Self doubt and recrimination

The last thing you want to do if you write a blog is frustrate readers but I think the way I’ve been bandying around a statistic I’ve labelled ‘investors’ return’ may be doing that.

In an introductory post on Latchways, a company that manufactures safety equipment for people who work at height, I recently said:

I can only legitimately expect a return of… 7%

Trident disagreed. You can read his comments here, and here. In summary, he exposed the assumptions behind my calculation, which I had glossed right over. My calculation assumed no growth, and for a highly profitable business in what Trident thinks is a growing market that seemed unlikely. The return an investor might get from an investment in Latchways could be significantly greater than 7%.

It probably will be, but its still doubtful I'd add Latchways to the Thrifty 30 portfolio at its current price. My default position researching a company is to assume no growth for two reasons:

1. The usual caveat about past performance. It's dangerous to extrapolate it into the future because the future is unpredictable
2. This is my first time investigating a company that makes safety equipment for engineers up pylons (for example) so my ability to forecast anything is negligible.

By ignoring growth I ignore any increase in profit Latchways might make in future. And since the value of the shares today depends on that profit, I'm only prepared to add the shares to the portfolio at a very low price.

The frustration for an investor like Trident, who would factor growth into his calculations, must surely be that I haven't rationally appraised Latchways' growth prospects. I've just written them off. Investors like me cast around for cheap shares in strong looking businesses. We hope they will grow, and when they do we profit enormously because we paid such a low price. That means we pass-up many excellent investments that look expensive but in hindsight weren't.

I've made a career out of ignoring opportunities like these, but for some reason ASOS and Abcam are the ones that haunt me. Maybe XP Power will join the ghouls' gallery one day.

I can't apologise for that. It's the way I invest, and although my investing process is evolving I don't envisage a radical shift into growth companies any time soon.

The thing I must apologise for. The thing I feel ashamed about. And the reason I am so grateful to Trident for provoking a short period of self-doubt and introspection, is, through sloppy use of language, I've allowed the 'investor's return' to mutate into something it's not. It's not even a measure of return…

The statistic I'm using is the earnings yield. Like the PE ratio, it compares price to earnings. Although I calculate it a different way to get a typical earnings figure, essentially it's just a company's earnings (average or for a single year) divided by its current share price and expressed as a percentage. That way it can be compared to other kinds of yield like interest rates.

Taking last years earnings (about 61p), the current price (about ''10.50) and using the conventional calculation, Latchways' earnings yield is:

It's like a measure of return because earnings are what remains of profit for shareholders after the company has paid all its bills. So investors are 'getting back' about 6% of their investment in earnings.
It's not an actual rate of return, though. Investors don't actually get that money.

The earnings yield takes no account of what management does with retained earnings, which is Trident's point. If management invests those earnings back in the business profitably they will compound and returns will be higher. If management blows the money on unprofitable projects, the compounding will work the other way, and shareholders will be poorer.

The return an investor receives also depends on the capital gain (or loss) he makes when he sells the investment. A company that has invested shareholders' earnings wisely will likely have risen in market value, so long as it wasn't outrageously expensive in the first place. A company that has wasted shareholders' money will probably have fallen in market value.

The earnings yield is a vague guide to value. If you think of the market as a hurricane, and financial statistics as sturdy objects to hold, then the earnings yield is better than nothing. You're more likely to survive the hurricane holding onto it than abandoning yourself to the wind. In the long-run investors who buy cheap shares (on high earnings yields) prosper.

Bandying the earnings yield around as a measure of return, though, without explaining the vague assumptions beneath, gives it too much credibility.