A pivotal point throughout the security analysis process lies in determining a company’s use of its free cash flow (FCF). After analyzing a number of holding companies (a company that derives its revenue from partially or fully owning other companies) I realized that this business construct can potentially have a significant advantage over other businesses that focus on a specific industry segment.
Let’s first review the ways in which companies can utilize their free cash flow – there are four main ways in which companies can generate value for their shareholders by using their FCF:
1) Reinvest the free cash flow into the business (e.g. opening new stores, creating new product lines, upgrading software and equipment (for increased profitability rather than maintenance purposes)
2) Acquire other companies within the industry
3) Pay out dividends to shareholders
4) Repurchase company shares
Let’s look at the various alternatives and how they affect the value added for shareholders.
The value added through the first point really depends on the characteristics of the company’s business as well as its industry. Looking at the restaurant industry, many restaurant chains reinvest their free cash flow by opening new stores. This can potentially be very rewarding if the restaurant has a strong brand that drives customers in and can open new restaurants in locations that strategically make sense. To understand the value of such reinvestments to him, the investor first needs to determine what his own desired (realistic) rate of return should be. If he wants to generate an average 10% return on his portfolio over a 5 year time frame, it would make little sense if the restaurant company was to have a rate of return (after-tax profit/ original investment) of below 10% on new restaurant openings (assuming the new restaurant openings are the main utilization of its FCF). To give a practical example, at a cost of $4 million per restaurant, the expected after-tax profit should be around $400,000 per year in order to justify the investment for the investor. If a restaurant can achieve such profitability, the investor should be happy with this reinvestment. The problem though is that very often, managements blindly reinvest money into their business model via the opening of new stores and such, with a focus on unit growth rather than an adequate bottom line return as a measure of success (to give a very specific example, it is especially so in the casual dining restaurant industry).
If reinvestment in the own brand makes little sense, managements might decide to go with the second option and acquire another company within their industry. This can potentially add a lot of value if the target company is acquired at a bargain price due to being in a distressed state which, upon close analysis by management, is determined to be of a solvable (and hence temporary) nature. Even if no such bargain can be found, a competitor acquired at a fair price with promising underlying economics can do very well for shareholders if management is able to integrate and operate it well. However, buying companies at bargain prices, or even at fair prices for that matter, is often easier said than done. Given the nature of takeovers, which generally include a hefty premium over the current share price (in 2012 the average premium on M&A deals was 25%), the company needs to be substantially undervalued or have significant potential for such a deal to eventually unlock value for shareholders. Further, the investor needs to remember the first reason as to why the company made an acquisition rather than opening new stores which would have been substantially cheaper. If the acquisition was made because additional stores would not have generated a satisfactory rate of return, then will the acquisition of a competitor, or another company within the same industry, not also be subject to the same unfavorable factors that prevented the company from simply opening new stores? This might not be the case if the acquired company is attractively valued or significantly differentiated, e.g. due to brand value, but this question should be extensively explored. Too often, managements who cannot reasonably utilize method one go with the very similar option two since this growth in top line and store count as well as the addition of another wonderful, superior brand is promoted as a measure of success.
So what can management do if the return derived from FCF reinvestment (in new stores or other companies within the industry) is unattractive due to low margins and a substandard rate of return?
