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Thomas Macpherson
Thomas Macpherson
Articles (144)  | Author's Website |

Thoughts on Return on Capital vs. Return of Capital

An answer to a reader's question of my preference for return on capital or return of capital

August 01, 2016 | About:

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.

  1. 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.
  2. 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.
  3. 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.
  4. 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 (NASDAQ:CPSI)

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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About the author:

Thomas Macpherson
Thomas Macpherson is Managing Director and Chief Investment Officer at Nintai Investments LLC. He is also Chairman of the Board at the Hayashi Foundation, a Japanese-based charity serving special needs children and service pets. The views expressed in his articles are his own and not necessarily those of the firm. He is the author of “Seeking Wisdom: Thoughts on Value Investing.”

Visit Thomas Macpherson's Website


Rating: 4.9/5 (10 votes)

Voters:

Comments

Robert Abbott
Robert Abbott premium member - 2 years ago

I appreciate your general guidelines on Return on Capital vs AWCC.

Nelson Hsu
Nelson Hsu premium member - 2 years ago

Hi Tom, I appreciate the color on CPSI. Off the top of my head when I briefly looked at it, I concluded that it was a fairly saturated market from a customer count perspective and CPSI needed to sell more products to existing customers to drive growth. I thought it was difficult to extroplate revenue growth from need because of budgeting considerations. Most of the hospitals relied on government funding and who knew when that would happen for each locality? Would you agree?

Belarophon
Belarophon - 2 years ago    Report SPAM

Great post. When you bought CPSI I just thought 'Good fundamentals. But kind of expensive...' I guess this is the right time to quote some of my spanish friends who used to say 'Sometimes you win and sometimes you lose'. Time will tell...

snowballbuilder
Snowballbuilder - 2 years ago    Report SPAM

Hi Tom great article (as usual)

You choose an interesting topic and always add something real and concrete example and this is important.

I think one of the key IT to be flexible and opportunistic

There could be a time for reinvesting a time for aggressive buyback and a time for Special dividend

A really great capital allocator is the one that can figure IT out and be aggressive on the choice

Of course that is pretty rare and you can Also rip good return by a less opportunistic and more regularly (scheduled) capital allocator Who choose to regularly split the available cash in dividend , reinvesting and buyback

One of my holding TIP S.p.A Who is run by Who i think is a really great capital allocator (Mr Giovanni tamburi) have always had an opportunistic and flexible view on capital allocation ... They have paid dividend buyback stock collocate warrant and bond loan Made big acquisition

Another one Recordati S.p.A have always payed 50% of the net profit in dividend and reinvesting the other Half. I think the managers at recordati know they limit as capital allocator so they have choose a simple and consistent rule.

I have great respect for BOTH the managers and i m making really good money from BOTH the holding .

In theory the opportunistic choise could lead to greater return but in practice you need a really great capital allocator (and that is rare like finding a great investment manager) ....

If the company is really good also a simple and sistematic asset allocation can lead to really good return with less risk and less requirement of rare capability of the manager in the capital allocation choice

Hope to have added something to the discussion. Just some personal thoughts . best snow

Zejia
Zejia - 2 years ago    Report SPAM

Hi Tom, I remember I've read an article comparing investing a high quality stock at not a cheap price(maybe we can say fair price) vs a mediocre company at a cheap price. Over a long term, say 15 years, the investment return for the former far outweigh the latter. So the mistake may not be so"epic" if putting it in a long term,though the process of experiencing a 20% loss is really painful.

Some of my thought: on capital or of capital, investors should first consider their investment objectives- whether you want capital gain or income stream. Then for the management, the worst thing the management team does is retaining the earnings when there isn't a good reinvestment opportunity or the opposite.

Now back to CPSI, if it can achieve 50% ROIC, why did the management pay dividends? Would it be better(having the intrinsic value compounding faster) if they retain the earning and reinvest in the business, such as developing products or expanding the market? Would like to see your thought. Whether there are any regionales behind and whether you agree with the management of doing so. Thanks Tom.

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Thanks Bob. In my eyes, it's one of the more important metrics when thinking about a possible investment. Thanks again. Best - Tom

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Hi Nelson. Thanks for your comment. My investment in CPSI was never exclusively based on EHR adoption in rural hospitals. My thoughts focused more on the clinical and population health outcomes data that will be vital going forward. The purchase of Heathland supports this thesis. I just didn't think it would entail a 25% loss and CPSI leveraging its balance sheet as they over the past 3 months. I have wait now to see if I was early - and hence wrong - or if I am flat out wrong. Either answer isn't a great feeling for myself or the Trust's directors. Thanks again for your comment. Best - Tom

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Thanks Belarophon. See my comment to Nelson above. I'm hoping I'm in the former category of your Spanish friends' analysis! Best - Tom

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Hi Snow. Many thanks for your comment. As usual you add a great insight to the conversation. I think you are spot on when you see great capital allocators are flexible and opportunistic. Very rarely are decisions on capital allocation cut and dry or static in nature. The ability to react to what the markets give you as well as your own corporate responsibilities require management to constantly evaluate whether return on capital or return of capital is a better choice for their shareholders. Thanks again for a great comment. Best - Tom

Thomas Macpherson
Thomas Macpherson premium member - 2 years ago

Hi Zejia. Thanks for your comment. In regard to CPSI's dividend policy, they have traditionally maintained roughly a 3% yield going back a decade. Part of this has been the company is not capital intensive and management felt they shoud return a portion of cash back to shareholders. Another reason is they invest in opportunities that can achieve high returns on capital. Beyond that they use for the dividend. I hope this answers your question. Thanks again for your comment. Best - Tom

michaelno
Michaelno - 2 years ago    Report SPAM

Hi Thomas, interesting subject. When we talk about dividends, we must remember that they have to be reinvested by us after-tax. In other words, if management were to retain the capital and reinvest it into a S&P 500 index, it would crush our returns we'd get from getting a dividend, paying the tax, then reinvesting the proceeds into a S&P 500 index. The company would be reinvesting $1 while vs shareholders reinvesting $0.85.

Another consideration is the balance sheet. There are too many examples of companies that have high capital expenditure requirements, yet issue dividends. Cliffs Natual Resources issued dividends while piling on debt, then when trouble hit the cut the dividend. What they were left with was no dividend, a stock price that crashed, and a lot of debt. This is a common theme in cyclicals like airlines, autos, etc. They are essentially funding their dividend with debt since the added debt greatly exceeds the dividend issued.

Dividends should be issued by "asset-light" businesses that have trouble reinvesting FCF. Also by large, mature businesses with no opportunities for acquisitions.

Transdigm is an interesting case study in special dividends.

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