The Search for and Scarcity of Excess Returns
- The first number is the expected return on the investment, given its risk. As I noted in my last post, the cost of capital, computed right, should be an opportunity cost that reflects the expected return that investors in the company can generate by investing elsewhere in investments of equivalent risk.
- The second number is easy to compute for investors in publicly traded securities, since it a function of how much cash the investments returned (in dividends or other forms) and the price change over the year. Measuring the return earned by companies is more problematic, especially for ongoing and evolving investments. The most logical place to start is with the earnings generated by the company on these investments, but that number, is volatile and may not reflect the true quality of investments. The actual earnings (and returns) for a company will move a lot from year to year, sometimes because of actions taken by the firm and sometimes because of macroeconomic shifts. In addition, a company’s earnings and investing history is framed by accounting statements. Thus, accounting profits (net income, operating income) become a proxy for true earnings and the book value of capital invested (book value of equity, invested capital) stand in for earnings and investments, and we get two of the most widely used accounting returns: the return on (invested) capital and the return on equity.
I am well aware of the weaknesses in these measures. The first is the use of the most recent year’s operating income in the numerator. Earnings at companies can vary over time and the most recent year may yield a number that is not representative of the company. (I did also use a ten-year average income to generate returns to try to counter this problem). The second is that the book value of equity is an accounting number and as such, is affected by accounting decisions on capitalization/expensing, depreciation and write offs. The third is that netting out the most recent period’s cash balance, especially at technology or growth companies, can result in a negative invested capital. Finally, this measure, even if the earnings and invested capital are measured right, will be biased against young companies and companies investing in long-gestation period investments (infrastructure, toll roads etc.), since it will be low in the early years.
The Evidence on Excess Returns
Trident Fund LP February 2021 Performance Update
Trident Fund LP performance update for the month ended February 2021. Q4 2020 hedge fund letters, conferences and more Trident Fund LP Performance The Trident Fund LP returned 6.1 percent in February, and the fund is -0.5 percent net for 2021. In February, Trident profited from rising interest rates and commodity prices to regain losses sustained Read More
|Return spreads based on trailing 12 month returns: January 2015|
As with any measure, the rankings reveal as much about the quality of the measure as they do about the quality of the sectors. Tobacco companies are at the top of the list partly because repeated stock buybacks have depleted the book values of equity and invested capital, at last in the United States. Aerospace and defense is a volatile business and the high positive excess returns in 2014 can turn negative, if the airline business is troubled.
The most striking feature of the data, to me, is that the proportion of companies that earn less than their cost of capital, 65.36% of all companies and 53.99% of companies with market capitalizations that exceed $50 billion. That indicates either that competition is a lot more intense in more businesses than we think and/or that management at many of these companies are either unaware or indifferent that their businesses are not generating sufficient profits, given the risk.
This may reflect my biases but everyone should care about these excess returns. Investors should be valuing companies, based on their expectations of future expected returns, and pushing for change in companies that don’t deliver them. Anti-trust regulators can use them as proxies for determining whether competition is adequate in markets and lawmakers should consider excess returns rather than absolute profits, in making public policy.
- An ERP Retrospective: Looking back (2014) and Looking forward (2015)
- Country Risk, Return and Pricing: The Global Landscape in January 2015
- The Tax Story (in January 2015): Myths, Misconceptions and Reality Checks
- Putting the D in the DCF- The Cost of Capital
- The X Factor in Business: Excess Returns and Value