A Value Investor’s Total Return Always = “Trade” Return + “Hold” Return

by Geoff Gannon

Someone emailed me about NACCO (NC). This is a stock held in accounts I manage. The email came up with an expected return calculation that didn’t include any change in the stock’s P/E multiple. NACCO trades at a P/E less than 8. So, I responded to the email by talking about how big a difference your total return expectation – as a value investor – can be in a stock depending on whether you assume a low P/E multiple will eventually expand into a normal P/E multiple, or whether you just assume your return in a stock will be what you get  from holding it forever.


As a value investor buying a stock – it is easiest to think in two terms: 1) The stock's "hold" return and 2) The stock's "trade" return. The reality is that while the general public investing in an index fund and holding it just gets the "hold" return less fees paid on those index funds, to advisors, etc. A stock picking value investor gets a different return. It might be better. It might be worse. But, a significant portion of a value investor's lifetime investment returns tends to come from the "trade" aspect of stocks rather than the hold aspect.


Let me give you an example. Say NACCO earns $5 a share today and grows earnings by 3% a year for the next 5 years. At the end of 5 years, you sell the stock. Well, the stock's earnings will be $5.80 a share in 2024. But, the question here is what will you sell the stock for in 2024.


Let's say future prospects for the stock look particularly gloomy in 2024, and investors value it at just 5 times earnings. That would be $5.80 * 5 = $29/share. You would lose money on the 5-year trade since the stock is now at $38 (when we're saying you hypothetically buy it). I put aside the issue of stock buybacks, dividends, etc. In reality, it's possible you could recoup as much as like $25 over those 5 years through some combination of those things. So, yes, it's still possible you might come out ahead in my scenario. But, I'm separating out "stock buybacks, dividends, growth, acquisitions, etc." and labeling that your "hold return". So, in this scenario - you might make $25 by holding the stock, but you'd lose $9 by "trading" it. This would net out to a return of like $16 made over 5-years on a $38 investment. You might make a little more than 7% a year under this scenario, despite the fact that you should be making about 13% a year ($5/$38 = 13%) each year just from holding the stock. Now, yes, this can be avoided if you hold the stock FOREVER. If customers do not go out of business, close coal mines, etc. - then, you could keep holding the stock in year 6 and beyond. The longer you hold a stock, the more important the "hold" return (which generally can be estimated as FCF Yield plus FCF growth) matters. When Warren Buffett holds stocks like Coke, American Express, etc. for 30 years - it becomes relatively unimportant what the initial price he paid was or what price the stock now trades at. What matters most is how much FCF it produces in those 30 years and how much that FCF is growing over time. But, this is unusual. While many founders, owners of private businesses, and even a few Warren Buffett type investors do hold a couple businesses for 30 years and get rich or poor without much regard to the price at which the business can be sold to others - you probably won't.


Odds are that if you do buy NACCO today, you will find a better stock to buy in the future. Many people consider me a longer-term oriented value investor. And yet, I have to say that stocks I've owned without the intention of selling quickly still end up existing my portfolio within about 3-7 years. This is probably similar to something like an LBO. Although they may do work looking at what they can extract from the business - they know that they are likely to sell out to another buyer or take the company public again within about 3-7 years.


This is potentially the way in which having a publicly quoted price for a stock you own is an advantage. If you bought NC and held it forever, you might make 13% a year if everything went right. But, you'd be taking the risks of things going wrong. And so, you have like a 13% return and whatever risk is associated with that return as your investment. If NC was a private business you were investing in that you knew the family would never sell - you could analyze the deal completely on those terms. Basically, what is FCF yield? And how much - in nominal terms - do I expect that FCF to grow each year? Then, imagine I hold forever. That's the "hold return calculation".


