Reviewing the Fundamentals: The Three-Legged Stool of Stock Market Returns

Factors that drive stock returns and our framework for each.

A three legged stool cannot stand upright for more than an instant if it only has two legs. There are three legs to the stool that comprise a stock’s total return; growth, yield, and change in valuation. Unlike a piece of furniture, a stock can sustain above average returns with just one or two legs for a lengthy period of time. Eventually, though, investors who own stocks with less than three legs inevitably end up in the same place: on their back.

When I think back on 2022 what stands out is the return to normalcy in terms of what counts for investors.  For the last several years it seemed that only one leg of a stock’s return received much attention; growth. Briefly, during early 2021, it seemed none of the legs counted (meme stocks). Businesses that earned billions in revenue yet reported widening losses were rewarded by ballooning stock prices. To me, a company generating billions in revenue and no profits is closer to a charity than a business. As the saying goes, anyone can create a billion dollar business by selling dollars for fifty cents.

In recent years we would hear things like “investing through the income statement” and “CAC to LTV” on a regular basis to justify stock prices. Sometimes these arguments are valid. More often, they are not. Investors ventured further up the income statement in search of a ratio that a business could be valued on. Eventually “price to gross profits” or “price to revenue” became the norm to value high growth and unprofitable businesses. I prefer to view these valuation metrics as “valuation before costs that actually matter”.

No matter the stock, a common theme was present; returning cash to shareholders mattered little and valuation mattered less. Those ideas have been turned on their head this year with growth-at-any-cost stocks getting crushed while cheap stocks returning capital to shareholders have thrived, at least on a relative basis.

For a value investor, 2020-2021 was a strange time. Sure, it was fun to watch the price of our stocks rise in an almost unabated manner, but it was also uncomfortable to invest in a world with negative interest rates and ultra-loose monetary and fiscal policies. It felt unnatural. In “Financial Euphoria”, Matt wrote about the state of things at the end of 2020 and it seemed inevitable that it would not end well for investors who focused on growth while ignoring valuations and yield.

You don’t need an advanced degree in mathematics to grasp the three factors that drive a stock’s return, but the concept seems to get lost on investors often times for some reason. Given the reemergence of the importance of shareholder yield and valuation, now seems like a good time to review each of the components. 

Growth + Yield + Change in Valuation Framework

When Matt and I analyze a stock we try to estimate its future growth, yield, and change in valuation over a five to ten year period. We combine these factors to estimate the stock’s prospective investment return.

Our favorite investments have all three “engines” working in our favor, but our favorite is yield. We focus on yield more than most investors because we think it is most knowable to us. Growth and valuation seem to get the most attention, but it is shareholder yield that is often the ballast, albeit an unsexy one, to enduring returns.

Shareholder Yield

Shareholder yield is straightforward: the cash shareholder receive from the company divided by the price of the business. In a private investment there is only one way to receive yield — dividends. Public companies have the added benefit of returning cash to shareholders by way of share repurchases. We define shareholder yield as the sum of dividends and share repurchases divided by the market cap of the business.

Investing in businesses with attractive shareholder yield gives us the opportunity to own stocks with what we consider a “high floor”. We like stocks that are returning a meaningful percentage of their market cap to us each year through dividends and buybacks. This means that, before contemplating any growth or change in valuation, the businesses should kick off a solid return.

Further, if you buy a stock returning a high percentage of its market cap annually it’s unlikely to experience a dramatic further decline for any extended period of time. As long as earnings are stable to up (a big caveat), if a business returning 10% of its market cap declines by 50% it will then be able to return 20% of its market cap to investors. Public markets are generally too efficient to allow situations like this to persist for long, making it easier to assess the long-term downside for stocks with predictable and attractive shareholder yields. It also makes stocks much easier to hold when inevitable declines do occur. Let’s say AutoZone declines by 50% next year. In almost any scenario the company is going to be buying back shares hand over fist while this declines lasts. Continuing shareholders will be much better off over the long term having held through a temporary decline, as each investor will own a larger share of the business without laying out a dollar of their own.

Demanding some yield eliminates unprofitable enterprises from our scope, which should keep us out of serious trouble. There is seemingly no floor to how low a stock can fall if it is not supported by cash flow from the business.

