Your required return: An 8% per annum return on investment over 10 years

Successful investing should be based on purchasing assets yielding a good long term return at the right price

I was reading The Outsiders: Eight Unconventional CEOs and there was this portion where it highlights the CEO of Washington’s posts mantra for acquisitions is that it must meet a 11% cash yield over 10 years.

I thought that is rather interesting seeing that many are asking what is the right price to buy stocks.

The most important skill for a CEO is capital allocation, and for the investor it is also the same skill.

Yield versus business cycles and risks

Many a times, the evaluation is done for an asset next year yield to be X%, which would have met your required return (dream return)

One needs to look more into the return per unit risk.

By that if your asset(purchase) yields 8% when their business is doing best, you failed to wonder: how would it look when business isn’t so  well??

If your asset yields 8% when their business is in a doldrums, and that is the minimum it can go (lowest operation risk), then wouldn’t that be a better investment?

Risk Premium

An asset with higher risk demands higher return.

If you evaluate an asset to be high risk, you shouldn’t be ok with a 8% return. Due to that risk it should be at least returning you 12% say for example.  8% means you are not getting a good deal, not much safety.

First REIT

I come back to yesterday’s example where this Indonesia hospital trust’s yield is at 5.3%.

We know that the master lease is 15 years and the assets are purchase with a 9% net property income.

At a interest cost of 4% roughly, 9% is a rather good asset yield to have.

And this looks a good purchase if they can lock in that cash flow for 15 years with a roughly 2% growth rate.

But First REIT price to book value now is 1.55 times. Which means that you are roughly paying for substantially less on that asset yield.

Would a 5.3% compensate the risks (what are the risks here?)

It looks like my average cost at 83 cents, which is below its book value looks much better.

8% as my required return

I don’t care whether it comes from dividends or buybacks. In the long run cash flow or earnings yield should return me roughly 8%.

That is after factoring historical earnings, cash flow projections when the company is doing on average rather than when its doing really really well.

That gives me more safety. Of course the business story shouldn’t change so much.

I would purchase at 6-7% yield if the business gives me less risk.

I would purchase at 9-12% yield for business that are higher risk which I may deem the risk is more difficult to estimate, or I think the risk is lower than the return.

Summary

It is the evaluation of risk in the business and understanding the business so as to tune the right price to buy that is difficult.