The Best Business: Part 2 and Market Turmoil
Since it’s been a couple months since my last post I’d recommend re-reading the first part of this two-part series to familiarize yourself with some initial concepts.
Towards the end of this article I provide some perspectives on public markets given the overall weak performance during the first half of the year.
Agenda:
Return on Invested Capital / Return on Incremental Invested Capital
Leverage
Next Topic
Market Commentary
Notable Tweets
Previously, we discussed the areas of quality that are most often analyzed by investors: revenue growth and margin profile. If you were thinking of owning a business, the rate at which the business is growing and the profit the business takes home after costs are both extremely important. Rate of growth and profit are crucial because they are some of the variables that determine the amount of Free Cash Flow, cash available to the company’s owners after taking into account all operating, financial, and capital expenditures (investments required to maintain/grow the company).
These concepts are based on sourcing information from the Income Statement and Cash Flow Statement. However, if you were to analyze a business, you’d also focus on how efficient the business is and how healthy the business is in its current state. This requires some information from the Balance Sheet, where the Assets (what the company owns), Liabilities (what the company owes), and Equity (the left over capital) are detailed. This is important because different businesses require different amounts of capital to operate effectively.
Asset Turnover
As an investor your preference might be to own a business that can produce revenues with less incremental capital, not more. This would be referred to as an asset-light business. The market likes to pay a premium for these types of companies (sometimes within the software industry, for example) because they can scale their business models without the need for a lot of incremental capital.
Imagine a food retail business that requires high-turnover of its assets: perishables and constantly stocking the shelves. Now compare that food retail business to an apparel retailer who will only have to re-invest in inventory perhaps every season. Both of these industries will have a higher turnover of assets than that of a electronics retailer who might only need to re-stock its shelves with the latest models once a year. A company that is able to utilize its asset base productively will likely have high capital efficiency. Operating in a lower turnover industry will make a higher efficiency more likely.
Information on capital efficiency is found on the Balance Sheet and Income Statement by taking Total Sales and dividing it by the company’s Average Total Assets over a specified period. This information is more helpful for asset-heavy companies such as a retailer, that is required to purchase inventory repeatedly to generate sales, versus asset-light companies that may generate revenue off of a smaller asset base such as a software company that will generate revenue by marketing subscriptions to a specific product that may only require a high upfront cost.
Return on Invested Capital
Another applicable and telling metric that fundamental investors use to assess the efficiency of the business is Return on Invested Capital (ROIC). The equation is Net Operating Profit / Invested Capital (note: there are variations of this measure such as Return on Assets (ROA) and Return on Equity (ROE)). This metric looks at the capital required to invest in the company’s assets and uses profits, not sales, in the numerator of the equation.
The ROIC provides a % return based on how much the company earns relative to the capital that was required to invest in the company to produce the respective earnings.
If this return is above the cost of capital then the business is operating successfully. In a perfect world, the company should be able to reinvest this marginal return year after year and compound its earnings for the owners of the business.
ROIC - Cost of Capital > 0
Check out this article on Warren Buffett’s $1 test
In reality, competition, technological change, and economic conditions all affect the ROIC. If a company was able to operate with a certain ROIC in the past, future developments, if detrimental to the company’s competitive advantage, represent a constraint on whether the company is likely to operate as efficiently going forward.
As a result, taking a look at ROIIC, the Return on Incremental Invested Capital can be a more helpful metric.
ROIIC is simply the Change in Net Operating Profits over the Change in Invested Capital between a projected year and the year prior.
Since a company’s share price is a reflection of go-forward expectations, having a thesis around the incremental capital efficiency is more helpful than ROIC, which is backwards-looking.
If you’re curious to learn more about ROIC/ROIIC you can refer to this great paper by Michael Mauboussin. Investors looking to own quality businesses for the long-term could leverage the ROIC concept to gauge how good of a business their target company actually is.
Leverage
Taking on debt (“leverage") is often referred to as a “double-edged sword.” Not only does it inflate the potential returns, but it also increases the potential risk of loss.
So how does debt inflate returns? Well, if a company raises money via debt there is less equity that the company is required to use for its projects. Real estate is a prototypical industry where debt is leveraged. The more debt a real estate investor could raise, the less capital he will be required to pay upfront for an asset. Taking on debt reduces the very hefty upfront costs of purchasing real estate (office buildings, hotels, and apartments are all expensive assets).
A more common example of leverage is a mortgage; most homeowners don’t pay the full price for their house upfront. Rather, a bank or lender will provide the majority of the capital in exchange for a series of payments over a number of years (20 or 30 years).
