In recent years, proponents of value investing have placed a much greater emphasis on calculating return on capital (ROC). The concept is supported by the famous Buffett quote: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” According to Buffett, he came to that conclusion sometime after be purchased See's Candy at a sizable premium to its tangible assets. Prior to that time, "The Oracle" had concentrated on purchasing companies at sizable discounts to their tangible book values. Buffett credits his longtime confidant Charlie Munger for assisting him in internalizing that epiphany.
The concept was further etched into the value psyche when Joel Greenblatt created his "Magic Formula" which described the importance of ROC in his investing classic: "The Little Book That Beats the Market." Greenblatt's simple edict proposed that investors could outperform the overall market by adhering to two simple concepts. Specifically, investors should focus on purchasing equities which were fairly priced (in terms of pretax earnings yields) and exhibited high rates of return on invested capital. In other words, it was the return rate of the capital invested in a business that mattered, rather than the price per share of the capital in the form of a discount to book value. The assumption is that value was best represented by a company’s efficiency in generating profits as opposed to the merely relying on the discount at which the assets could be purchased.
Buffett acknowledged his failure to identify the concept that long term value is a function of ROC when he purchased Berkshire Mills at a substantial discount to the company's tangible book value. In terms of the balance sheet, the business appeared to be a prudent purchase; however, the perpetual decline of the business belied the value of the assets. Simply stated, the intrinsic value of the business was significantly less that the value of the net assets of the business. Such businesses are referred to as "cigar butts," and they only offer value if their liquidation value substantially exceeds their market price.
As my long time readers are aware, I am a proponent of purchasing stocks which trade at a discount to their tangible book value rather than attempting to analyze the business value of a company by determining their likely long-term rates of return on capital. Ideally a stock would possess both factors (a discount to net assets and a significant business value); however, the aforementioned combination is rarely available to investors during typical market conditions.
It is my contention that the average investor is better served by purchasing a diversified mix of stocks that trade at a large discount to their net tangible assets rather than purchasing a diversified mix of stocks that exhibit high rates of return on capital. Today's discussion will focus on the inherent risk that typical investors face when they pursue the latter philosophy.
Misjudging the Competitive Advantage of a Company
Consistent ROC over time is largely a function of the durability of a company's competitive advantage. As a company's competitive advantage begins to erode, their margins tend to contract. Variable costs such as advertising are likely to increase as the company attempts to maintain its revenues. Gross margins can retract as the company is forced to drop its selling price to maintain sales.
As costs rise and margins contract, reinvestment in the business becomes less efficient and eventually, the investor's intrinsic calculations which relied upon earnings growth can become overstated. Moreover, every dollar reinvested in the business returns a smaller rate of return.
Investors Frequently Misread the Normalized ROC and Cyclicality of a Business
Most investors tend to disregard the cyclical-adjusted earnings of a business; thus they tend to misread normalized ROC. Virtually every business displays cyclicality is some form; however, relatively few investors factor in the full enhancement on rates of return during these favorable periods. Furthermore, investors tend to purchase equities during these periods of favorable earnings and enhanced rates of ROC, incorrectly assuming that temporary earnings spikes are an indication of future growth.
In Chapter 20 of "The Intelligent Investor" Benjamin Graham noted the following: "Observation over many years has taught us the the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions."
The housing boom which occurred during the first decade of this century temporary inflated the earnings and rates of ROC for a multitude of companies ranging from home builders, to commodity companies, to material suppliers, in addition to hundreds of banks and many other financial institutions.
Countless investors mistakenly assumed that ROC rates and earnings yields would be durable in nature prior to the credit crisis which accompanied the housing bust. Investors who employed leverage based upon their faulty assumptions suffered permanent loss of capital. So too did investors who panicked and sold out of equity positions during their lowest valuations, assuming that ROC rates and earnings would never return to their former levels.
What differentiated the housing bubble from the Internet bubble were the seemingly reasonable rates of ROC which typified the soon-to-be afflicted businesses. Prior to the stock market crash, many value investors felt confident that the stocks they held were reasonable in valuation and would continue to provide them with adequate rates of ROC. The thought process justified either maintaining or increasing their investment positions in stock with high rates of ROC prior to the crash. Most value investors did not comprehend the ephemeral nature of the reasonable earnings yields and the high ROC rates in businesses which were directly or indirectly related to the housing boom. The situation was unlike the Internet bubble where value proponents were tipped off by excessive valuation metrics.