This leads us to the third point, dividends. Continuing the previous example, a prudent management might conclude that pouring money back into opening a new restaurant for $4 million, with the new restaurant being largely undifferentiated from the already existing 10 chain-restaurants which would be within a radius of 3 kilometers, is undesirable. Upon serious contemplation, as it has become expected at earnings calls to announce the number of net new restaurants to exemplify the company’s success and please analysts, the managers decided to be ‘bold’ and distribute a large portion of their excess earnings to their shareholders so that they can be reinvested at better rates, as based on the capital allocation skill of the shareholders. While this is a laudable decision in theory, there are a number of problems presented to the shareholder who, surprisingly often, will be unaware of the pitfalls due to the excitement of receiving an actual pay-off (however nominal) to his/ her investment rather than having the money grow intangibly through retained earnings. The first problem lies in the infamous double taxation of dividends – first, the company has to pay taxes on its earnings which then are again taxable by the shareholder. In the U.S., assuming the investor has a marginal tax rate of 25% or 28%, the qualified dividend rate would be a flat 15% (as of 2013) (if the dividend is not qualified, it would be taxed at a flat rate equaling the investor’s marginal tax rate). Right away this shaves 15% off of the distributed portion of the company’s free cash flow and has, as far as the investor is concerned, gone to waste. Once the investor has received his share of 85% of the FCF allocated to dividends, the next question becomes what to do with the money? Assuming our investor does not lack ideas, the next cost, which is too often ignored but bears its effect on eventual returns, is the frictional cost of reinvesting the money, i.e. paying your broker. Depending on the size of your dividend, the fees of your brokerage and through how many transactions you reinvest the money, this may again shave off a number of percentage points from the return that can be achieved through the reinvested income distribution.
Hence, while at first glance a great solution for the investor, dividends may lead to the government and your brokerage taking a large bite out of your returns.
The number of prudent managements and boards of directors that have, over a number of productive board and management meetings and in uncompromised awareness of their fiduciary duties, considered the shortfalls to the average investor of the previous three methods might arrive at number four of our potential FCF uses. Stock buybacks can be a beautiful thing – to repurchase shares when the stock price hovers clearly far below the company’s intrinsic value (and to issue shares only when it is equal to or above intrinsic value) can add a lot of value to shareholders. By repurchasing shares, the future FCF of a company has to be shared by fewer and fewer shareholders, hence increasing their share of the pie. If these repurchases are also conducted at very low prices, the remaining shareholders clearly benefit. To quote an example, let’s picture a company with a constant FCF (no growth!) of $100 million and outstanding shares of 100 million. Assuming a constant 12 times Price to FCF (P/FCF) multiple, the share price in year 0 would be $12. If the company was to repurchase 8.33% of its outstanding shares per year over the five years (using all of the FCF), the share price at year five would be $18.537, implying a 9.08% compound annual growth rate (CAGR).
If the company was to buy back shares when the stock is clearly undervalued, e.g. if a good business was able to buy back shares at an 8 times P/FCF multiple and if the multiple subsequently expanded (as the market recognizes the good underlying economics of the business), the value added for the shareholders would be significantly greater. Let’s assume the same scenario as before: 8.33% share repurchase rate, constant FCF, 100M shares year 0, but assuming an 8 times P/FCF multiple in year 0, 1 and 2, and a multiple of 12 times in years 3, 4 and 5 as the market changes its assessment of the company. The share price would have advanced from $8/ share to $18.537 by the end of year 5, yielding a CAGR of 18.3% - given the fact that the intrinsic value multiple should have been ~12 times P/ FCF (as per management’s assessment), by buying back shares at 8 times, the company purchased 8.33% of the company per year (until the end of year three) at 66 cents on the dollar.
While all of this sounds great, what if the shares are overvalued? In that case, buying back shares would be like the double taxation on dividends. Too often, managements are also not aware of the intrinsic value of their company and base a ‘cheap price’ merely on the share price history rather than on the underlying economics of the business, which could lead to the false assumption by management of a "cheap valuation" and subsequent share repurchases while the share price could actually be far than adequate based on potentially deteriorating underlying economics of the business. Hence, many managements simply go by the first or the third method of mindlessly opening new stores or paying out earnings in dividends (usually both) which can destroy a lot of shareholder value.
The ultimate question that is uncovered by our four options is: Why are there only four methods and what do you do if none of them can efficiently be applied by the company (the sad answer to this one may be "sell the stock")? Doesn’t the global economy contain an inconceivable plethora of businesses and financial assets that management could put its money into rather than being confined to this incredibly small spectrum of its own business model? That’s like insisting on eating the same food every day because it’s what you’ve always done in the past – a vicious circle.
The obvious answer is that many managements are (more or less justifiably as based on the company’s track record) fully consumed by their management duties, have to spend all of their time steering their company and do not have any expertise in other industries. Further, it has become expected that managements, for this widely accepted reason, stay within the confines of their industry because they supposedly don’t have the competency to invest money elsewhere and would therefore merely destroy shareholder value. However, no one stops to think whether utilizing methods 1-4 actually turns out to be any better.
