low PE ratios, low price to book ratios, and thus fit into the third type of business. The best way to get great returns from an airline is to buy it and shut it down. Think about it this way, airlines make something like 3% cash returns on capital.

How do you get stock market returns like…say, 8% per year, from a business that, at best, makes 3% returns on capital? You don’t in the long run. You can in the short run.

If you buy an airline at half of book value and its book value makes 3% per year, you can make 6% per year at most. So what’s the right amount to pay for an airline assuming you want 8% per year? Less than they trade on any given day, assuming you can shut the thing down. More likely, the airline will operate indefinitely and continue to push returns lower and lower towards your 6% return limit. If airlines really cared about their shareholders, they’d shut down tomorrow because you can’t get stock market returns from 3% returns on capital.

Don’t Get Me Wrong…

I’ve invested in businesses that generate low returns on capital, even though I make fun of airlines for it. Adams Golf was one. In a good year it would make something like 11-12% returns on capital. In a bad year during a financial crisis, returns were negative. All in, I figured the average should be about 8% per year. Equity market returns.

The good news is that I paid way less than book value, and the company could get book value for its assets if it liquidated. So I had a margin of safety. Airlines aren’t going to get book value if they liquidate. Most companies won’t.

Furthermore, I had reason to believe Adams Golf had assets that were more valuable to other companies than they were to Adams. I thought Adams could make as much as 15% or more on capital if it were bought out, synergies (like shipping golf clubs, buying raw materials, paying for the backoffice stuff, etc.) were realized, and I also thought that more capital could be pumped into the business if it could sit on a stronger balance sheet. So I was willing to invest in Adams, even though it had less than stellar returns on capital, because the price was cheap enough and because the book value was worth more than stated book value.

I’ve also invested in businesses that fit in the first description. Metropolitan Health Networks was an asset light company that turned knowledge of Medicare into big money. I was buying it at 2x book value, but I knew that it could grow without any real limits because it was a $370 million company by revenues in Medicare and Medicaid-related businesses (which cost the US federal government $800 billion+ per year). It had less than 10% of the contracts with Humana, which was Metropolitan Health Networks’ biggest customer. Growth was unrestricted.

These are two entirely different businesses, but both provided for good returns because they were purchased with the right mindset. Remember, there are only three limits to investment performance. One will affect you. I’m not picky in so far as which limit I want to test. I just want to know which limit is the most relevant.

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