What makes up investment return. It's these three things

January 12, 2018

It's the new year. Time to stop horsing around and get something done. At least until the holidays are again in sight, a window my eight-year-old son defines as May, we need to buckle down in this newsletter. Today I'm going to discuss the three factors that drive all stock returns. But first...

Something interesting happened in 2017 that did not get much media coverage. While the media pontificated about the United States, the amazing returns happened overseas, particularly in emerging markets. The Vanguard emerging markets index, with dividends reinvested, returned 31.37% over the full year. Anything above 30% is an outlier in my mind, and I wanted to point it out, because it happened quietly.

"Quietly" is important here. By the time Wall St, CNBC, and your local UPS driver are fawning over an investment, the big returns often have been made.

There are 3 components that make up all returns in equity investments. Two of them are based on business performance, and one is speculative. They are: 1. The dividends you are paid as the owner. 2. The earnings growth of the underlying businesses and 3. The speculation factor that investors place on future potential. That's it. The entire stock investment universe sits on that three-legged stool.

1. A share of an index fund you own will pay you a dividend each year, generally in cash. It goes right into your investment account - you can see it there as a separate line item. As an example, if the index fund trades for $100 a share, you might be paid a $2 dividend. This means you have a 2% return from dividends.

2. The earnings growth of the businesses in the underlying index is the second part of business performance returns. If the earnings inside the businesses are growing at, say, 4%, the value of your index has gone up by 4%. With the 2% in dividends from the previous paragraph, you now have an investment that has increased in value 6%.

3. The speculation factor is what investors say stocks are worth today, given their outlook on the future. This is commonly expressed as the price to earnings ratio, and it can vary widely, ranging from lower than 10 to higher than 50. An example of price to earnings: if a share of an index fund that had business earnings of $1 sold for $20 in the market, it would have a price to earnings ratio of 20. The earnings may not change, but as people's speculative outlook changes, it will adjust the price of the index in the market. If the price to earnings valuation declined 1%, that would bring the overall return in the example above from 6% to 5%.

When you hear people talking about "what is going to happen in 2018 in the markets," I want you to keep two things in mind:

1. At the end of the year all of the market's return is going to depend on the three sources above.

2. No one has any ability to predict them reliably in advance.

Historically, the effects above increase together in good economic times and contract together in bad economic times. This compounding effect creates swings in security prices, sometimes dramatic. Of the three, dividends historically have been the most stable. More on that in a future newsletter. Before the holiday season begins in May.

Dan Cunningham