This is where the construct of holding companies measures up very favorably. The very nature of holding companies implies that they own other companies, which gives the manager freedom in venturing into industries he/ she perceives to be lucrative and enables the most effective allocation of capital. The example that first comes to mind is Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial); it is by far not the only company employing this strategy; however, it is the most successful one. The very evolution of Berkshire itself, from a failing textile mill to an insurance conglomerate (utilizing the benefits of float), to purchasing undervalued media companies, railways, a candy store chain, shoe companies, a Chinese automaker, aviation companies (more or less successfully) etc. illustrates the versatility of this business model. A holding company with a good capital allocator is set to fare at least as well as a company that is bound by the requirement to invest within its industry (most of the time the requirement is even more narrow than the entire industry and focuses on the specific industry segment and the demographics that apply to the specific brands), for the holding company will continue to invest in an industry that remains the best choice until the value added does not suffice to satisfy shareholders anymore. Also, holding companies can scour the global markets for equities and other investments (exploiting market developments such as South Korea in 2003 through 2004) that promise value while only very few managements of regular companies have the courage, and trust bestowed to them by their shareholders, to be able to do so (and even less do so successfully).
Conclusion:
This fifth method to utilize FCF, which is fairly exclusive to holding companies due to the restrictions placed upon the managements of regular companies by popular expectations and conventions, actually encompasses an infinite amount of ways to invest FCF as it represents the investment in anything that could possibly be invested in. Hence, methods 1, 2, 3 and 4 which most regular companies are confined to are mere atoms in the universe of method 5 of successful capital allocation, so why limit yourself to such a narrow spectrum?
A Word of Caution:
However, successful capital allocators are few and far between, and while the Holding Company construct is a very promising business model, it cannot solely be relied upon for good returns. Many regular companies can still be found upon strict security analysis that promise good returns by investing within their industry, but it is important to always be aware of the shortfalls of methods 1-4 of FCF utilization and to look out for the rare management that successfully deploys method 5.
Let’s first review the ways in which companies can utilize their free cash flow – there are four main ways in which companies can generate value for their shareholders by using their FCF:
1) Reinvest the free cash flow into the business (e.g. opening new stores, creating new product lines, upgrading software and equipment (for increased profitability rather than maintenance purposes)
2) Acquire other companies within the industry
3) Pay out dividends to shareholders
4) Repurchase company shares
Let’s look at the various alternatives and how they affect the value added for shareholders.
The value added through the first point really depends on the characteristics of the company’s business as well as its industry. Looking at the restaurant industry, many restaurant chains reinvest their free cash flow by opening new stores. This can potentially be very rewarding if the restaurant has a strong brand that drives customers in and can open new restaurants in locations that strategically make sense. To understand the value of such reinvestments to him, the investor first needs to determine what his own desired (realistic) rate of return should be. If he wants to generate an average 10% return on his portfolio over a 5 year time frame, it would make little sense if the restaurant company was to have a rate of return (after-tax profit/ original investment) of below 10% on new restaurant openings (assuming the new restaurant openings are the main utilization of its FCF). To give a practical example, at a cost of $4 million per restaurant, the expected after-tax profit should be around $400,000 per year in order to justify the investment for the investor. If a restaurant can achieve such profitability, the investor should be happy with this reinvestment. The problem though is that very often, managements blindly reinvest money into their business model via the opening of new stores and such, with a focus on unit growth rather than an adequate bottom line return as a measure of success (to give a very specific example, it is especially so in the casual dining restaurant industry).
