In a sense, an equity portfolio (or a collection of businesses) can be seen as a type of savings account. In this case, our job, in terms of portfolio management, is to build, optimize and maintain the savings account in a way that maximizes the risk-adjusted returns for its owner (in the form of free cash flow). Things brings the question, what type of savings account would you prefer to have? A traditional savings account or an equity portfolio?
A high interest rate may come immediately to your mind when considering how to answer this question. What would you say if the interest payment can be reinvested at a much higher rate? How about an interest rate that itself can rise over time? Would either of these sound too good to be true? Well, they are precisely the unique advantages of equities (or equity portfolios), which we, as investors, should attempt to fully capitalize on. Now, if you are unfamiliar with investing, you may be wondering how this is possible. With regard to the former, the economic moat comes into play to produce and protect the high return earned on invested capital. For instance, Egyptian diagnostics services provider IDHC (LSE:IDHC, Financial) leverages its regional scale and reputation to ensure favorable pricing from suppliers and efficiently acquire new customers while deploying capital to expand into new geographic and adjacent markets. According to our proprietary data, the company has earned a more than 100% cash return on incremental equity (a good proxy for return on reinvestment) for the last five years.
Not all businesses heavily rely on capital expenditure to grow themselves. Take a look at Mastercard (MA, Financial). The global payment network operator would benefit from inflation as it charges fees based on gross dollar volume. Therefore, the company could still grow its free cash flow, even if it did not gain share from the cash segment in the total payment market. Bioventix (LSE:BVXP, Financial) is another example. The UK-based sheep monoclonal antibody developer earns revenue primarily through royalty fees from blood tests that use its antibody products. The company does not spend a dime on getting those blood-test machines into hospitals. As a matter of fact, it does not even “produce” those antibodies but instead authorizes the production to third parties in most parts of the world. As a result, it should be no surprise to see a staff list of only 12 full-timers for this global business.
So how have we at Hillside accomplished this so far with our portfolios? Our recent look-through review indicates that our models, in terms of the equity portion, delivered a free cash flow yield of around 5% and a five-year CAGR in free cash flow of approximately 25%. When was the last time that you saw any bank offer an interest rate close to this on a savings account? Moreover, do not hold your breath waiting on the bank to double the rate. Our analysis also points to an above 50% cash return on incremental equity, implying attractive reinvestment opportunities. These opportunities, however, are limited, given the capex-to-sales ratio of approximately 4% - and hence, our duty to allocate (residual) capital at the portfolio level on an ongoing basis.
The figures above have probably made you thrilled – a high-yield savings account with a rising interest rate (the pace of which far exceeded the inflation rate historically) alongside a super-normal rate of return on reinvestment seems too good to be true. So, what is the catch here? Firstly, businesses have risks – i.e., uncertainties relating to sales, profitability, cash flow – that means that the future “interest payment” from the equity portfolio can change considerably over time. In this regard, it is our job to concentrate our portfolios on high-quality companies (e.g., those with a highly-recurring revenue stream, durable competitive edge, conservative balance sheet and low capital requirement). Then, there is also the market risk – the share price (or the market value of the portfolio) can be volatile in the short run as the market plays the role as a voting machine. Since nobody is able to time the market consistently, the solution is simple – commit only long-term capital to the stock market, and “don’t just do something, sit there.”
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. I/We have position(s) in any of the securities referenced in this article.
This article was written by the author and first appeared in Hillside Wealth Management's monthly newsletter.