The combination of a sufficiently high hold return and a high willingness on your part to hold a stock forever if you never get offered a good price to sell at is the best defense in investing. This is what makes your investment safe. Investments are not safe whenever you - as the investor - are unwilling to hold the stock for a long time. That's because even a good, safe business could drop 50% in quoted price (though not in intrinsic value) next year. In fact, even the safest and best business will probably do that once every 20 years or so. If you are purely a "trader" and not a "holder" through insufficient offers for the stock you own - then, you'd risk selling when price is well below intrinsic value. So, being willing to hold a stock long-term - and never selling into bad offers for your business - are the key to not getting as bad returns in the stock market as many individual investors get. In theory, these investors should make the 8% or 9% or 10% that the market does while they are in it less whatever fees they are paying. For example, over the last 15 years, they should have compounded their money at 8%+. In reality, many do not because they sell at bad times. So, holding a good business and ignoring low offers for your stock is key in protecting you from underperformance.


But, many stock picking value investors want to outperform the market - not just match it. How do you do that? Warren Buffett has had periods where he can do it simply by finding businesses that have a higher hold return than the stock market. This can work. If you bought Microsoft or Wal-Mart or Southwest Airlines or something at the right time and held for 30 years - you would have more money at the end of your investment in those stocks than you would have had you put that money in an index. This is the Phil Fisher approach.


It's not the Ben Graham approach. The Ben Graham approach is to buy a stock selling at a discount to what it is worth and then - within a few years - sell that stock for closer to what it is worth. Graham often bought "net-nets" at 2/3rds of their net current asset value. If the stock simply did not burn up any cash, receivables, etc. in its operations - it basically operated at breakeven on a cash basis - and the stock eventually traded at 1 times NCAV, then Graham could make about 15% a year over a 3-year holding period. His "hold" return would be zero percent a year (the stock would pay no dividends, make no buybacks, and it wouldn't grow). But, he would buy at 65 cents on the dollar today and sell at a full dollar on the dollar in 3 years. The compounding of 65 cents into 1 dollar over a 3-year period is a 15% return. That's a pure "trade" return. Graham didn't intend to hold the business forever. He didn't pick the business because he liked the business. He simply bought the business today at what he though was an irrationally low price to be able to sell it at a more reasonable price. The quicker that reasonable price came, the higher the annualized return would be. This is because the value gap Graham was exploiting can only close once. The stock isn't returning anything to people who just hold the stock. But, the market is going from valuing net assets at 2/3rd to valuing them 1 for 1. That 35 cent value gap is the same whether it happens in one year (a 50%+ return for Graham), 3 years (a 15% return for Graham), 5 years (a 9% return for Graham), 10 years (a 4% return for Graham) or 15 years (a 3% return for Graham). Obviously, there are risks NCAV could shrink. But, there is also the possibility it could grow, the company could generate some "hold" return on top of the trade return, etc. And, assuming the stock took 3-15 years to reach the price/asset value Graham assumed was acceptable, then his "trading" the stock would add anywhere from 3% to 15% a year to whatever return he got in the stock. In practice, this makes a huge difference. Many investors buying businesses they knew were better than what Graham bought wouldn't outperform Graham - because, the businesses they were buying weren't better ENOUGH than the bad businesses Graham owned. A good business would need to outperform a bad business by 3% to 15% a year just to outperform a value portfolio bought at 2/3 of "intrinsic value" and held for 3-15 years. That's really tough for good businesses to do. It's really hard to get a hold return in a stock that is so high it can make up for that kind of annual trade return boost. Consider that most stocks historically don't have better than about an 8% hold return (if you held the market forever, you'd rarely compound at much better than 8% a year). If Graham could get 3% to 15% more per year by trading stocks (basically, "buying low and selling high") and these stocks had any sort of hold return on top of that - even a bad one - he could easily match or beat those people who were just holding stocks. In reality, even mediocre businesses often generate some hold return. It's not unusual for a stock people tell you is a terrible business to actually grow 2% a year and pay a 2% dividend over the last 15 years. Well, that's a 4% hold return. If you can just eke out a 5% or better annual "trade" return in such a terrible business - you can actually beat people who just hold the S&P 500. As an illustration: imagine you buy a business at 2/3 of book value and it grows book value by 2% a year while paying you a 2% dividend yield. You hold it for 10 years. At the end of those 10 years you sell it for 100% of book value (instead of the 2/3rds at which you bought it). What's your annual return? It would likely be 2% (BV growth) + 2% dividend yield + 4.4% "trade return" (the multiple going from 0.65x BV to 1x BV) equals 8.4% annual return. Even that subpar business could match the market over a 10-year holding period simply because you bought it at 2/3rds of some price/value ratio and it eventually trade at 100% of that price/value ratio. Basically, by buying a worse businesses at a lower price than others pay for good businesses you could offset the lack of quality in the business even over a long holding period like 10 years. If you got lucky and the market revalued the stock in 5 or 3 or 2 years instead of 10 years - you'd outperform the market by quite a bit in this bad business.


