Why Is There So Much Confusion About Total Return Investing?

by: Lawrence Weinman

I must say I came away perplexed when reading many descriptions and critiques about the "myth" of the total return goal in investing. I doubt I will convince a particular group. This is an effort to clarify things for those that might be open to approaching this issue from a different perspective.

The object of total return is to attain maximum growth of wealth. To put it most simply the goal is to increase the value of the investment portfolio. In fact it might clarify the discussion if the term total return was put aside and growth of wealth, growth of account value or even maximizing account value was used as a substitute. At this point the only (yes it's a big one) debate is how to allocate the portfolio to maximize growth and minimize risk ... the quest for the elusive alpha.

To correct one misnomer, the idea of total return as a goal in investing is independent of any "withdrawal strategy" for retirement.

Consider the following scenario: Mr. and Mrs. Total Return who are about the retire at the end of 2008. In January of 1983 they received an inheritance of $200,000. They took those funds and established an investment account and began their career as value stock investors At retirement the account value has reached $4,000,000 through total return investing all of the following : interest,dividends reinvested and capital gains of stocks held or bought and sold in the portfolio.

Since receiving the inheritance, they have put a large part of their other investments in bonds They concentrated their bond investments in their 401ks and IRAs where there is no tax on current income.

They chose bonds over something like dividend growth stocks because they wanted diversification as well as interest income that was reinvested. They puzzled over the concept of yield on cost and didn't understand how some evaluated bonds solely on interest earned. Their bonds produced capital gains and interest income both of which were reinvested in the low cost bond funds and ETFs. Some notes on their bond allocation will come in part 3.

They know that bonds and stocks are inversely correlated and that bonds go up in price(and down in yield) in recessionary conditions. That will give them capital gains in bonds in the years that stocks fall in value they could have capital losses on their bonds. But they will earn higher interest due to higher rates on new bond investments.

In fact it was directly analogous to those stock investors who are happy when their stock price falls and they can buy at higher yields. Although unlike the dividend investors Mr. and Mrs. TR do pay attention to total return not just yield. For that reason they control the risk of capital loss in their bonds by seldom going beyond a 5 year duration.

The last few years with sluggish stock returns and a massive rally of bond prices they found their strategy served them well.

Mr. and Mrs. Total Return are dyed in the wool stock pickers. They considered themselves disciples of Ben Graham and Warren Buffett. Just like them, they seek to buy great companies at discount prices i.e. when the stock price was below the company's intrinsic value.

Following Buffet's example they also saw no reason to confine their stock holdings to dividend stocks. Although he certainly appreciates the growing dividends from KO and others. Buffett held onto Wells Fargo (NYSE:WFC) after it eliminated its dividend (which it is reinstating).

In fact the only persons to whom the couple gave money to invest were Munger and Buffett through their shares in Berkshire Hathaway (NYSE:BRK.B). They never collected a single dividend from BRK.B which has never paid one. They are certainly fine with that.

BRK.B has however engaged in stock buybacks of BRK.B. And his recently released letter to shareholders (page 7) he explains how happy he is with the stock buyback program of IBM (NYSE:IBM) which generates value for shareholder. Buffet invested $10.5 billion in IBM that holding is now worth $11 billion.

Recently they have noticed the fall in BRK.B's price to book (and stock price) no doubt related to concerns over succession. After all Buffett and Munger the brilliant managers for decades are now both in the 80s. For now they are holding on but watching carefully.

They do their homework researching individual stocks and learning about value investing. Here are some of the authors and books they have found most useful.

"The Little Book That Beats the Market" by Joel Greenblatt. Interestingly Greenblat favors his "magic formula" for individual investors who want to stock pick but also promotes value indexing for those not comfortable picking stocks. His magic formula is to screen stocks It iis composed of just 2 parts EBIT/Enterprise Value and Earnings Growth. Greenblatt has been called the modern day Benjamin Graham since he has modified a formula used by Graham and Buffett. The magic formula is analysed here

Since Greenblatt realizes this strategy which involves turning the portfolio every year is not for everyone. Therefore he is also an advocate of value indexing. His website evaluates equal weighted index for the S+P 500 available as an ETF. He also evaluates fundamental indexing large cap (NYSEARCA:PRF) and value indexing (NYSEARCA:VTV) .

"Fundamental Indexing," by Robert Arnott and Jacob Hsu this approach ranks stocks by dividend sales, cash flow, dividend and book value, The approach is used by ETFs and (NASDAQ:PRFZ).

Several books by Larry Swedroe which explain Fama and French's 3 factor model for explaining stock performance: Beta, Market Cap and Book to value. They advocate tilting a portfolio towards small cap and value stocks to produce superior risk adjusted returns.

A great book called "Value Investing from Graham to Buffett and Beyond" that contains essays by the greatest value investors.

The latest edition of "What Works on Wall Street" which advocates a value screen composed of p/e price/sales p/b ebitda/enterprise value price to cash flow and shareholder yield (dividends+buybacks).

Mr. and Mrs. Total Return use a variety of these factors to screen large cap stocks. Then they begin their research to stock pick with a mix of the above factors. Then they dig into their research.

As for dividends: if their stock screens turn up stocks with dividends they may buy them but it is not a make or break criteria for them. They certainly never eliminate from consideration stocks that don't pay dividends. If their hero Warren Buffett doesn't rule out an investment simply because it doesn't pay a dividend ... why should they ?

Over the 25 years they have added international stocks to their other investment accounts with a tilt to emerging markets. Since they are not comfortable picking individual international stocks they use low cost ETFs such as (NYSEARCA:VWO) for emerging markets which recently cut its management fee and VEA for developed markets.

They are intrigued by newer ETFs that tilt to small cap and value in emerging markets and in developed markets value (BATS:EFV) and small. But due to the short history of most of them, they haven't taken the plunge yet.

A lot of material here. In Part 2 we will look at how they did. The article will also show how their accumulation period total return strategy doesn't tie them to any particular approach to generate cash flows when they need them.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Mr Weinman's clients own PRF PRFZ VBR and VWO.