Andrew co-founded Platinum in 1994 as the Deputy Chief Investment Officer, having worked alongside Kerr Neilson for several years at Bankers Trust and perfecting the craft of.. More
During Platinum’s 2019 Australian Roadshow, CIO Andrew Clifford used the following example to illustrate clearly how an investor might like to “think like a private owner”. This approach can help to deal with the challenge that comes from trying to invest for the long term, while being forced to deal with the distraction of an ever changing share price.
A framework is required to assess potential returns from an equity investment. The proposition is that “thinking like a private owner” is a sensible approach, and protects investors from the affliction of “loss aversion”. To illustrate this we use a real example and have chosen a company Platinum owns in several portfolios. The company's profits have been indexed to simplify this paper.
2009 earnings indexed to $100. Source: Data from FactSet, Platinum Investment Management Limited.
The company earned $100 in 2009 and its shares cost $1,236 on 1.1.2010*, for a P/E ratio of 12.4x, or inversely, and preferably, an earnings yield of 8.1%. The share earned 8.1c in 2009, for every $1 invested. If this continued forever, 8.1% would be the rate of return.
Prior to this time, sales had grown steadily, even during the GFC but as a cyclical business, profits had been volatile, so the earnings yield may not be reliably maintained, though the track record was of earnings growth. The company illustrated is large and a global leader in its key business segments. It has strong technological leads over its competition. Our analysis led us to believe that the company had good prospects of increasing its earnings over time.
At the start of 2010, US 10-Year Treasury Notes yielded a “guaranteed” 3.8% p.a. The shares provided an uncertain, but probably growing, return starting at 8.1% p.a. which looked solid.
Looking out over what happened in the next six years is informative.
Based on the initial cost ($1,236 per share on 1.1.2010*) the company generated an earnings yield of 13% in 2010, and averaged 17% per year out to 2015. This looks far superior to the guaranteed 3.8% from US government bonds, or the S&P 500, which averaged 9% over the same timeframe.
The sole owner of a private company would have evaluated returns this way. Ironically, though most stock market investors just focus on the share price. On that basis, with the price at $1,921 after six years, this represented a total return, including dividends of 9% pa.
For the same period, the S&P500 Index returned 13% pa including dividends. Most investors would prefer this to the company, even though a private owner would have chosen the company’s earnings outcome. When focussing on the share price, it changes investors’ thinking.
This is a mirage. The share price is an abstraction, not the business itself. Investors should be more concerned with underlying returns of the business than fluctuations in the share price.
The S&P 500 Index far outperformed the underlying earnings of its constituent companies. This simple re-rating is good fortune for their shareholders. An investor in our company would have hoped for the same, but despite the underlying value of the business increasing significantly, it did not happen.
This is one of the hardest parts of investing. By 2015, many shareholders of the company would have felt despondent, and it would have been tempting to sell, and invest elsewhere.
However, in 2016 and 2017 the profits really took off, reaching record levels. And finally, the stock price followed.
By the end of 2017 the shares had returned 16% pa including dividends, beating the S&P500’ (now 14%pa) and trouncing the bond’s 3.8%.
Moreover, on 2017 earnings, the company still had a starting earnings yield of 12%. Compare this with S&P 500 Index below 5% and 10-Year US Treasury Notes at 2.4%.
This company is Samsung Electronics.
True Value Investing
The core of true value investing is to look at implied returns from securities as this Samsung example illustrates.
An investor should seek to build a portfolio of equity and debt securities with good implied returns and achieve appropriate diversification across geography and sector. This should achieve a good result over time if we have the requisite level of skill.
The challenge is the assessment of any company’s earnings potential. This requires a true understanding of what the future holds for a company, not just observing a set of numbers.
At no times, do we use an index as a reference point. For adequacy of returns, we can look at the risk-free rates of return on government bonds or bank deposits, and, the implied rates of return from all the individual companies that we choose to examine. To assess the index, requires an assessment of all companies, which is a huge task. We can assess a company against a broad range of alternatives, rather than every single alternative.
At no time, does one need to predict the company’s future share price. The efficiency of markets should eventually bring the company’s share price to reflect its intrinsic value.
Interview with Kerr Neilson
A Crash Course in Investment Management
Why We Need to Think Internationally When Investing (Video)
Why Indices Lead Investors Astray
Facts, Feelings and the Importance of Composition
Is Passive the Way to Go? (Video)
The Platinum Way (Video)
Who is Platinum? (Video)
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