The Importance Of Capital Intensity And Thoughts From Einhorn

It seems as though there has been a recent debate on going within the value investing community pertaining to ROE, ROIC and net-nets. At one hand of the spectrum we have the argument that value investors are throwing in the towel and buying anything with a high ROE while using 20+ years discounted cash flows to support their thesis. The central argument is, there is no margin of safety if one pays more than NCAV or liquidation value. At the other end of the spectrum we hear that the most profitable way to invest over the long-term is continually buying and selling assets trading below NCAV, P/B or low P/E. I do agree that assets available below NCAV, low P/B or low P/E can be profitable but we must ask ourselves why is Mr. Market willing to offer us a business at a price that values the business higher dead than alive?

According to Buffett “the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.”

This is because 1) the market has discounted the asset for a reason, likely because the expectation is for the business to continue to destroy value as it is capital intensive in a declining industry where business metrics are deteriorating 2) The economic value the business earns is not enough to cover the cost of the capital used to generate it and 3) The company has poor corporate governance, questionable management practices and bad capital allocation.

Take a textile manufacturer as an example. This is a very simplistic example ignoring depreciation tax saving among other things. The company is currently earning $1,000 while revenues are declining (or stagnant) at $10,000 and the NCAV is $10,000.

Cash: $8000

Accounts Receivable: $5000

Inventory: $2000

Long-Term Debt: $4000

Accounts Payable: $1000

The company is selling for $7,000 or a 30% discount from NCAV and a P/E of 7. Sounds like a good deal right? Not so fast.

We need to examine the capital needs of the business. What if the company requires $1,500 a year to remain competitive in terms of maintenance capital expenditures? Simply stated, the company needs new machines and equipment to remain productive and keep costs low or face losing market share to competitors who do. Now the company has negative $500 free cash flow a year and you get your equity in the form of machinery. Keeping all variables constant in 5 years the company will have NCAV of $7,500, cash will be $5500, sales will be $10,000 (or less) and income will be $1000 (or less).

Assuming the market revalued the company along the way (@ a 30% discount to NCAV), it will now be worth $5250. The company would experience cash burn and have to make the difference through a secondary offering, debt or both in the long-term. Is this adequate margin of safety?

So what is the point? Context matters and it is imprudent to invest blindly in anything.   

ROE and ROIC arguably don’t matter nearly as much if the company is not capital intensive. The most important variables are how long the competitive advantage will continue and the rate of growth on unit volumes. Here is what Einhorn had
to say about the matter.

“I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees…in fact, they probably wouldn’t increase at all. When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position.”

The place to find value in non-capital intensive companies is the earnings power. Think of Microsoft or another software company. The marginal cost associated with growing revenues are minimal, as the core infrastructure (the software) only requires small adjustments and tweaks overtime and costs pennies to duplicate. Each additional customer added or sold to actually costs less overall. Think if you could develop software for $100,000 total and sell each copy for $101 at a cost of $1. Once you achieve the break-even point of 1,000 customers, each additional customer sold to will only cost $1 or a hypothetical 10,000% ROE.

There are two main risks for non-capital intensive businesses, reinvestment risk and risk the competitive advantage will be lost. Do they return cash to shareholders? Do they attempt to diversify their revenue stream? More often than not the capital is squandered by investing in capital-intensive businesses after generating more cash than they know to do with. The blessing becomes the burden.

Let us circle back to Einhorn.

I believe it is very important to analyze ROE and marginal returns on capital…but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.

The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.

This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE.”

ROE can improve three ways: 1) better asset turns, 2) better margins and 3) by adding leverage. This analysis can be performed further in depth with the Dupont method. Now is there really no margin of safety in earnings power? If you and I were to agree to a deal where you lend me money ($X) for 10-years in return for $100, how much would you lend me?

I assume it wouldn’t be $100 or even $90. It would of course depend on the opportunity cost of your $100 during the next 10-years… but is everyone’s opportunity cost the same?

If I were in your situation I wouldn’t take less than $25 representing a 15% discount rate. If you were now to offer me $80 upfront for $100 in 10-years, I would take it and think of this as a margin of safety. Here is why. First the $80 represents a 2.25% discount rate or an ability to borrow at 1% less than the current prime rate. I would then invest the money during the next 10-years and collect the difference depending on the IRR.

