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11 Sep Capital Returns vs. Capital Appreciation

Seemingly conflicted investment philosophies abound. The goals of the individual and institutional investor alike will drive the way we see stocks and their relative value. There are two ways to look at a stock. Long term investors are looking for capital appreciation. Those in this “buy and hold” boat care less about capital returns (at least in the near term) and more about their capital appreciating. On the other hand, there are those in the other boat whose philosophy revolves directly around cash returns on cash invested. It’s what we might call the investors looking for capital returns. They’re both at the game for the same reason, to get a return on capital invested, but the long-term investor isn’t always looking for something quick.

Shareholders typically only care about one thing: the price of the stock. It is in their best interest, once they have ownership to drive P/E ratios as high as possible. Because that ratio is just math, it can be relatively easy to manipulate given the right incentives. Private equity firms and hedge funds are looking for something completely different. They’re looking for the ability to throw some cash at an opportunity and then wait for a short period (relatively) for a quick cash return so they can reinvest the monies elsewhere.

If you’re an IPO investor, you typically care more about capital appreciation, than cash-on-cash returns at least in the near term. Sam Walton knew this philosophy when he gifted his children shares in Wal-Mart stock, knowing that the appreciation would bring wealth. In any start-up, unknown or growth deal, the value will always be had in a low basis of the securities in which you’re buying. Getting in at the beginning when the basis is ultra-low and the value generated from the returns of the business is high–that’s where you want to be.

Hopefully, at some point, all capital that appreciates will eventual be traded in for cash. At that juncture a capital return calculation is in order to see where the investment went vis-a-vis other similar opportunities. For more information on this topic, might I suggest this excellent article posted at SeekingAlpha. It is important to keep in mind that these two ideas are not mutually exclusive strategies, but investors and investment managers can pigeonhole themselves into thinking that one form is better than the other without really knowing their doing so. I also would not tend to favor one over the other but include both as a good general rule for investing. One keeps more proverbial “dry powder” coming in for other potential opportunities and the other helps grow true wealth over time.