If reinvestment in the own brand makes little sense, managements might decide to go with the second option and acquire another company within their industry. This can potentially add a lot of value if the target company is acquired at a bargain price due to being in a distressed state which, upon close analysis by management, is determined to be of a solvable (and hence temporary) nature. Even if no such bargain can be found, a competitor acquired at a fair price with promising underlying economics can do very well for shareholders if management is able to integrate and operate it well. However, buying companies at bargain prices, or even at fair prices for that matter, is often easier said than done. Given the nature of takeovers, which generally include a hefty premium over the current share price (in 2012 the average premium on M&A deals was 25%), the company needs to be substantially undervalued or have significant potential for such a deal to eventually unlock value for shareholders. Further, the investor needs to remember the first reason as to why the company made an acquisition rather than opening new stores which would have been substantially cheaper. If the acquisition was made because additional stores would not have generated a satisfactory rate of return, then will the acquisition of a competitor, or another company within the same industry, not also be subject to the same unfavorable factors that prevented the company from simply opening new stores? This might not be the case if the acquired company is attractively valued or significantly differentiated, e.g. due to brand value, but this question should be extensively explored. Too often, managements who cannot reasonably utilize method one go with the very similar option two since this growth in top line and store count as well as the addition of another wonderful, superior brand is promoted as a measure of success.
So what can management do if the return derived from FCF reinvestment (in new stores or other companies within the industry) is unattractive due to low margins and a substandard rate of return?
This leads us to the third point, dividends. Continuing the previous example, a prudent management might conclude that pouring money back into opening a new restaurant for $4 million, with the new restaurant being largely undifferentiated from the already existing 10 chain-restaurants which would be within a radius of 3 kilometers, is undesirable. Upon serious contemplation, as it has become expected at earnings calls to announce the number of net new restaurants to exemplify the company’s success and please analysts, the managers decided to be ‘bold’ and distribute a large portion of their excess earnings to their shareholders so that they can be reinvested at better rates, as based on the capital allocation skill of the shareholders. While this is a laudable decision in theory, there are a number of problems presented to the shareholder who, surprisingly often, will be unaware of the pitfalls due to the excitement of receiving an actual pay-off (however nominal) to his/ her investment rather than having the money grow intangibly through retained earnings. The first problem lies in the infamous double taxation of dividends – first, the company has to pay taxes on its earnings which then are again taxable by the shareholder. In the U.S., assuming the investor has a marginal tax rate of 25% or 28%, the qualified dividend rate would be a flat 15% (as of 2013) (if the dividend is not qualified, it would be taxed at a flat rate equaling the investor’s marginal tax rate). Right away this shaves 15% off of the distributed portion of the company’s free cash flow and has, as far as the investor is concerned, gone to waste. Once the investor has received his share of 85% of the FCF allocated to dividends, the next question becomes what to do with the money? Assuming our investor does not lack ideas, the next cost, which is too often ignored but bears its effect on eventual returns, is the frictional cost of reinvesting the money, i.e. paying your broker. Depending on the size of your dividend, the fees of your brokerage and through how many transactions you reinvest the money, this may again shave off a number of percentage points from the return that can be achieved through the reinvested income distribution.
Hence, while at first glance a great solution for the investor, dividends may lead to the government and your brokerage taking a large bite out of your returns.
The number of prudent managements and boards of directors that have, over a number of productive board and management meetings and in uncompromised awareness of their fiduciary duties, considered the shortfalls to the average investor of the previous three methods might arrive at number four of our potential FCF uses. Stock buybacks can be a beautiful thing – to repurchase shares when the stock price hovers clearly far below the company’s intrinsic value (and to issue shares only when it is equal to or above intrinsic value) can add a lot of value to shareholders. By repurchasing shares, the future FCF of a company has to be shared by fewer and fewer shareholders, hence increasing their share of the pie. If these repurchases are also conducted at very low prices, the remaining shareholders clearly benefit. To quote an example, let’s picture a company with a constant FCF (no growth!) of $100 million and outstanding shares of 100 million. Assuming a constant 12 times Price to FCF (P/FCF) multiple, the share price in year 0 would be $12. If the company was to repurchase 8.33% of its outstanding shares per year over the five years (using all of the FCF), the share price at year five would be $18.537, implying a 9.08% compound annual growth rate (CAGR).
