I am frequently asked about whether I prefer return on capital versus return of capital in my investments. My initial answer to this question is usually “it depends”, but my genetic makeup of sloth and indolence generally lead me to favor allowing management to generate return on capital versus making me find great opportunities by the return of capital. As Edgar Bergen (and Warren Buffett (Trades, Portfolio)) so aptly said, “Hard work never killed anyone, but why take the risk”.
Before making any decisions on which return is better for investors, it would be wise to take a look at some relevant facts. First, some definitions. Return on capital measures the return that an investment generates for capital contributors. It indicates how effective a company is at turning capital into profits. Return of capital (and here I differ with some definitions) is when an investor receives a portion of his original investment back - including dividends or income - from the investment.
Last year, Michael Mauboussin published an interesting update on management skills in capital allocation[1]. Some of the data mentioned in the article directly impact our evaluation.
- Internal financing represented more than 90% of the source of total capital for U.S. companies from 1980-2014. This is a higher percentage than that of other developed countries including the United Kingdom, Germany, France and Japan.
- Mergers and acquisitions (M&A), capital expenditures and research and development (R&D) are the largest uses of capital for operations. In the past 35 years, capital expenditures are down - and R&D is up - as a percentage of sales. This reflects a shift in the underlying economy. M&A is the largest use of capital, but follows the stock market closely. More deals happen when the stock market is up.
- The amount companies have spent on buybacks has exceeded dividends for the past decade, except for 2009. Buybacks only became relevant in the U.S. starting in 1982. Any use of earlier data makes it difficult to compare apples to apples. The amount of payout has remained nearly the same, but the form of such payout has moved away from dividends and towards stock buybacks.
- After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business (as cited by Warren Buffett (Trades, Portfolio)).
There are arguments for and against whether an investor should seek return on capital or return of capital. The answer you choose can make a huge impact on your long-term returns. But in either case, it requires finding individuals (either management of portfolio holdings or yourself as an investor) who are outstanding allocators of capital.
The argument for return of capital was most strongly made by the late great Peter Bernstein. In a fantastic October 2004 interview[2] with Jason Zweig, he went so far as to say that management should have no role in allocation of capital. He advocated that 100% of all net income be sent to shareholders directly – a rather extreme version of return of capital. In the interview Bernstein said:
“In the 1960s, in "A Modest Proposal," I suggested that companies should be required to pay out 100% of their net income as cash dividends. If companies needed money to reinvest in their operations, then they would have to get investors to buy new offerings of stock. Investors would do that only if they were happy both with the dividends they had received and the future prospects of the company. Markets as a whole know more than any individual or group of individuals. So the best way to allocate capital is to let the market do it, rather than the management of each company. The reinvestment of profits has to be submitted to the test of the marketplace if you want it to be done right”.
On the other side of the argument – in favor of return on capital – is the idea that a business that generates high returns on deployed capital should not return ANY of it to shareholders. Like the inevitable snowball analogy of increasing size over time, businesses that can maintain high ROC over an extended period of time need little or no effort from shareholders other than to step aside and let management do its magic.
A Working Example: Computer Programs and Systems (CPSI, Financial)
Taking this from a rather esoteric discussion to a more concrete one, I thought I would use a current Nintai Charitable Trust holding as an example – Computer Programs and Systems. The company has a stellar 10 year record of 38.5% ROE, 29.3% ROA and 58.4% ROC. What’s not to like? Well, a lot actually. Without a doubt, CPSI has been a truly epic mistake in my investment career. Another can be found here. Nothing sickens us at the Nintai Charitable Trust more than an unforced error like our investment in CPSI. We bought at exactly the wrong time – purchasing shares in December 2014 at $58.91 – just as the market for rural based electronic health record hospital systems peaked. But we compounded this error by purchasing more in February 2015 at $47.76 and then - in an act of true folly - made one more purchase in August 2015 for $45.75 per share. Shares are currently trading at $40.68 per share. Ouch.
There were reasons, of course, for making these purchases. Or at least, that is what we say to make ourselves feel better. Theoretically, CPSI’s push into services and data management should provide the company with a long and profitable runway. The operative word being “should”. Time will tell whether our thesis plays out over the long term.
I spent roughly $400,000 of the Trust’s capital to accumulate 7,350 shares in CPSI. Those shares are now worth roughly $300,000. This roughly 25% negative return on capital has been offset by a relatively generous return of capital of roughly $26,300 in the form of dividends. This reduces our loss (not for tax purposes, alas) from 25% to roughly 18% since we purchased these shares. In the long term, if the company continues to yield roughly 6% annually (and that is a big if) my yield to cost will work its way to zero. Meaning, I will have been paid back my initial investment by return of capital alone.
So Which Is It: Return OF or Return ON?
The measure of whether an investor should focus on return on capital versus return of capital really depends on what rate of return management can make versus the company’s average weighted cost of capital (AWCC). For a company that achieves 50% ROC versus an AWCC of 7.5%, the answer is clear – let management keep doing their job and – as Greg Allman said so wisely – “move away slowly”. Things get harder as ROC goes down and AWCC goes up. At the Nintai Charitable Trust we use general guidelines for when we want to see return on capital turn into return of capital.
Return on Capital >4 times WACC = No return of capital
Return on Capital >2 but <4 times WACC = Some return of capital
Return on Capital <2 times WACC = Do not invest
These are guidelines only. Occasionally holdings may violate these for a short period during recessions or a retooling of strategy/products and we are fine with that in the short term. In the case of CPSI, we think we have the best of both worlds. After the integration of the Healthland, we think margins, profitability, and growth will return to more historic rates. Until then, return of capital reduces our cost average and allows us to deploy capital at higher rates for the moment.
Conclusions
The debate between return on capital versus return of capital really depends on two items – the results of how management deploys capital and the investor’s needs/use of returned capital. For management that generates significant returns on capital, then by all means let them do their job. For management that cannot find opportunities to produce returns significantly greater than their weighted average cost of capital, then investors should look to see returns in the form dividends or stock buybacks. While there is no cut and dry answer, the question of return on capital versus return of capital is driven by your investment’s skill in capital allocation and your individual investment strategy.
As always I look forward to your thoughts and comments.
Disclosure: Long CPSI
[1] “Capital Allocation – Updated Evidence, Analytical Methods, and Assessment Guidance”, Michael Mauboussin & Dan Callahan, June 2, 2015
[2] The full interview can be found here: http://money.cnn.com/2004/10/11/markets/benstein_bonus_0411/index.htm
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