Quality Control: Sorting The Investing Wheat From The Chaff

There’s nothing more beguiling than a cheap looking share. And in times such as these, where we have seen prices of shares on our watch list rise well above where we hoped to achieve a favourable entry point, the allure of such apparent bargains becomes more powerful. That is human nature I suppose. If I went into the supermarket tomorrow to find that my favourite bottles of wine had all doubled in price, I’d be far more tempted to buy one of those cheaper ones that nobody wants. But if temptation got the better of me and I’d spat out the first mouthful before pouring the rest away, I’d have received no value and be pretty annoyed that I let my standards slip. Perhaps it wasn’t such a great bargain after all.

I think this is where the use of the word “cheap” can cause problems when it comes to investing, although we are all guilty of using it. It perhaps wouldn’t be so bad if we all used the term to express our view that a share is selling at a substantial discount to what we believe is its intrinsic value, but instead we usually see it applied to basic valuation metrics such as the P/E ratio or yield: referring to apparent “cheapness” where they are at a discount to the market for example. What’s worse is that we often compound the problem by comparing such ratios between companies with very different business models.

The use of such misleading labels only serves to create the false notion that we must be getting a bargain for such shares. But, like the bottle of wine, we need to ensure that it isn’t deservedly cheap otherwise the bargain is illusory.

Although many investors will concede that this is an obvious point to make, in my experience most of them will focus more on cheapness than “quality”. Whilst paying a bargain price for a share is of great importance for value investors with a shorter term horizon wishing to realise capital gains, the long term buy and hold investor will likely achieve better results by paying a fair price for a share of a good business that will compound in value over time.

What is quality?

This is a question which tends to cause some disagreement between value investors, some of whom disagree that such thing exists at all, perhaps concerned that it is too woolly and subjective an attribute which cannot readily be computed from a set of accounts. But this just really depends on how we define quality.

Although a renowned value investor, Warren Buffett is usually associated with quality investing. One of the commonly quoted parts of his 1989 shareholders’ letter is where he refers to the “cigar butt” approach to investing:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the “cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.”

He goes on to call this approach to investing “foolish”, concluding that “time is the friend of the wonderful business, the enemy of the mediocre” and that “it’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

So what does he mean by a “wonderful company”? Jump forward to his 1992 letter and he states:

Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”

One of the UK’s respected fund managers, Terry Smith of Fundsmith and CEO of Tullet Prebon (LON: TLPR) has commented a number of times along similar lines (which is unsurprising as he does seem to have been heavily influenced by Buffett’s writings, but I don’t blame him for that). Smith has previously written:

At Fundsmith we define quality companies as those which over a full business cycle are able to deliver superior returns on capital in cash, with the ability to reinvest at least some part of those returns in growing the business and so compounding the returns, and which are able to do so without requiring leverage.”

Both of them are basically saying the same thing: that they want to invest in businesses which earn more relative to each additional pound invested in the business. Of course, this is entirely logical and seems too obvious to question, but in my experience the majority of investors don’t consider this point. There is a tendency to focus on earnings and earnings growth, without asking the question: how much capital was invested in order to achieve those earnings? If you mentioned to them that the interest you received in your bank account had increased by 50% last year, I suspect many would be quick to question how much additional money you had invested in the account. A 50% increase in interest income would be far less impressive if you told them that you had doubled your cash invested. But for some reason this basic point can get lost when applied to companies.

In terms of how to measure this for businesses, there are some formulas known variously as return on capital employed (“ROCE”) or return on invested capital (“ROIC”) and a few other similar names which I will generically refer to as ‘return on capital’. I won’t going into the intricacies of those calculations and their variants in this article (I may inflict that on readers with a high pain threshold and strange affinity for accounting some other time), but they basically calculate earnings (ignoring the effect of interest), known as ‘net operating profit after tax’ (“NOPAT”) divided by either (a) shareholders’ equity plus net debt, i.e total capital; or (b) operating net assets, largely property, plant and equipment plus net working capital (although a Google search will yield various different versions of these).

The particular relevance to long term investors here is that we should be concerned with how well that portion of our earnings which aren’t distributed to us by way of dividends are being invested on our behalf. As a minimum, I want to ensure that a pound retained by the business will create more than a pound of value for me, otherwise I would rather the directors distribute all of the surplus cash flow.

Value considerations

Notwithstanding the prevalence of relative valuation measures such as the P/E ratio, at a push most investors would concede that, in theory, the most accurate valuation would be determined by discounting the future cash which could be taken out of the business by its owners. Yes, that is a difficult thing to establish without the gift of clairvoyance, but just because the estimation of it is difficult, its importance as the theoretical cornerstone of valuation should not be dismissed.

