Consider STRET. The quick answer is that in the short-term, total return as calculated by STRET is heavily influenced by whether the stock is over-priced or under-priced, according to the current PE ratio, compared to the forecast PE ratio. In the longer term, this influence starts to be replaced by the importance of the forecasts of earnings growth and the payout ratio.
For simplicity, assume that there are no dividends. If the current PE ratio equals the forecast PE ratio, then the return on the investment given by STRET will be equal to the growth rate of the earnings for all investment periods.
More usually the current PE ratio will be higher than the forecast PE ratio since we want to build in a margin of safety. In this case, the return on the investment as calculated by STRET will be less than the growth rate of earnings. However, as the investment period increases, the value of STRET will increase. In a sense this is because the loss is amortized over more years.
Imagine the extreme case when the PE drops by 50% overnight. This will give an immediate negative return. However, if the PE drops by this amount while the earnings are steadily growing, then the investment return will eventually be positive.
When the current PE ratio is lower than the forecast ratio, then the STRET value will increase as the investment period increases.
This is the situation when there are no dividends and so the discussion also applies to STRETD.
When dividends are paid the situation is more complicated since we have to take into the payout ratio, but the basic idea is the same: short-term results are mainly driven by changes in the PE ratio, longer-term results mainly driven by earnings growth and the payout ratio.
