Total Return Investing

Components of Total Return Framework

In a world focused on relative performance and its various benchmarks, we pride ourselves in being total return investors, and as such we always bring everything back to the metrics we see as composing total return—yield, growth and change in valuation. While we cannot predict the returns our portfolio will generate in the future, we can analyze our returns to date and how the composite metrics may be expected to drive returns going forward.

The total return for all investments, in our view, is made up of the yield and the price change, or capital appreciation or depreciation, of the security, whether that security is a stock or a bond. Decades of history suggest, in our view, that equity prices, over the long-term, will generally follow the per share measures of value like earnings, dividends, cash flow, book value, etc.  However, in the short-term, equity prices tend to be far more volatile than their earnings, as sentiment swings with the economy in general or a single company’s fortunes in particular.  In other words, valuation fluctuates even if earnings and dividends are stable.  So, by dis-aggregating changes in a stock’s price into two components: growth and changes in valuation, we get a simple equation: Total Return = Yield + Growth +/- Change in valuation.

Not only is this simple construct useful in explaining total return history and total return expectations, for us, it acts as a constant reminder of what criteria really matter in stock selection and portfolio construction.

While these components may seem obvious to some, we do not see this framework used by most fund managers to describe their returns.  Instead, historic returns are compared to various benchmarks or indices and broken down into “alpha” and “beta”.   How much of a given return is “alpha” and how much is “beta”?  These rhetorical questions cannot be answered because we don’t know how the relevant benchmark or index performed during this hypothetical example.  Since EIP is not an index investor, we think about how to maximize returns adjusted for risk focusing on the drivers of that return as discussed above.  Our view is that other factors are useful to analyze and understand only to the extent that they affect these extrinsic drivers and the risk of the investment.

Earnings Stability

As a total return investor, EIP focuses its investment approach on the component metrics of total return including yield and growth. We consequently seek to construct a portfolio that compares favorably by these metrics not just with the energy sector or a given index but more broadly against the S&P 500 and the market as whole. While our portfolio companies’ price performance may move in sympathy with the energy sector or the broader market in the short term, our concern, once again, is for competitive returns over a long time horizon, and earnings stability in particular in our view directly affects yield and growth and therefore drives long term returns in a number of ways.

First of all, we believe companies with stable earnings tend to have higher long-term earnings growth due to the fact that earnings cyclicality is disruptive to the business planning process of publicly traded companies and subject to investor pressure favoring acquisition or divestment depending on performance. We also believe that earnings stability can support higher dividend payouts and capital spending discipline because companies would be reluctant to set dividends at a level where earnings variability could compel them to a near-term cut. Finally, earnings stability provides long term protection for how the market values companies as data shows that earnings stability and valuation tend to be correlated over time.

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