It’s worth noting that I’m not referring to hyper-cyclical stocks that occasionally can return huge portions of their market cap via special dividends from windfalls in commodity prices. That can work as well, but that’s not our game. We’re looking for businesses that can return a predictable and growing amount of cash to us each year through a variety of macro-economic conditions.

Growth

Growth starts at the top with revenue growth. But blindly projecting revenue growth based on past results (or hope) is pointless without understanding the underlying drivers of revenue. We generally assess growth by way of unit (or volume) growth as well as price growth.

Again we are looking for simplicity. Take Domino’s Pizza Group, for example. It isn’t terribly difficult to grasp that the company’s revenue growth will be driven by the number of restaurants and the growth in sales at each restaurant. The same is true for AutoZone. We also look for businesses with some operating leverage where profits grow modestly faster than revenue because the businesses aren’t terribly capital intensive.

Although we look to shareholder yield to anchor our returns, we prefer to buy businesses we think are likely to grow at least modestly over the long haul. A business that isn’t growing is dying because employees need raises and suppliers raise prices.

We care more about the duration of a company’s growth than its magnitude. Slow and steady, sustained for a long time, is fine by us. We avoid hyper growth companies because, statistically, their growth often fizzles abruptly. We don’t know how to predict them.

There was a reason Peter Lynch advised investors to stay away from anything growing faster than 20% per year. Lynch didn’t consider himself smart enough, and we certainly aren’t, to consistently and accurately assess the durability of growth rates in excess of 20% per year. When that growth ends, it is often accompanied by a collapsing valuation multiple.

Change in Valuation

If you get the first two legs of the stool correct, the third leg, valuation, is about just not screwing things up. Valuations, especially in public markets, are notoriously fickle and influenced by things outside of investors control, mainly interest rates. Fortunately, because yield and valuation are tied at the hip, by demanding a solid shareholder yield up front you limit yourself to overpaying. Let say you are looking for investments with 7% shareholder yield. In that scenario you’ll be evaluating stocks selling for 14x earnings or less (1/7%).

We never have a “target price” for a stock based on a static P/E multiple and an earnings prediction. Rather, we invest based on forward rates of return. We look for valuations that are more likely to expand than contract, and the cheaper the better.

It also pays to be conservative on your assumption of a long-term multiple. We bake in a margin of safety by generally assuming our stocks will be valued at the long term market average, eventually. We own what we consider to be far above average stocks and only expect an average valuation by the market over time, and instead rely on the yield + growth component to earn the bulk of our returns. Should we achieve a valuation re-rating it is merely a cherry on top.

Matt and I have a saying based on nothing but our own personal observations and experience; “everything eventually trades for 10x earnings”. We like to keep this in mind when we buy a stock and we assume at some point it will trade close to a double digit earnings yield if it isn’t already there.  

The Glue Holding The Stool Together

Perhaps the most important component of all of this, the glue that holds the stool together, is predictability. Predictability of the business and predictability of capital allocation are both must-haves for us. It’s hard to overstate the importance of predictability and it took us years, and many mistakes, to internalize why investors we admire such as Ackman and Buffett talk about it so often. Without being able to understand the durability of the earnings and the way management will allocate capital, it becomes impossible to assess likely rates of return. If we can’t understand a business enough to decide we would like to own the entire thing, we shouldn’t own a single share.

The predictability hurdle leads us to discard most stocks we study. Fortunately we only need to find a handful that meet the bar of predictability and expected returns.

A business’s predictability is influenced by four factors. One is your personal circle of competence. The stocks I understand and consider predictable may not be the same for you, and vice versa.

Second is the business’s industry. Some industries are highly cyclical, capital intensive, and have significant operating leverage. Other industries are dependent on commodity prices outside of their control.

Third is the company’s competitive advantage. Companies in cyclical industries that are not predictable quarter-to-quarter or year-to-year may still be predictable over the long run if they possess durable competitive advantages.

For example, Progressive’s month-to-month and quarter-to-quarter returns are volatile but the company’s durable low-cost advantage makes it is likely to produce predictably good returns over the long run.

The final factor affecting predictability is capital allocation. A predictable earnings stream is worthless if management squanders the cash before it can reach shareholder’s pockets. Predictable and intelligent capital allocation turns predictable earnings into predictable stock market returns.