In a corporate context, debt is generally “cheaper” capital given that debt investors require a lower return on their investment than equity investors. This is due to the contractual obligation that requires security of a debt instrument as well as the primacy of debt versus equity in case the company goes bankrupt.
For example, if a company only raised capital via equity in the past, and now decides to raise money via debt, the company’s capital structure will be made up of a cheaper blended cost of capital. In other words the “required return” that the company takes into account when making capital allocation decisions can be lowered with adding some debt to its Balance Sheet.
Companies with leverage can essentially generate returns on their investments on a lower upfront amount of capital. Just like some companies can naturally leverage their scalable business model (AKA operating leverage) to grow the business with a marginally lower cost structure relative to its sales growth, companies can also lower upfront costs by raising debt. However, as enticing as this sounds, raising debt creates a fixed cost of interest payments, as well as the principal payment at the end of the debt’s maturity. These payments create a big risk in the face of uncertainty.
A company with high leverage, a large amount of debt relative to its level of earnings, carries a higher risk if something unforeseen occurs. This is because the company is still contractually obligated to pay it’s debt holders back on a fixed timelines. Debt investors won’t let the company off the hook — there’s an obligation for them to get paid in a timely fashion.
In addition, companies with a heavy debt load will need to reserve extra cash to pay off their debt principal at the maturity date, which could detract from the rate of re-investment to support growth.
Investors in quality businesses should take time to get comfortable with the level of debt a company holds, especially in businesses that are less predictable or exposed to tertiary impacts (regulation, commodities, etc.). Leverage introduces more risk to a business.
If you want a view into the harms of leverage in corporate America the Petition newsletter is a great place to begin.
Conclusion
I hope the concepts that I introduced in Part 1 & 2, help you continue to build a framework to use when searching for quality businesses to own. Understanding growth, margins, efficiency, and leverage are truly essential if you are hoping to own or even start your own business.
In addition, it’s important to remind yourself that you may find quality businesses that are trading at unattractive prices from time to time, especially in the public market. This is when valuation, the assessment of an company’s worth, acts as a guide.
My next article will delve into the concepts such as Unit Economics and Working Capital.
Market Perspective
Time in the market versus timing the market. I’m sure many of you have heard this axiom over the past few months. It rings true, now more than ever. A retail investor with the primary goal to invest his/her savings for 10+ years has very different priorities than a professional money manager who needs to consider client expectations and record quarterly/annual returns. Having the flexibility to think in 5, 10, or 15-year increments may be the best advantage of a retail investor.
However, in today’s environment, inflation eats away at our purchasing power and worries of a recession impact how we spend and invest. The negative feedback loops of people having a pessimistic mindset and adjusting spending habits can inflict an economic slowdown. Often, during market downturns, people will try to predict where the economy is going and develop opinions around the worse possible future state. The thing about macroeconomic predictions is that they are often wrong. The economy is a complex system with unpredictable methods of adapting to differing levels of supply and demand. No matter how well-pedigreed a person is, his/her effectiveness as a macro-prophet is likely slim-to-none. This is why the current state of the economy is likely to develop in ways we will not expect, although it will seem obvious in hindsight.
However, the bottom line is that the S&P is down ~19% YTD and there’s still a lot that can hurt equity valuations going forward: higher interest rates, sustained inflation, recessions, geopolitical unrest, food shortages, and housing slowdowns.
What this means is that many public companies and indexes are priced to reflect negative expectations. The aforementioned risks are fundamental reasons why the market has had one of its worst 6-month starts since the 1970s. However, an optimistic view is that this environment presents opportunities to own quality assets at cheap prices, representing high go-forward returns. The times to be a deliberate buyer are when asset prices reflect the worst of what’s to come and when pessimistic expectations still seem like they have room to run. Historically the best time to be an incremental buyer is when expectations for growth are impaired to the point of no return. Think back to 1983, 2001, 2009. I’ll qualify this by re-emphasizing that the environment now is what it is for a reason and if conditions worsen there will be more room for markets to fall. You must be comfortable with downside whether you’re investing into rising tides or no tide at all. You’ll be compensated with solid returns if you buy risk intelligently when no one else is.
Markets go up a lot and they go down a lot…your job isn’t to predict when that will happen, but to behave rationally even when the public is panicking. This memo from Howard Marks does a great job at framing these ideas.
A few interesting tweets/articles to read:
Guggenheim Investments on Pullbacks
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