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A Recipe

May 2013

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In last month’s report we looked at the components of total return for stock investments and concluded:

Total Return = Dividends +/- (Earnings Growth + Change in P/E ratio)

This framework is commonly applied to individual stocks and to stock market indices. But it can also be very helpful in managing client portfolios.

Price = Earnings

Earnings growth, changes in the P/E ratio, and dividends all contribute to a portfolio’s performance. However, our analysis suggests that the key to this recipe is earnings growth. For example, in this chart, we present the price (first blue line), earnings (green line), and P/E (second blue line) for a sample of Capital companies* at the end of the first quarter of 2013.

*Sample group is FISV, DHR, AME, ECL, and WAG equally weighted

Although changes in the P/E ratio seem to provide a better explanation for the short-term movements in prices, earnings growth was the key longer-term driver. In fact, during this eight-year period, the growth in earnings explained 90%** of the change in price.

** The correlation coefficient for earnings and price was 90%.

Relative Price = Relative Earnings

This same analysis framework can be applied on a relative basis. And, it can be very helpful in constructing and managing portfolios. In these charts we look at the relative# price, earnings, and P/E of the sample of Capital companies at the end of the first quarter to the S&P 500.

# The relative charts are made by dividing the Composite by the S&P 500. An upward sloping line means the Composite did better than the S&P 500 and vice versa.

The top line is the companies’ price relative to the S&P 500 price. The middle line is relative earnings, and the bottom line is relative P/E.

Similar to absolute prices and earnings, there is a very strong historical relationship between the relative price and relative earnings lines over the period.

In fact, the relationship is even stronger. Based on the correlation analysis, relative earnings explains 95% of the relative price.

What does all this really mean? It strongly suggests that constructing a portfolio of companies that collectively grow their earnings faster (upward sloping relative earnings line) than the S&P 500 on a consistent basis is a very important determinant of performance.

We remain focused on understanding the current trends in fundamentals because it gives us the best probability for success.