What Factors Do Long-Term Investment Returns Depend On?

Have you ever wondered what long-term investment portfolio return depends on?

To be able to earn a good investment return on our portfolio, we would first have to understand what factors drive the return, and then work on optimising them.

So, your long-term portfolio return would depend on first, the individual return of each of your investments; and second, your portfolio construction which drives the return at the portfolio level. 

Let’s talk about the former today, and the latter another time.

Return Of An Investment In Stocks

Broadly speaking, the individual return of an investment in the stock of a company comes from these factors:

1. The change in intrinsic (/ market) value of a company per share over time, which depends on:

   1. the change in earnings/ free cash flows of the company; 

   2. the share buyback yield;

   3. the change in valuation multiple; and

      
      

2. The dividend yield.

   
   

Let’s take Adobe as an example. From early 2013 to mid 2023, its share price has grown by ~1,280% to become a 13.8x bagger.

Since Adobe does not distribute any dividends (so 0% dividend yield), the entire 1,380% investment gain constitutes the 1,380% change in market value of the company per share.

611% of the return came from the growth of its earnings per share (EPS) (from $1.69 in end 2012, to $10.29 in end 2022). 

And this 611% (or 6.1x) return from EPS growth is driven by:

• a 476% (or 4.76x) EPS growth excluding buyback yield (driven by Adobe’s organic growth and acquisitions, which it had done many); and

  
  

• the buyback yield, which boosted the returns by 128% (or 1.28x). This 128% boost from buyback yield is calculated as [1 / (1 – 22.1%)], where 22.1% is the total % of shares bought back by Adobe (which translates to ~2.5% a year).

  
  

Meanwhile, the change in valuation (P/E) multiple was 226% (from 23x to 51x) during the same period, which boosted the total investment return to ~1,380% (= 611% x 226%).

As you can see in the table above, the investment return (of 30% a year) was mainly driven by the growth in EPS (of 17% a year) (before the buyback impact), which should be the case for any long term investment.

In the short term, the change in valuation multiple (8.5% a year, in Adobe’s case) could be a major driver of the total investment return, but in the longer run, the total investment return would depend more on the growth in earnings or free cash flows (but only if it’s quality growth, and that’s why ROCE matters, which we discuss in the future).

Impact Of Earnings Growth Vs Multiples Changes

If a Ferrari races a Toyota, which will win?

What if the Toyota is given a 500 metre head start? Now, who will win?

The answer is, it depends… on how long the total race distance is.

If the race distance (read investment/ compounding period) is long, then the Ferrari will overtake Toyota at some point of time. That’s how compounding with higher quality works.

For example, let’s assume that a company would grow its earnings by 15% a year for the next 15 years (so, if it is earning $100 million today, it would earn $814 million after 15 years). And assume that we buy the company at an earnings multiple of 15x today, but when we sell, we would be able to sell the company at double the multiple, at 30x, so our final investment return would benefit from the 2x jump in multiple.

In this case, would the multiple increase be a major contributor to the long term investment return?

As shown in the chart below, in the initial years, most of the investment growth comes from the multiple increase. For example, after 2 years, the stock would have grown to 265%, and 60% of that growth (of 265%) is contributed by the increase in multiple, while the earnings growth did only 40% of the work.

However, over time, the earnings growth becomes a more important contributor to the total investment growth.

• After 5 years, the earnings growth would be driving half of the total investment growth (to 402%). 
  

• And after 10 years, the earnings growth would be driving 67% of the total growth.
  

• And after 15 years, 80% of the growth!

  
  

It’s important for us investors to understand this point, and appreciate that, if our investment horizon is truly long term, then it’s much better for us to be buying and accumulating wonderful companies at good prices, than good companies at wonderful prices.

This is exactly how Warren Buffett’s investment strategy has shifted, after being influenced by the thinking of Charlie Munger, Phillip Fischer etc, with him first time “overpaying” for quality by purchasing See’s Candies (in 1972), which turned out to be a fabulous investment.

As Benjamin Graham said, “The bitterness of poor quality remains long after the sweetness of low price is forgotten”.

And as Warren Buffett said, “Time is the friend of the wonderful company, the enemy of the mediocre”.

Investment Returns Without High Earnings Growth

So, we have seen above that the majority of Adobe’s investment returns was driven by its growth in earnings.

Is that the only way to achieve a good investment return? 

There are companies, which despite having just moderate growth in earnings, have generated tremendous shareholder returns due to their strong free cash flows generation and buyback yields.

As shown in the table below, both Apple and Domino’s Pizza achieved a CAGR of ~20%-21% in appreciation of their share prices, over the past 10 years, despite having just a 8%-12% CAGR for its earnings growth, and despite Domino’s Pizza actually facing a slight headwind from its valuation multiple contraction. 

The rest of the “appreciation” work was done by compounding effect of the buyback yield, due to the management’s diligent capital allocation to buybacks (buying back ~45%-51% of shares at attractive prices during the 10-year period).

Note: The “Change in market value per share” is calculated as, e.g. for Apple: 21.4% = (1 + 0.080) x (1 + 0.062) x (1 + 0.058) - 1. Source: Company’s annual report; Morningstar (for dividend yield); and MoneyWiseSmart’s analysis.

That’s why the management’s capital allocation skills matter.

And chasing high growth is not the only way to achieve high investment return in the long run – Warren Buffett knew this (of course) and has smartly compounded Berkshire’s returns through its purchase of Apple’s shares. 

In fact, high growth, but bad capital allocation, can actually lead to bad investment returns, which we will talk about in the future.

Summary: Key Drivers of Long-Term Investment Returns

To summarise, in the long run, the investment return of a stock depends more on the below, which are what we as investors should focus on:

• the long term growth in earnings of the company, which is only of good growth (and not cancerous growth) if the company’s return on capital is high (and we will discuss this topic on return on capital in the future); and

  
  

• the return of capital activities (like buybacks or dividends) of the company, which is affected by the management’s capital allocation skills (which is very important, which we will discuss in the future). 

  
  

So, what do you prefer your long term investment returns to come from?

What type of companies do you prefer to own? Ferraris (with high return on capital, and good capital allocation leading to strong return of capital), or Toyotas? 

Let us know your pick!

If you’d like to discover more about investing in high-quality companies, you can check out our Multibagger Research Series Preview here, where you’ll get to see a sample of how we do in-depth research into several businesses.