Do YOU Know How to Make Money from Dreams and Nightmares?

Know the ‘Dream Factor’ to make money in stocks

Understanding where stock market returns come from in Asia’s markets

One dollar became 258, but where did it come from? If an investor put one dollar in Asian stock markets (excluding Japan) in 2000 and let it grow until the end of 2013 they would have ended up with 258 dollars. But where did this return come from? It came from five factors, four of which are related to the fundamentals of a company and the economy it operates in, while the fifth has to do with how the investing public feel about the future – hence we call this last one, the “Dream Factor”.

Four factors are about business fundamentals

The first and largest factor is inflation, which over that time contributed about 44% of the total gain. The second highest factor, the real growth in book value per share, contributed nearly 40% of returns. This is the core “growth” objective of business. Growth in book value comes from retained profit, which in turn comes from either growing revenue, reducing costs or both. So book-value growth is proof that a company not only has demand for its products, but that it can operate efficiently enough to make a profit.

Incorporated in the growth in book value per share is the third factor, which is the impact of a company issuing new shares in the stock market. If a company raises money by issuing a large number of shares, but uses that money for less profitable investments, then it will be a drag on book value per share, diluting an investor’s ownership interest. This element is embedded in growth in book value per share.

The last fundamental factor is dividend yield, the portion of profit that is paid out to shareholders. This contributed about 30% of return.

Factor five is all about dreams of future growth and opportunity

When investors in the stock market are willing to bid up the price of a stock, even though the underlying factors didn’t change, it means that they are more positive about the future growth potential of the business. If the underlying book value of a stock does not change and investors push up the price-to-book (PB) ratio from say 1x to 2x, a multiple expansion, it is an expression of their dreams of the future. When those dreams are crushed, they could just as easily push the price back down to 1x PB, which would cause the stock to collapse and de-rate. In the case of Asia, the “Dream Factor” has been reduced to such a point over those years that it has actually been a drag of 10% of the total return of 258.

Knowing where we are to know where to go

It is important to know what factors are driving performance to give yourself a guide for what to do next. In the case of Asia ex-Japan, the low “Dream Factor” makes us relatively comfortable to invest in 2014.