The relevance to valuation is that those companies with a higher return on capital will, for a given level of growth, require less additional (incremental) capital invested in items such as property, plant and equipment and working capital and therefore generate higher levels of free cash flow, resulting in a higher valuation. It also means that companies with a higher return on capital will be less reliant on debt in order to finance their growth requirements.

In fact, without delving into the maths, it can be shown that enterprise value (EV) of a business (namely the sum of the market value of its equity, minority interests and net debt) using the discounted cash flow method, but on the simplified assumption of a constant return on capital and constant growth rate boils down to the following:

EV = {NOPAT × (1 – g/ROIC)} ÷ (WACC – g)

where:
NOPAT = net operating profit after tax;
g = growth rate;
ROIC = return on invested capital; and
WACC = weighted average cost of capital (being the rate at which the cash flows are discounted)

Even if you are not interested in the theory underlying that, there are some relevant to conclusions to draw:

(1) The drivers of value are not just earnings, but also growth, return on capital and cost of capital. Whilst most investors appreciate that higher growth rates warrant a higher P/E ratio, it is not very often acknowledged that return on capital is a differentiating factor.

(2) If a company’s return on capital is equal to its cost of capital, then the growth rate could be any number and it would have no effect on value. It is however earnings growth which generate the headlines regardless of how much additional capital was invested into the business to achieve it. In fact, in the case where return on capital is lower than the company’s cost of capital then value is not created at all, but rather destroyed. The commonly used PEG ratio is therefore meaningless in itself.

(3) Where the growth rate is nil, return on capital becomes irrelevant and the value is equal to NOPAT ÷ WACC. This provides investors with the opportunity to arrive more quickly at a conservative valuation on the assumption of no future growth.

As can be seen from the above, earnings multiples will mean very different things when comparing different business and so attaching the notion of ‘cheapness’ to such a metric, whilst commonly seen, is of limited use. Take for example two companies, both with the same profit and growth rate of 5%, but they have different ROICs of 10% and 20%. Based on the above the EV/NOPAT multiples would be 12.5 and 18.75, yet we would usually see the latter dismissed as far more expensive without consideration of this factor. What is happening however is that the company is consuming far less cash flow in order to achieve that same 5% growth rate.

This is where the value investor mindset of taking comfort in assets is, in my view, a red herring. As with the ubiquitous P/E ratio, a low price to book ratio is often referred to as another sign of ‘cheapness’ but this is another sweeping generalisation. The value of the company will be determined by the cash flows generated from the operation of the company’s assets, not the book value of them, unless you are a liquidator and even then the book value is a poor guide. A low price to book value may simply signify that the company generates a lower return relative to its asset base which will have the consequential impact on cash flows as the company grows. It can be counter-intuitive, but assets aren’t necessarily a good thing as as can be seen below it is usually the ‘intangible’ assets of a company not reflected on any balance sheet which can create the most value.

Quality is sustainable

It should be noted that we are not just looking for companies with a high return on capital, we are looking for ones with a sustainably high return. High returns on capital suffer from an inherent economic threat, and that is mean reversion. In theory, businesses which are achieving ‘excess’ returns on capital are likely to attract competition which will have the effect that those returns will revert closer to the cost of capital.

Identifying those companies which can maintain excess returns on capital is probably one of the hardest things to do as it relies on qualitative assessments as well as quantitative. A high return is indicative of a company having some sort of competitive advantage and so there requires an assessment of whether those competitive advantages can be sustained for long periods of time in order to avoid mean reversion. Going back to Terry Smith, this is what he had to say on this particular point:

The companies in our portfolio do something which is not meant to be possible – they do not mean revert. By a combination of brands, and/or intellectual property, distribution networks, installed bases of equipment and franchises, they have managed to sustain above average returns indefinitely. As a result, they tend to spend long periods of time being undervalued by the market which not unreasonably tends to value them on the assumption that their returns will gravitate to towards the mean. This is what provides our opportunity to buy them relatively cheaply.

History provides a perspective on this. At what PEs would developed world consumer stocks need to have been purchased in 1980 to have returned the same as the S&P 500 since then? An investor could have paid 200 times earnings for Walmart in 1980 and performance would still have matched the S&P. The number for Colgate is 41 times, Pepsi 46 times, McDonalds 70 times and Coke 260 times. Some PEs of 15-20 may not be so expensive after all.

