Two Sides Of The Investing Coin

Lately I’ve been looking at possible investments for some of our excess cash.  Its got me thinking about markets, investing, and market cycles.

All markets go through cycles.  Boom and Bust.  By the look of things, we’re in the “boom” part of the cycle right now.  Valuations are not on my side.

Some years stock prices will be booming, some years they’ll be in the gutter.  Business cycles are just the way capitalism works.  Good companies survive the market cycles.  Poor companies get tripped up and fail.  Obviously if we want our money to grow, making good investments is key.

Looking for Exceptional Returns

When I invest in individual stocks, I hope to achieve exceptional returns from my investments.  If I didn’t want exceptional returns, I wouldn’t invest in individual stocks.  I would simply invest in index funds and accept what the market sends my way.  My preference is to do a bit of both.

So how do we pick out the companies that provide us with exceptional returns?  Just read this post and you’ll be set for life!  

Ha!  Of course, I’m only kidding!  If only it was simple!  

All joking aside, I can get you started in the right direction….

To begin with, there are two sides to the investment coin.  I like to call them value and quality.  One matters more in regards to short term returns, and the other matters over the very long term.  They don’t frequently happen together, but when you find both working in tandem, returns can be exceptional.

Value

Value investing gets a lot of press these days.  It’s a well known strategy, and people understand it.  Buying companies when they’re on sale is easy to grasp, and who doesn’t love a deal?  We frequently hear about the using different measures used to evaluate “value”:   Price to Earnings, Price to Book, Price to Sales,  Price to Cash Flow, Earnings Yield, and so on.  These are all excellent metrics to evaluate business valuation.

Unfortunately, value traps can also exist.  Value traps are companies that look cheap using common metrics, but they’re cheap for a reason.  Value traps have serious problems, and may not be able to recover their former glory.  Maybe their industry is changing.  Maybe profitability is permanently declining; there could be any number of reasons.  

Whatever the reason, try to avoid the value traps.

Value investing can be a huge boon to our investment returns, but it can also cause us to unintentionally invest in poor companies.  Ideally, we want to invest in companies that aren’t just cheap – but cheap and good!

Quality 

Unfortunately, quality businesses rarely go on sale.  Quality businesses are the double-rainbow unicorns of the business world, and share prices reflect that.  They’re really good companies.  They aren’t immune from the chaotic forces of change and time, but they have a habit of achieving success despite the odds.

Over time, a quality business stands out because it invests capital continuously at high rates of return.  These are the Johnson & Johnson’s, Cokes, and Abbot Laboratories of the world.  Yes, I’d even put Phillip Morris into this category.  Over time, Phillip Morris has been the most successful stock in the world.

There’s quality traps to avoid here too:  Growth businesses always seem like quality companies at first.  They grow fast, and stock prices rocket to high P/E levels.  Entering new markets, growth often exceeds 20% a year, and investors see this as incredibly positive.  The estimates for growth always look tremendous.  While growth companies look fantastic, it could also just be dumb luck.  

When a company is in it’s massive growth stages, it’s hard to truly evaluate quality.  That new market is untapped, and any investment made by management looks excellent – Even gold plated washrooms, catered lunches, and private jets.  Business managers can do stupid things with money, and from a financial metrics perspective you wouldn’t notice.

One day though, the cows will come home.  The industry won’t be so hot, and growth will slow.  Will those business managers be able to keep-up living the high-life and still realize those same fantastic returns?  Probably not, and the stock price will come crashing down.  Zynga is a perfect example of this happening in recent years.

Put simply:  Growth is not the same as quality.

Quality companies can find ways to keep growing at a reasonable and steady pace.  They do smart things with shareholder money.

So how do we evaluate a good quality company vs. a poor quality company?  Enter a little talked about measurement: Return On Capital.

What Is ROC?

What is Return On Capital?  Quite simply, Return On Capital (sometimes called ROIC) is the business return derived from the business’s assets.  

Wikipedia defines the measurement like this:

ROC = (NetOperatingProfit – AdjustedTaxes) / InvestedCapital

Joel Greenblatt defines Return On Capital in his book (The Little Book That Still Beats The Market) as the following:

ROC = EBIT / (Net Fixed Assets + Working Capital)

Both definitions are pretty similar, but I prefer Greenblatt’s definition.  It removes some of the unnecessary noise of excess cash on the balance sheet and intangibles.

Confused?  Still don’t understand ROC?  An example might be a better way to illustrate how it works…

Let’s say one day you decide to start a candy business.  You decide you’ll need to invest $200,000 into equipment, inventory, and some cash for working capital.  Things go pretty well that first year. The business earns $50,000 after taxes.  That means your return on capital is 25%.  That’s a decent ROC.  Now you have an extra $50k to put to work.  Can you achieve a 25% ROC next year?