Not Adhering to a Proper Margin of Safety
Taking Investment positions based on a company's ROC still requires buying at a price that provides the investor a sufficient margin of safety. As Buffett has pointed out on numerous occasions, an investor must pay attention to the price he pays for a stock. Failure to adhere to that principle can subject an investor to below average returns for an extended period of time.
During the late 1990's Microsoft (MSFT) recorded ROC rates in the high 20 percent range; however, the stock also routinely traded in excess of 50 times its earnings. For investors who did not pay attention to the price they paid for stock, the result was disastrous. Investors who bought "Mr. Softy" in the late 1990s are yet to recoup their purchase price despite its outstanding operating results and its consistently high rates of ROC.
Inability to Identify Embellished Earnings
Embellished earnings translate into embellished rates of ROC. While the income statements of most companies reasonably depict the true nature of a company's profitability, not all companies have such veracity in their earnings reports.
Overstating earnings for an extended period can permanently distort an investor’s analysis of a company and render its ROC rates irrelevant. Embellished earnings distort balance sheets as well by inflating such things as retained earnings; however, most assets are less susceptible to financial shenanigans than the entries on an income statement.
ROC Rates Can Be Distorted by Non-Cash Charges
One sure-fire way to inflate ROC is to purchase a business at a price well over its tangible equity and subsequently write down the goodwill from the balance sheet.
Let's say that Company A buys Company B for $100 million and records 20 percent of the business as goodwill on the balance sheet. Let's further assume that three years later the earnings of the company take a dive and GAAP accounting rules require that Company A impair the $20 million from its balance sheet.
Suppose that the company had $200 million in equity prior to the goodwill impairment and now the balance sheet lists the equity at $180 million. For the sake of argument let's say the company carries no debt (ROC = ROE) and recorded $20 million in net income in the year prior to the impairment and $20 million in net income in the year following the $20 million write-down. In the middle year they lost the $20 million back which resulted in the goodwill impairment. Bear in mind that the business contains exactly the same components and earned identical profits in both years.
In the year prior to the impairment the company would have shown a 10% ROC; two years later the ROC would have magically grown to 11.1% without recording a nickel more in profit. The only difference was the elimination of the goodwill on the balance sheet. If the management received bonuses for increasing ROE, they might have recorded a tidy little windfall for merely taking an impairment. On the other hand, an investor who valued the company by using its tangible book value would have calculated the value of the company exactly the same for both years.
Clearly, the $20 million in goodwill which was taken off the books must be added by into the formula if the ROC calculation is expected to contain a shred of validity.
Putting the Pieces Together
No sane value investor would dare argue that calculating ROC is a trivial tool in evaluating the efficiency and the long-term income growth potential of a business. The devil lies in the details as well as the skill of the business analyst in arriving at a figure which approximates reality.
The problem with using some form of ROC in evaluating the value of a business and prognosticating its future growth rate lies in the reality that the vast majority of individual investors either lack the skill or the time to perform proper calculations. Further, most investors hold a large amount of individual stocks and performing the necessary diligence which is required to calculate legitimate figures can become an arduous task.
As discussed earlier, typical investors face a myriad of problems in assessing the intrinsic value of a business when using ROC as a primary component. Their analysis is highly susceptible to false premises in regard to the realistic moat of a business, the degree of its cyclicality, the veracity of its earnings as well as assessing the effects of its non-cash charges on its rate of return.
Additionally, many businesses carry excessive cash on their balance sheets. Many traditional ROC calculations do not factor in the value of the excess cash; instead, the excess cash actually reduces calculations on the rate of ROC. Should the company declare a special dividend or use the cash to buy back shares, their ROC would immediately improve without regard to any change in business practices. In such cases, a novice investor might actually deem the value of the company to be greater after the issuance of a large special dividend.
It has long been my contention that most individual investors are better served by purchasing a large basket of stocks which trade at significant discounts to their stated tangible book value. In essence, that was the practice which Walter Schloss used to record compounded gains in excess of 20% over multiple decades.
Of course Mr. Schloss was also more astute at analyzing the earnings power of a business over time than the average investor, but he was also quick to point out that few people possess the ability to outperform the market by consistently picking outstanding businesses at fair prices. Indeed, Mr. Schloss left that practice to the Warren Buffetts of the world.
Also check out:
- Joel Greenblatt Undervalued Stocks
- Joel Greenblatt Top Growth Companies
- Joel Greenblatt High Yield stocks, and
- Stocks that Joel Greenblatt keeps buying
About the author:
John EmersonI have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.