For example, AutoZone spends nearly 100% of its free cash flow on buybacks. Knowing this, we can model shareholder yield as 90-100% of free cash flow. If we don’t know how cash will be used, we can’t handicap growth and yield.

Meta (formerly Facebook) stands in stark contrast. Cash many Meta shareholders expected to receive as yield is now being spent pursuing vague and uncertain growth ambitions. AutoZone is more predictable because its earnings reliably reach its shareholder’s pockets.

Putting it Together

Forget stocks for a minute. Imagine you own an apartment building. The apartment building generates $100K in profits (free cash flow) and you pay $1M for the building. You’ve purchased the building for a 10% free cash flow yield, 10x earnings, or a 10% “cap-rate”, a common metric for valuing real estate.

Paying $1M for a property that you’ll be able to take $100K out of each year means your “yield” leg of the stool is 10%.

Let’s say you have rent escalators that dictate 5% rent increases each year. Your “growth” leg of the stool is 5%.

Finally, you paid 10x for the building and, over the next five years, the area of town enjoys a modest rise in property values, and interest rates fall a bit causing property valuations to rise. After five years you are able to sell the building for 13x earnings or a “7.5% cap rate”. You’ve enjoyed a bit of multiple expansion and the change in valuation leg of the stool has added 6% to your annual return.

What are your total returns? They will approximate “growth” of 5% + “yield” of 10% + change in valuation of 6%, or roughly 21% in total.

Source: Author

An important takeaway from this example is that you don’t need blazing growth to earn great returns. Just 5% growth can generate excellent returns if the price is right and the earnings are paid out to shareholders.

Now let’s see how overpaying can impact the returns on the apartment building. If instead of paying 10x I pay 20x (or a 5% cap-rate) and keep all other factors the same, my IRR is a measly 3% annually.

Source: Author

Change the starting multiple to 30, 40, 50x or higher and it becomes very difficult to overcome a collapsing multiple, regardless of growth. Many investors are finding this out the hard way presently.

Now change “purchase price” to “market cap”, “rent escalator” to “free cash flow growth”, “rental profits” to “dividends and share repurchases”, and “apartment building” to “Domino’s Pizza Group or Davita” and this is how we evaluate forward returns for stocks. It really doesn’t have to be more complicated than that.

Buying stocks for conservative prices that generate a growing stream of cash that is predictably returned to shareholders works because it has to work. Stock prices must eventually follow their cash flows. If we are right about the business and don’t screw up the valuation, one way or another the cash from the business finds its way back into our pockets. Owning a collection of these is unlikely to result in a bad outcome over long periods of time.

The last step in the process is to prepare yourself to be wrong and accept the fact that no framework is always going to work in every situation. Investing is supposed to be hard which is why we own 10 stocks rather than 3. It’s why we emphasize a margin of safety that includes price as well business quality and predictability.

We emphasize these things but are in no way immune to mistakes. We owned and held Meta at $350 per share last year and still own it today. With the benefit of hindsight it sure looks like we were lulled to sleep and brushed off the rising valuation. We contemplated selling it late last year but thought it still offered good value compared to our opportunity costs. Whoops. The business and capital allocation policies have been less predictable than we thought when we purchased it in 2018. Fortunately, if you own a portfolio that emphasizes low starting valuations, steady albeit unexciting growth, and shareholder yield, you can withstand the occasional (and inevitable) setbacks.

Finally, the three legged framework I’ve described is not the only way to invest, it’s just what works for us. Some people can successfully pay astronomical prices for stocks in hopes of finding the next Amazon. Others buy negative growth businesses in commoditized industries for super cheap multiples and wait for them to re-rate, while collecting nothing in the way of yield or growth. It doesn’t bother us when others make money using these approaches, we just don’t know how to do it.

It does seem likely that the framework above is more repeatable and durable than most, but to each his own!

---

Thank you to everyone that reads our blog; we genuinely enjoy writing it and we love hearing from our readers. The plan for 2023 remains the same as the last several years. We’ll post about businesses we are researching and that we find interesting and high quality. We’ll keep posting the transcript notes and reading round ups and anything else we think may be worth sharing to clients or fellow investors. Please feel free to share our information with anyone that may find it useful and we look forward to 2023.

Happy New Year and thanks for reading!

If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com. You can also find more information on our website. We recommend starting with our Fundamentals. Thank you for reading!

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.