If the company was to buy back shares when the stock is clearly undervalued, e.g. if a good business was able to buy back shares at an 8 times P/FCF multiple and if the multiple subsequently expanded (as the market recognizes the good underlying economics of the business), the value added for the shareholders would be significantly greater. Let’s assume the same scenario as before: 8.33% share repurchase rate, constant FCF, 100M shares year 0, but assuming an 8 times P/FCF multiple in year 0, 1 and 2, and a multiple of 12 times in years 3, 4 and 5 as the market changes its assessment of the company. The share price would have advanced from $8/ share to $18.537 by the end of year 5, yielding a CAGR of 18.3% - given the fact that the intrinsic value multiple should have been ~12 times P/ FCF (as per management’s assessment), by buying back shares at 8 times, the company purchased 8.33% of the company per year (until the end of year three) at 66 cents on the dollar.
While all of this sounds great, what if the shares are overvalued? In that case, buying back shares would be like the double taxation on dividends. Too often, managements are also not aware of the intrinsic value of their company and base a ‘cheap price’ merely on the share price history rather than on the underlying economics of the business, which could lead to the false assumption by management of a "cheap valuation" and subsequent share repurchases while the share price could actually be far than adequate based on potentially deteriorating underlying economics of the business. Hence, many managements simply go by the first or the third method of mindlessly opening new stores or paying out earnings in dividends (usually both) which can destroy a lot of shareholder value.
The ultimate question that is uncovered by our four options is: Why are there only four methods and what do you do if none of them can efficiently be applied by the company (the sad answer to this one may be "sell the stock")? Doesn’t the global economy contain an inconceivable plethora of businesses and financial assets that management could put its money into rather than being confined to this incredibly small spectrum of its own business model? That’s like insisting on eating the same food every day because it’s what you’ve always done in the past – a vicious circle.
The obvious answer is that many managements are (more or less justifiably as based on the company’s track record) fully consumed by their management duties, have to spend all of their time steering their company and do not have any expertise in other industries. Further, it has become expected that managements, for this widely accepted reason, stay within the confines of their industry because they supposedly don’t have the competency to invest money elsewhere and would therefore merely destroy shareholder value. However, no one stops to think whether utilizing methods 1-4 actually turns out to be any better.
This is where the construct of holding companies measures up very favorably. The very nature of holding companies implies that they own other companies, which gives the manager freedom in venturing into industries he/ she perceives to be lucrative and enables the most effective allocation of capital. The example that first comes to mind is Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial); it is by far not the only company employing this strategy; however, it is the most successful one. The very evolution of Berkshire itself, from a failing textile mill to an insurance conglomerate (utilizing the benefits of float), to purchasing undervalued media companies, railways, a candy store chain, shoe companies, a Chinese automaker, aviation companies (more or less successfully) etc. illustrates the versatility of this business model. A holding company with a good capital allocator is set to fare at least as well as a company that is bound by the requirement to invest within its industry (most of the time the requirement is even more narrow than the entire industry and focuses on the specific industry segment and the demographics that apply to the specific brands), for the holding company will continue to invest in an industry that remains the best choice until the value added does not suffice to satisfy shareholders anymore. Also, holding companies can scour the global markets for equities and other investments (exploiting market developments such as South Korea in 2003 through 2004) that promise value while only very few managements of regular companies have the courage, and trust bestowed to them by their shareholders, to be able to do so (and even less do so successfully).
Conclusion:
This fifth method to utilize FCF, which is fairly exclusive to holding companies due to the restrictions placed upon the managements of regular companies by popular expectations and conventions, actually encompasses an infinite amount of ways to invest FCF as it represents the investment in anything that could possibly be invested in. Hence, methods 1, 2, 3 and 4 which most regular companies are confined to are mere atoms in the universe of method 5 of successful capital allocation, so why limit yourself to such a narrow spectrum?
A Word of Caution:
However, successful capital allocators are few and far between, and while the Holding Company construct is a very promising business model, it cannot solely be relied upon for good returns. Many regular companies can still be found upon strict security analysis that promise good returns by investing within their industry, but it is important to always be aware of the shortfalls of methods 1-4 of FCF utilization and to look out for the rare management that successfully deploys method 5.