Discount Rate Capitalization Factor Cash Flow Net Return Break Even Borrowing
6% 1.79 $143.27 $43.27 $55.84
7% 1.97 $157.37 $57.37 $50.83
8% 2.16 $172.71 $72.71 $46.32
9% 2.37 $189.39 $89.39 $42.24
10% 2.59 $207.50 $107.50 $38.55
11% 2.84 $227.15 $127.15 $35.22
12% 3.11 $248.47 $148.47 $32.20
13% 3.39 $271.57 $171.57 $29.46
14% 3.71 $296.58 $196.58 $26.97
15% 4.05 $323.64 $223.64 $24.72

Depending on my discount rate, for every $0.01 above the breakeven borrowing rate you offer me, I will be adding to my edge or margin of safety. Because the future is uncertain, and hard to predict we demand a higher margin of safety from intrinsic value and likely blend a range of values. I would rather be approximately right instead of precisely wrong.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

This brings us to the Triple play. What is a triple play? Most baseball fans will understand the sports reference but how does it relate to investing?

There are three ways to earn an investment return.

1) Revenue growth

2) Margin or inventory turn expansion leading to higher net income

3) Multiple expansion

I like to invest in companies that I think are capable of all three to maximize my overall expected return. The point of the post is there is many different ways to build wealth each with its own risks. It is up to the individual investor’s style and personality to determine which strategy (or combination of strategies) he or she pursues.

Competitive Analysis And The Fallibility Of The P/E Ratio

How does one go about systematically comparing companies within a given industry? Do you compare P/E ratios? EPS? Sales growth? ROE? PEG ratios? All are conventional metrics that may seem integral to the investment process, when in fact, they all may be mis-leading.

Take the given example of company “A” with a price of $10,000, sales of $12,000, net earnings of $1,000 and sales growing at 10% per annum. While company “B” also has a price of $10,000, the sales are $10,000, with earnings of $900 and sales growing at 10% per annum. Both also have $5,000 equity. At first glance you may think company “B” is priced higher based on the conventional PEG ratio of 1.11 versus 1, the P/E of 11.11 versus 10 and equal sales growth (Ceteris Paribus). 

Now you may take the opposite opinion that company “B” is of higher quality due to the net margin percent or how efficiently they convert sales to net income. I would argue that the information is incomplete and we must ask ourselves how much capital was used to produce the sales (working capital) as well as how much capital (capital expenditures) will be needed to sustain the 10% growth in the future. 

 

I would side with both Buffett and Greenblatt on the importance of the working capital profitability ratios (Sales/(Current Assets – Current Liabilities), used in combination with both ROIC and inventory turnover (including fixed assets, says Buffett) when determining companies financial strength in a given industry. Greenblatt does not include goodwill or intangible assets due to the complexity of valuing these assets accurately (brands, patents, excessive purchases, etc.) and uses the following formula:

EBIT / Fixed Assets + Working Capital = Return on Capital

A company’s ROIC may be compared to the company’s weighted average cost of capital as another source of efficiency. When you calculate the ROIC, working capital profitability ratio and inventory turns within a given industry, it is a great heuristic to take the top ranking company and further analyze the cash flow stream expected in the future, finding an appropriate present value of the cash flows.

The company with the highest ROIC and working capital profitability ratio is likely dominating the industry and will probably continue to do so, as this is clearly a competitive advantage. If you think about it logically, the company is able to turn a higher profit for each dollar invested, enabling them to grow at a faster pace than competition. If the growth rates are essentially the same (like in the example above) the company will use less capital to produce the gains thus leaving a larger surplus for shareholders.

Over time, due to the creative destruction of capitalism, margins will compress (higher costs, lower prices) and the most efficient company will be able to pass their savings to the consumer through further price cuts or simply charging more in relation to costs (higher gross margins) than competitors. The company that is the most efficient will prevail, likely gaining a larger share of the market than it previously had. This is under the assumption of a free market, and the companies in the industry do not participate in a monopoly or duopoly and prices are not regulated or fixed.