Notice that debt doesn’t doesn’t factor into the equations.  How the investment is financed isn’t relevant for the calculation.  You could buy that candy store with cash, or you could borrow that $200k from your Aunt Flo.  As long as the return is $50k, the ROC will be the same.

Not all companies are going to have high returns on capital.  Some business managers are going to make better decisions and some industries are going to be much better than others.  As investors, we want to pick the best of both worlds, better managers AND better industries.

Some companies may also have difficulty putting excess earnings to work into the business.  They may instead choose to pay-out those earnings as a dividend.  

How does this work out long term, assuming fairly constant returns on capital?  Let’s take a look at some of the different possibilities:

Clearly, the company that can continually invest the most capital at the highest rates of return is going to be the winner.  Company A in our example is that winner.  It can invest all new capital at a 25%.  Company A and Company B are both examples of the kind of company we’re looking for.  They realize high returns on capital from what they invest. Over time, our return (as individual stock investors) should approach the average ROC.

Time is the enemy of the bad business and the friend of the good business.” — Warren Buffett

Why use ROC instead of ROE or ROA?

Clearly, there are other measurements we could use to evaluate quality.  Some of the more common ones are Return on Equity (ROE) or Return on Assets(ROA),  Shouldn’t we use those measures instead?

When an investor looks at a variety of stock investments, he or she needs to select the best investment  from the many possible options.  Unfortunately, different companies and industries are going to have different tax levels, debt levels, and intangible assets (like goodwill) that seriously distort comparisons.

Return On Equity and Return On Assets use net income, and make no attempt to remove those financial distortions.  Using ROE and ROA for making investment comparisons is fraught with problems.

Return on Capital tries to get down to just the capital invested in assets, and remove some of that excess noise.  Joel Greenblatt gives this concept plenty of attention in his book (more than I’ve given it here).  I suggest picking up a copy for further reading if you’re interested.

Value or Quality?

So now we’re down to the brass tacks of it.  Which is more important, value or quality?  The answer is: they’re both important.

In the short term, valuation and market cycles will control your returns.   Over the very the long term, stock returns will begin to approximate business returns.  Said more simply, if a business sees a 10% return on capital, over time the stock should also return 10%.

It’s a simple mathematical fact.  The two can diverge significantly at times, but eventually they will converge.  

Want a real life example?  Let’s use Berkshire Hathaway to illustrate the point…

Imagine for a moment we have two investors that buy into Berkshire Hathaway.  Investor A buys shares on October 13th 1987 at the high point, hoping for long term returns.  Investor B buys shares on October 27th at the low point because they seemed like a good value.  How did the investment turn out?  It depends on how long they held on:

Big surprise – Both investors realized incredible rates of return!  Within 5 years (October 1992), Investor B doubled the return of Investor A because he invested when the price was low.  

If Investor B sold in 1992 (to “lock in” his gains), he would have been making a giant mistake.  1992 is roughly the point where quality returns overtook value returns.  Value investing made a 100% return, but quality investing made over 4000%.  If you hold stocks long enough, eventually compounding matters more.

The Different Kinds Of Quality

It’s important to remember Return On Capital is not a fool-proof investing method to financial gain.  Long term returns on capital are just one way to measure quality.  It doesn’t give us the entire picture.  

We need to further understand the durability of earnings, market share, quality of management, and competitive advantage to see the entire picture.  

Return on Capital is just one place to start – A quick filter to sort the wheat from the chaff.

If you’re interested in learning more about investing in quality businesses, I recommend The Essay’s of Warren Buffet: Lessons For Corporate America.  The strategy of buying quality companies at fair prices has served Berkshire Hathaway very well over the years.  They know quite a bit about quality over at Berkshire.

I also highly recommend Joel Greenblatt’s book The Little Book That Still Beats The Market.  While Mr. Greenblatt may believe he’s found a magic formula to investing success, he’s definitely onto something by focusing on the fusion of Value and Quality.

Can You Wait Long Enough?

It’s rare, but sometimes value and quality do come together at the same time.  That’s when I choose to invest in individual stocks.  It’s a buy and hold for a really long time strategy.  

I’ve talked about a couple of these investments already on this blog.  In the case of Montpelier and MAA it took at least five to ten years for those outsized returns to be realized.  Patience was key to realizing that compounding value.

In fact, most of the individual stocks in my portfolio I’ve owned for more than 10 years.  Some are even approaching 20 years.  Investment fees are basically zero for that entire time period because I’m not chasing short term gains.

It’s not perfect, but it’s been a recipe for very good returns over the years.  

Are you patient enough?

[Image Credit: Flickr]