What are the primary factors which determine the long-term returns on any particular investment decision? Whether you are buying a property, or bonds, equity in a business or allocating to a private equity fund, in all cases these are investment decisions, and it is important to understand the underlying factors which determine what your returns will look like in the future.
The quality of the assets is an important factor, no doubt. What are you buying, you want to avoid very low-quality assets most of the time, unless you are an expert in that field, and even then, we would tend to advise avoiding the lowest quality assets. Higher quality is preferred. But this, surprisingly, is not the most important factor for determining investment returns.
What about the region or country in which one is investing? An investment where the assets are predominantly in France, or the United States, may have very different characteristics and risk profiles to an investment in Egypt or Thailand. Again, this is an important factor to consider, but it is not the biggest determinant of the return profile of any investment.
And we could continue in this vein with other important factors. Is the equity investment in a business with high or low levels of debt? Is the bond investment into corporate or government notes? How much diversification is there in the fund you are investing? All relevant, all important, but none nearly as important as the factor we have in mind here.
By far and away the most important factor in determining the returns an investor can expect to achieve is price. What was the initial price paid for the investment. It may sound oversimplified, but it is easily, and all too often overlooked by professional and retail investors alike.
Everything else, the quality, the location, the leverage, etc. are distantly relevant when compared to the enormity of the importance in the price you pay for an investment. Imagine, for example, a high-quality, well-located investment property in New York or Paris. You may have bullish expectations about the future of these returns based on the location, growing demand, rising populations and scarce supplies. Sounds like your investment returns should be healthy, right?
Let’s think of another example. A technology leader in cloud computing releases another round of artificial intelligence (AI) applications which dominate the market. As the world moves towards more cloud computing and AI functions, this company is set to keep growing its revenues and profits at a high rate over the next decade. Again, this sounds like investment returns should be strong?
In both cases and many more we could illustrate, on many of the important aspects of an investment these examples fit the bill. They are very high quality, located in attractive jurisdictions, exposed to long-term structural tailwinds which should support growth in income, etc.
But in all cases, if the price being paid for the investment at the start of the investment period is high, then investment returns will be low over the time horizon in question. An investor could yield far greater returns from investing in much lower quality assets if those assets are being purchased at a more attractive price. The lower the price relative to the quality of what you are buying, this is the secret to delivering strong returns.
Picking the best technology, the best quality products, the best locations, whatever the case may be, are all well and good. But what price are you paying? And how does that price compare to the underlying value and quality of the assets you are buying?
This is why we continue to believe that a strategy of targeting quality at low prices is the optimal long-term approach for investors looking for strong returns through the investment cycle. A patient approach focused on buying high quality, but only buying when the prices are attractive, biases the portfolio toward stronger returns.
Understanding the importance of price versus all other factors, is critical for investors seeking long-term success in their investment returns.