Back to our example of company “A” and “B.” You may be asking, “Okay, so ROIC is better than P/Es and PEGs, but why are they fallible and what is wrong with ROE?” Well, simply stated, due to the effect of depreciation, taxes, and other cost cutting, income can be easily manipulated and over-stated/under-stated depending on managements’ incentives. In our example, company “A” had $1,000 net income and company “B” had $900, assuming both have equity of $5,000 the ROE of company “A” would be 20% while company “B” would be 18%. Well, it just so happens company “B” has higher deprecation charges (due to a previous acquisition), sheltering some of the taxes with a non-cash accounting entry, had a $100 NOL carry forward and is a royalty-based businesses (uses no or very little additional capex and working capital) to produce its income. Essentially, company “B” had higher net income when we account for the higher depreciation and $100 NOL, as well as a clear competitive advantage, efficiently allocating capital. The choice is an obvious one now… or at least I hope.

Finally (for this post) it is important to understand the elasticity of demand of a particular product or service. Essentially, what are the alternatives and at what price will a consumer make the switch. Take a recent investment of Berkshire in Heinz, a well-known brand of ketchup in almost every house in North America. It is a globally recognized brand and if they decided to raise the price 2% to 5% above their competitors each year, it is unlikely a large exodus would occur. Like they say, “Heinz and no other kinds.” Another great example is toothpaste brand Colgate. When a product is being used in an area as sensitive as my mouth, I want a product I know and trust. I am not going to buy mystery brand “X” to save myself 10 cents on a $2.50 purchase. Colgate could actually raise the price a quarter, maybe even 50 cents and I would continue to pay it, also known as a low elasticity of demand or inelastic. Contrast a pair of socks: I really don’t care what brand I put on my feet and want the absolute cheapest per unit price I can find. Demand is elastic.

In “The Money Masters” there is a small excerpt I would like to end with from John Train provided below:

When a media executive asked a friend of the Wall Street Journal why it did not tie its ad salesmen’s compensation more closely to their productivity, the friend replied, Well, the salesmen would just go across the street.” The executive answered, “There ain’t no across the street from the Wall Street Journal. These types of businesses make for excellent investments.

 

Joel Greenblatt: ROIC is better than ROE

I found these articles creeping through the stacks over at Scribd. Focus your attention on the the sections with the headings, “Return on Invested Capital: ROIC is Better Than ROE” and “Return on Invested Capital: True Performance”

A Basic & Useful Ratio Comparison

equityROE or the return on equity of a company can be a very useful financial ratio when used in combination with others. Return on Equity is Earnings/Equity or what the company can earn on invested capital. For example lets say you purchased a house for 100,000 and sold it one year later (Ex all fees and taxes for illustration purposes) for 130,000 you would have 30,000 profit.

30,000/100,000 = 30% ROE

Now when used in comparison with PE or price to earnings ratio you can find discrepancies between the market price and equity valuations. Earnings/Price gives you the PE but the price is the market capitalization “Mr. Market” is willing to give you on any given day or during any given period. Now lets take any given company, for this example I will use Apple (AAPL). Assume the price given by the market is 425B but the company earns 42.5B net income annually or otherwise known as priced at 10P/E. (42.5/425 x 100)

Now lets assume Apple has a ROE of 30% that means for every 1$ of “EQUITY” invested it can generate a 0.30 cent return annually but the market is using irrational behaviour quoting it at 0.10 earnings for each $1 of “PRICE” invested. Equity being a balance sheet item and rough approximation of business liquidation value, price being what someone is willing to pay on any given day, a stark difference.

Understanding the difference between market capitalization and equity (Assets-Liabilities=Equity) is very important and should not be used interchangeably as one has much more volatility from day to day and week to week but should be used in comparison to see what the company could generate relative to the market quote.

My past experiences have led me to believe management as well as the prudent investor should actively buy shares (or buyback) when ROE exceeds P/E, although this is one ratio and should be used in conjunction with many other ratios (P/S, FCF, OCF, PCF, P/E, P/B, ROE, ROA) as well as thorough analysis of company annual reports and SEC filings. Most importantly ROE must be viewed from a historical average over 7-10 years minimum, assuring ROE is not declining consistently over the period.