Return metrics are usually normalized to annual periods. And this is because the dimension of time plays a crucial role in the realm of investment returns.
I want to introduce the $100 company and that won’t take long. The $100 company has no liabilities and only one asset item on its balance sheet: It holds USD 100 of cash in a bank acount. That’s it!
The company currently trades for $70 on the stock market, comprising of 100 shares outstanding trading at a price of $0.70 each.
i) This is an obvious steal, since we can buy the whole company and liquidate it. Without paying any liabilities, for each share we can pay out $1 to shareholders (so we could literally buy a dollar for seventy cents). This operation makes for an immediate and [non-annualized] safe return of 43.0%, since we bought the company/shares at a discount of 30% to fair value (cash).
After introducing a little friction into our idealized world, we can still garner a very high risk-adjusted return just buying and liquidating the company.
ii) We buy the whole company but this time we can only liquidate it after one year after some legal issues are resolved. Without paying any liabilities for each share we can pay out $1 to shareholders (so again, we bought a dollar for seventy cents). This operation makes for an annualized return of 43%, since we bought the company/shares at a discount of 30% to realizable fair value.
But there was a time when cash generated interests and employees demanded to be payed. In a more general sense: assets generate returns and companies incur operational costs.
iii) Again, we buy the whole company for $70 and liquidate it after one year. But the company’s manager wants to be payed his annual salary of $5. For not undermining our liquidation he also receives an additional severance pay of $5. The good news is that our cash generates interest of 10% p.a., amounting to a cash balance of $110 after one year, which is reduced to $100 after paying two times five dollars to the manager. We can pay out $1 to shareholders for an annualized return of 43%.
Some more friction like going to arbitration court results in an extended time-frame.
iv) We buy the company for $70 but can only liquidate it after three years. The company’s manager receives his annual salary of $5 and $5 severance pay. The good news is that our cash generates interest of 10% p.a., resulting in a cash balance of $105 in t1 and $110.50 in t2. After year three, we receive 10% interest and end with a balance of $121.55 in t3. After paying a total of $10 to the manager we end up with $111.55 that is distributed to shareholders for a total return of 59% over three years. This makes for an annualized return of 16.8%.
The time dimension
Time is a critical dimension in the realm of investing, for achieving high(er) annualized returns. Hopefully, the above examples serve as illustrations. Value investors want to achieve high(er) annualized returns above ‘fair returns’ by buying into companies at prices below their fair value. This is what value investors call ‘investing with a margin of safety’.
Fair returns (and discount rates) for any individual company depend on the business’ riskiness and its capital structure. In the above examples, we could argue for fair (riskless) returns being 10% p.a., since this is what the company’s asset ($100 cash) would generate on their own and the capital structure consists of pure equity.
Generated returns depend on the companies’ features. The cost structure (salaries) of the above company dampens the compounding of its economic equity value and its (gross) liquidation value.
Investors’ returns converge with companies’ returns the longer your holding-period until fair value is realized. The arrows illustrate lower returns (slope) for longer holding periods. Realizing the valuation gap between price and fair value can be done in a short oder longer period, with the former obviously pushing annualized returns higher. For achieving this during a shorter time frame, often so called catalysts are needed.
I hope you enjoyed my thoughts about the dimension of time.