I think this is where one of Buffett’s greatest strengths lies. Coca Cola is often put forward as the archetypal Buffett share and it has clearly performed exceptionally well for him over a very long time (I’ll trust Smith to have done his calculations above correctly!). When he began purchasing the company’s shares in 1988 the company had reported a very mediocre set of results based on Wall Street’s favoured earnings and the analysts were slightly taken aback by such a well known ‘value’ investor paying an average P/E in the high teens. But Buffett saw more than that: he saw a company of the variety referred to above: “one that over an extended period can employ large amounts of incremental capital at very high rates of return”. He saw the strength of the Coca Cola brand, the pricing power, the ability for continuing global expansion and the fact that potential competitors – even those with far more money than sense – would find it hard to take away its market share. He also saw a product whose future was easier to foresee: one that wouldn’t change over long periods of time, thereby making his assessment more reliable. No doubt he sees the same qualities in his most recent acquisition of Heinz; and in fact such strong consumer franchises have been a happy hunting ground for ‘quality’: in the UK companies such as Reckitt Benckiser, Unilever and Diageo are probably some of the best examples.

Quality of earnings

Accounting standards are designed largely to attempt to give a true and fair view of a company’s financial state of affairs and its profit or loss for a period. They are not designed for the purpose of attempting to value a company which may from time to time require an investor to make certain adjustments or assumptions.

We have shown above the difficulty in comparing earnings multiples between businesses, but another factor to take into account is the quality of those earnings. That may involve consideration of how to normalise earnings over a cycle or how to treat recurring exceptional items that are excluded from underlying operations. But there is a more insidious factor to consider, particularly where the business has a very high capital expenditure requirement.

Given that accounts are prepared under the historic cost convention, fixed assets are depreciated over a certain time period, depending on their estimates useful economic lives, with such depreciation charge being based upon their original cost. But this charge is based upon a cost which may no longer be representative of the cost of its replacement, for example due to the effects of inflation. The actual capital expenditure required in any one year in order just to maintain (not expand) the company’s current operating capacity – usually referred to as ‘maintenance capex’ – may therefore be higher than is being charged to the profit and loss account as depreciation. An owner of that business would not therefore be able to pay himself the ‘reported’ earnings if he wanted to ensure that the business’s operating capacity was sustained properly.

The above point was again raised by Buffett in his 1986 letter:

If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges … less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c)…)

… Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since( c) must be a guess – and one sometimes very difficult to make. Despite this problem, we consider the owner earnings figure, not the GAAP figure, to be the relevant item for valuation purposes – both for investors in buying stocks and for managers in buying entire businesses. We agree with Keynes’s observation: “I would rather be vaguely right than precisely wrong.”

…But calculations of this sort usually do not provide such pleasant news. Most managers probably will acknowledge that they need to spend something more than (b) on their businesses over the longer term just to hold their ground in terms of both unit volume and competitive position. When this imperative exists – that is, when ( c) exceeds (b) – GAAP earnings overstate owner earnings. Frequently this overstatement is substantial. The oil industry has in recent years provided a conspicuous example of this phenomenon. Had most major oil companies spent only (b) each year, they would have guaranteed their shrinkage in real terms.”

Clearly, the more capital intensive the business is, the more scope there is for owner earnings to be materially different from reported earnings – Buffett uses the example of oil companies above. He also makes it clear that he uses ‘owner earnings’ for valuation purposes as opposed to reported earnings which may not represent the true underlying economics of the business. Similarly, Smith confirms his use of the free cash flow yield as a means of valuation as opposed to earnings measures.

Final words…

I apologise for the above being theoretical in parts (well done if you got this far) and you will be forgiven for thinking that it is much harder to apply such theories in practice. But if nothing else we should appreciate that the stock market contains a wide array of businesses ranging from those with very poor economics to those with excellent economics. For dividend investors and other investors with a very long term horizon, holding quality companies will be what drives growth and income over the next 10, 20 and 30 years or more. ‘Quality’ companies will usually generate free cash flows sufficient to distribute a reasonable proportion of earnings with cash left over to reinvest in growth opportunities or even buying back shares without over-reliance on debt or diluting shareholders’ interests with rights issues to meet capital requirements. Such companies are not to be acquired at any price though: valuation is always of prime importance in investing, but be careful of illusory ‘bargain’ prices for poor quality companies and be prepared instead to pay a ‘fair’ price for good companies as the compounding of value over the long term will have a greater effect on results. Sorting the wheat from the chaff may not be simple, but it shouldn’t stop us trying.

Image courtesy of Stuart Miles / FreeDigitalPhotos.net