So, the reality for a value investor is that quite a lot of your return comes from the "trade" aspect of holding a stock instead of just the "hold" aspect. Let's take another look at NACCO and this time assume the reverse happens. In 5 years, investor sentiment shifts on this stock such that it's seen as a "normal" stock in terms of safety, quality, future prospects, etc. Is that impossible? This is, after all, a coal stock. I don't think it's impossible for investor sentiment to shift like that. Coal stocks will always be something avoided due to the risk that coal power plants shut down and we get less and less power from coal. However, NACCO's economics are frankly much better than normal businesses. The company earns higher returns on tangible equity than other businesses do. As you pointed out, "recurring" revenue of some kind makes up the majority of sales. These are under long-term contracts. The contracts are cost-plus and not tied to commodity prices, competitive factors, etc. So, that means "recurring revenues" become "recurring profits". These profits are earned entirely in cash. And the formula used to calculate costs rises with inflation. So, these are inflation protected, recurring profits. They are "real, recurring cash profits". Although coal may be a risky source for profits in the future - a dollar of real, recurring cash profits should be valued a lot higher than a dollar of profits earned this year under normal competitive pressures from a mix of new and old customers. So, it's not impossible that sometime in the next 5 years NACCO's stock price will spike in such a way that the stock can be sold at 15 times earnings. That's basically in line where with a normal stock has sold at times in the past. Assume again the stock grows earnings by 3% a year for the next 5 years. You get $5.80 a share in 2024 earnings. But, the market now prices that at 15 times earnings. That's $5.80 * 15 = $87 a share. Again, hypothetically, you buy the stock at $38 today. You sell at $87 in 2024. How much do you make?


Your "trade" return is 18% a year.


Your actual return in the stock would be some combination of the trade return and the hold return. Here, over a 5-year holding period, the combination of the two returns taken together something in the 15% - 30% a year range. But, it's risky. Both the trade return and hold return are tied to the same thing - the durability of the free cash flow. This is tied to how long customer power plants will keep operating. If they all continue to operate at the same levels for 5 or more years, it's possible you might see returns like that in the stock. After a long time of a stock producing good earnings, doing buybacks, etc. - it's common for investor sentiment to shift in a way that rewards each dollar of profits with a higher multiple.


So, you can analyze the stock as if today's multiple of 7.5 or whatever expands to 15 at some point.


Or, you can analyze the stock as if you just buy it today at 7.5x FCF or whatever and hold it forever.




You can analyze it on some combination of the two.


In reality, I've found the return you get is some combination of the two. But, remember - a specific stock comes with specific risks. If the stock you are analyzing fails to meet your growth expectations, FCF actually declines while you own it, etc. you get a double downward adjustment to your total return expectations. Your "hold" return drops because the company buys back less stock, pays less dividends, etc. And you get a lower multiple on the ending earnings of your stock - in 5 years, or whenever you might sell it - because investor sentiment has now turned even more negative.


But, what I've laid out above is the correct way to estimate your returns in a value investment. Over time, I've made a lot more money from multiple expansion than I would have initially expected. So, my own investment returns would be underestimated if I assumed that the stocks I owned generated just a "hold" return and wouldn't be sold at a higher price. If I don't make a mistake in judging the business - I tend to be able to sell the stock at a higher multiple sometime down the road. And this multiple expansion tends to provide much of my returns in a stock.

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