Thanks to Twitter, I became aware of a thought-provoking FT article by Terry Smith on returns on capital. In summary:
The problem is that while fund managers who buy these low-return companies wait for the events which they think will change the situation, the companies destroy value. But the reverse is true when you own shares in a company that generates returns well above its cost of capital.
So, ideally investors should look for companies with high ROCE and low cost of capital.
But I think there is a snag here. Investors are the ones who provide equity. If you want to know the cost of equity, look at the earnings yield (reciprocal of PE). What’s good for the company is what’s bad for the investor. If the company has cheap access to equity, then it means that I, as an investor, am willing to provide it, with a low return to myself. From my perspective, I want to provide equity when its cost is high, not low.
So what I’m looking for as an investor is a company that has a high ROCE, and high earnings yield. Did someone just say “Magic Formula”?
As an aside, it is interesting to see that although interest rates are low, companies have had problems actually accessing debt due to banking woes. This might explain two things: if debt finance is difficult to obtain, then companies must resort to equity finance. This pushes up the price of equity finance – hence why we have rising stock markets. The second thing it explains is why companies are stockpiling cash: debt is difficult to obtain, equity cost is high, so companies must build up reserves in order to finance expansion.
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It’s also interesting to ask: what would be the effect of more levies on bank balances? From an investor’s point-of-view, funds would flow out of banks and into something else. One place would be equities. So share prices would increase. Concomitantly, companies will reduce their bank balances too, because the cost of cash (wow, we’re now entering a whole new paradigm where not only does debt have a cost, but cash does too) – and that’s OK because the increase in share prices means that it’s cheaper to raise equity finance. It does make banks rather illiquid, mind.
So, if you believe that argument – I thought of it, so you probably shouldn’t – then actually this whole Cyprus thing is bullish for markets, not bearish. It’s probably really good too for mezzanine finance. In fact – and this one is not really a new idea by me – we could see the emergence of a whole new subsector in finance, where companies provide a substitute for banks.
OK, leaving those things aside and returning to the original point … there’s probably a more subtle interplay of ROCE and cost of capital, involving both the availability and cost of both of the components of equity and debt. It’s also not just about high ROCE, it’s about incremental ROCE. A company might have high ROCE, but if it can’t find any worthwhile projects to invest in, what benefit does it do me as an investor even if I can provide equity?
This leads us on to the next topic as to why Greenblatt chose tangible capital as a way of measuring returns. Although I have reservations about it, my understanding of his logic is that it is a way, albeit imperfect, of measuring a potential return on incremental capital.
I’m sure I’m missing out on a ton of other point, too, but that will do for now.
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2 Comments on this Article show/hide all
I agree on the point about this Cyprus business being good for equities. I mean people hold cash in the bank because its safe right?
The combination of rising equity markets with a flat-lining economy is not really that strange. In fact its bleeding obvious that with the economy showing no signs of recovery and very low interest rates stretching out to the horizon that a dividend yield of 3-4% starts looking pretty attractive even for a company that isn't growing. Meanwhile bonds, property and gold have all topped out and anyone holding cash in the bank is losing money in real terms, even without the threat of part of it being expropriated by the authorities.
So although a bank levy would almost certainly never happen in the UK ( or anywhere else), I think just the idea of it will have profound implications on people's perceptions of risk. This is good for equities.
I've copied below a comment I have just posted on another thread called "Where do I get my iunvestment ideas from" by canteatvalue which I think addresses some of the points raised here. http://www.stockopedia.co.uk/content/where-do-i-get-my-investment-ideas-from-72086/
My main focus is on finding quality at a reasonable price (QARP), so my key metrics are operating margins (which I like to see at 15% or more) and returns on total tangible assets (but after adding back non-acquisition related intangibles such as capitalised software development costs). I want a company to be returning at least 25% or more using this measure of capital efficiency (EBIT/Adjusted total tangible assets). Companies which do well using this metric generally have to spend less on replacing physical assets and can grow the business with less inventory/working capital. They usually throw off prodigious amounts of free cashflow which can be used to make earnings enhancing acquisitions (without the need for excessive & risky debt or dilutive share issues), pay generous dividends and/or finance share buy backs.
Reckitt Benckiser is a prime example of a company able to generate high returns on total tangible assets (around 70% when I last checked!). Other examples in my portfolio include IG Group, Euromoney and Dragon Oil.
I prefer this measure to ROCE, ROA or ROE. These other measures include goodwill and acquisition related intangibles and on the other side of the balance sheet, acquisition related debt. This makes it hard to compare how innately capital efficient a business is and unfairly prejudices companies which may have acquired economic goodwill through acquisition as opposed to companies which have created (non-reported) economic goodwill through organic growth.
I don't like using ROE because it bears little relationship to the return on my invested capital. So, if a company is generating 20% return on equity and I have paid 5 times book value to acquire the shares, my return on my equity is effectively just 4%!
I'll use ROCE to flag up companies making poor acquisitions based on EBIT/total assets less current liabilities. I try adding back any historic goodwill write-offs and aggregate amortised acquisition related intangibles to give me a more accurate picture of how much capital has been available to management but getting the adjusted numbers can involve alot of work. I'll use Net Debt/EBITA to avoid companies with excessive debt (I don't want to see this at over 2x or 3x).
Finding great companies is one thing. Buying them at the right price is another. I tend to use the forward earnings yield (the P/E ratio inverted) because it helps me to think of a stock as if it were a bond but with a variable earnings stream instead of a fixed income stream.
I've learned from Warren Buffett how a company growing earnings by 10% p.a. but which retains all or most of its profits is far less impressive than a company able to grow its earnings at the same rate but which passes most or all of its profits to shareholders in the form of dividends, buy backs and tenders.
To capture this insight in my own investing, I estimate the forward earnings yield over 5 or 10 years but make an adjustment to penalise companies earning a poor return on my money. I do this by adding to the cost of the shares an estimate of the profits per share to be retained by management each year.
So if the shares are 100p to buy and the company is forecast to earn 10p in the first year, my opening expected return on my invested capital (“ROMIC”) is 10%. If management retains the whole 10p of earnings, my investment going into the second year is now 110p (the price I paid for the shares 100p and the 10p of profits per share which is retained in the company). Let us assume management grow earnings to 12p in the second year. My return is now 12p divided by my total investment to date of 110p which gives me an expected ROMIC of 10.9% in the second year. In fact management must deliver at least 11p in earnings in the second year for my expected ROMIC to stay level at 10%.
I look for companies where the expected ROMIC is rising over time and is expected to reach 10% within 3 to 5 years of my original investment.