Thursday, September 15, 2011

"Total Return"

I hope to make reference to today’s article in the future…

Bill Gross, the legendary and infamous bond guru, and more recently anti-federal-intervention-activist, coined the term “Total Return” back in the early 80’s. He attached the name to his flagship fund: Pimco Total Return

Total Return (TR) is all investors care about—the bottom line is always performance. TR is defined as the sum of price appreciation and income:

            TOTAL RETURN   =          Price Return              +          Income Return

Active investment, such as one’s job, is primarily a function on Income Return – you collect a pay check for services rendered. So the concept really applies to passive investment(ing). When you passively invest in some asset, your returns will come from either selling that respective asset at a higher price and/or collecting a form of dividend. So let’s expand on this formula:

            TOTAL RETURN   =          Price Return              +          Income Return
                                       (Dynamic = change in Earnings & Multiple)  +  (Static = Market Dictates)

Talking points:

- Price Return is dynamic, and where the waters become muddied. When you buy a business, you are acquiring its earnings power. You pay a premium for that—some type of multiple over operating earnings. You receive the dynamic price appreciation as the business increases raw earnings power, or alternatively, from a “multiple expansion,” which is a fancy way of saying: what someone is willing to pay for the business. Hopefully you can see how this can rather easily turn into a matter of opinion…this is what markets try to reconcile.

- Income returns are “static” in that rates are locked in; like the background character in any screenplay, you know what you are getting. Knowing how much money you will collect is nice, and sometimes that is all one can ask for. However, thinking about the risks of inflation, credit, and all of those subtle and often unquantifiable threats can make this income return look not so great.

- How do you know what is prudent, do I want price return, income return, or both? If both, how much of each should I want? Obviously we just begun a conversation on dictating what you require out of your investments. From here, we can keep walking backwards while looking forward, and try to answer the questions of “what constitutes an investment?” and “what risks come with the returns that I am trying to obtain?”

I guess we will have to pick up this conversation…or better yet…use this theoretical backdrop in context. Because after all…people only care about real-life and the bottom line: Total Return.