Have you ever wanted to invest in a company because its stock was doing well or sell a company’s stock because it was lackluster? While that may seem like a sound basis for making an investment decision, it could result in a costly mistake. That’s because, at any given time, the company’s stock price performance may not be the best indicator of how well the company is doing, and it may also not be a good indicator of future investment performance.
In actuality, there are three “performances” that drive the overall performance of an investment. Each of these performances contributes different elements to the overall result that an investor achieves over time. The three performances are sequential. I refer to them as Business Performance, Shareholder Performance, and Investor Performance.
Performance #1: Business Performance
Most investors understand that investment performance is related to a business’s ability to make and grow profits. So, it makes sense to first look to a company’s business performance to see if it’s doing the right things and doing them well. A stock could be performing well at the moment but, if the company isn’t managing change well or is not prepared for black swans like a pandemic, its fortunes could quickly turn.
Well-managed companies with little or no debt and strong free cash flow can weather storms much better than debt-laden companies with high operating costs. A good example is airline companies, which were experiencing strong investment performance prior to the pandemic. However, even during the economic slowdown, they continued to take on enormous amounts of debt even as they were forced to ground most of their fleets. Their stocks still haven’t fully recovered while companies with strong balance sheets are experiencing record investment performance.
Business performance is all about decisions management makes in operating the business. High-quality companies focus on creating value for customers that leads to high profit margins and high returns on equity. Along the way, management must make decisions about how to allocate the company’s resources to build on what the company does and compound it over time. That’s what generates sustainable growth over the long term. Investment performance is sure to follow.
Strong management doesn’t focus on short-term results simply to boost their stock price. Instead, they stay focused on long-term return on equity and compounding it. That is the best indication that management’s interests are aligned with their shareholders’ interests, which brings us to the next component.
Performance #2: Shareholder Performance
Quality companies tend to have smart and strong leaders heading up their board of directors who look out for their shareholders’ interests. That’s because it is the shareholders who elect the board of directors as their representatives. The board decides, among other things, what to do with the profits the company makes. There are three primary ways in which the board can allocate profits on behalf of shareholders.
First, the board can reinvest some of the profits the company made back into the business. This is called retained earnings. Earnings that are retained (instead of being paid out) are invested into additional property, plant or equipment for the business in the hopes that the earnings will increase over time. Second, the board can take a portion of the profits and return them to shareholders in the form of a cash dividend. A cash dividend is a tangible way in which investors get a return on their investment. They buy stock and earn a cash dividend sometime later. Many companies consistently pay dividends because they are regularly making profits and using this as a way to return some of the profits to investors. The third primary way in which a board allocates profits is by repurchasing the company’s stock in the open market. This has the effect of reducing the number of total shares outstanding, making the shares of the remaining shareholders more valuable.
A business can generate profits, but the second step helps investors to understand exactly how those profits are being utilized on behalf of the shareholders.
Performance #3: Investor Performance
Putting investor performance last in no way diminishes its importance to the process, as long as its viewed in the right context. Investors are obviously crucial to the process of generating investment returns because they make the initial decision on how and when to allocate capital (i.e. to buy a company’s stock in the first place). That’s a significant part of the process. It starts a sequence of capital allocation decisions by the management of the business and by the board of directors on behalf of shareholders. However, once investors allocate their capital initially by investing in a company, they have little, if any, input or control. At the end of the day, they may receive cash dividends, which they must decide what to do with. Do they reinvest them to buy more shares? Do they invest the dividends elsewhere? Do they simply spend them? Ultimately, investors must then decide whether to continue to hold the stock of a particular company in which they have invested.
In summary, Investor performance is influenced by the original decision to buy the company’s stock at a particular price, what they do with any dividends that are paid, and whether they will continue to own the stock in the future.
Upcoming Series on Investment Performance
In the coming weeks, we will explore each of these three performances in depth so investors can better understand and evaluate their overall investment performance. Like an orchestra of various instruments, each of these individual elements of performance (business, shareholder, and investor) must all work together to produce a great symphony of investment returns.
