Saturday, 12 January 2013

Why you're undervaluing good capital allocation

"All I can do is remind them of the truth of Albert Einstein’s alleged response when he was asked, “What do you, Mr. Einstein, consider to be man’s greatest invention?” He didn't reply the wheel or the lever. He is reported to have said, “Compound interest.”"

There's nothing so much fun as playing with a compound interest calculator and seeing the crazy numbers that get spit out for one's investment lifetime. Money invested at 15% for 50 years multiplies a thousand fold. The difficultly, of course, is achieving 15% - no mean feat at all. I like to think of there being two general 'routes' to compounding: Closing discounts and intrinsic value growth.

Value investing disciples love to trot out the lines about buying £1 for 50p. Obviously, that's kind of a good deal. The problem with it comes down to what is that £1 made up of? How do you know it's worth £1? Sometimes you can find stocks which have liquid assets that have market values of X and the security is selling at less than X. This is a case where the return is largely going to be driven by the closure of discount - you don't expect X to grow necessarily over time but you reckon that the gain possible justifies the time you'd have to wait in the investment to realise your return. This approach works very well and is essentially the true 'Graham and Dodd' approach to investment and one that worked nicely for Buffett during the early years of his partnership.

The downside to this approach is that it requires the constant finding of good reinvestment opportunities - once the discount is closed, where do you go from here? You have to sell and find another discount to close. This is why this style of investing is commonly known as the 'cigar butt' approach; you're getting one last puff but that's it. Whilst you're buying £1 for 50p that £1 isn't going to grow in to £2, or £10, or £100.

The alternative approach is to find opportunities where intrinsic value can be compounded internally by the management of the company over a very long time period. These kind of situations are exceptionally rare but incredibly lucrative if they can be identified ahead of time. Some companies are just 'born with it' - the nature and characteristics of their business mean they only need to deploy a small amount of capital to grow significantly. This was Buffett & Munger's insight in to Coca Cola; the presence of a large, sustainable competitive advantage in an industry where the economic conditions are fairly stable meant that the business could earn incredibly attractive returns on the capital it kept inside the business and give the excess back to the shareholders.

I was very interested to read this article in the FT recently where they cite Jeremy Siegal's work indicating that the 'fair value' of Coca Cola in 1972 was a staggering 92x earnings. Can you imagine paying that much for any business? Coca Cola was hardly growing at Facebook style rates then, yet the combination of highly predictable business dynamics and fantastic compounding returns on invested capital produced these outstanding results when given a long time frame.

This leads me on to the main message of this post: Good capital allocation is systematically undervalued. It almost has to be due to the difficulty of comprehending the power of compound interest. Financial students are taught to discount future cash flows to compute present values, but what happens when the compounding rate is higher than discount rate? The maths says as the growth rate tends to the discount rate, the multiple one should pay rises asymptotically to infinity. Our valuation methods just cannot deal well with excellent long term compounding. Of course, trees don't grow to the sky, but sometimes even small textile mills do grow in to giants.

As another demonstration of what I mean, let's consider Berkshire Hathaway. The year is 1966, and you've just noticed that a talented young investor has taken control of this textile mill. You've seen his results under his partnership and can't help but believe that he's going to do a great job of capital allocation when he's there. Fortunately, a wormhole from the future opens next to you and out drops two things: a piece of paper with Berkshire's share price at the start of 2011 (~$120,000) and the average annualised returns of the market since 1966 till then (9.38%). You eagerly do a quick bit of maths and work out the fair value you should pay to get the same return as the market - $2123 (120,000 / 1.0938^45)

What is Berkshire's current share price? $20. Book value? $28.3 The fair value of Berkshire Hathaway, a textile mill with terrible economics, is 75x book value. Anyone buying now isn't buying $1 for 50c. They are buying $1 for 1c. The compounding effect of a manager highly talented in capital allocation is worth a premium so large it's completely unfathomable. Man's failure to conceptually grasp the power of compound interest creates this gigantic valuation discrepancy.

Now, there's an obvious criticism to my conclusion here. I've deliberately picked examples of two companies that have been utterly exceptional. You can't identify winners like this ahead of time, you cry! Hindsight investing does no one's wealth any favours.

I disagree with this verdict. Whilst you're highly unlikely to identify the next Buffett you can identify managements who excel at capital allocation by examining their actions and modus operandi because they follow patterns. I recently read a fascinating book that lead to me making the conclusions I've outlined in this post: Outsiders. In it, William Thorndike identifies eight CEOs who most outperformed the market over their reign of operation. Obviously Buffett is one of them, but have you heard of Henry Singleton? Tom Murphy? I highly recommend reading the book itself as I can't do it full justice in only a blog post but the lessons are clear; here's a good extract from the book description:
"Humble, unassuming, and often frugal, these "outsiders" shunned "Wall Street" and the press and shied away from hot management trends. Instead, they honed specific (and less sexy) characteristics including: a laser-sharp focus on per share value rather than sales or earnings; an exceptional talent for allocating capital and human resources; the belief that cash flow, not reported earnings, determines a company's long-term value; and, a penchant for giving local managers autonomy to release entrepreneurial energy."
Reading through it certain attributes come out time and time again. Only making acquisitions at incredibly attractive prices. Buying back stock when it trades at a discount to intrinsic value (and the corollary, using stock to make acquisitions when it's over-priced). A tough focus on the rate of return from capital expenditure. Avoiding hot trends and the 'de jour' market hypes.

Whilst identifying the next Buffett may be close to impossible, checking whether management display the signs of skillful capital allocation is not. The results of their endeavours should be obvious - good capital allocation has to lead to excellent growth in intrinsic value per share.

When analysing companies, I always look to see if I can find that elusively rare find - management which display all the calling cards of excellent capital allocators. In my portfolio today, I think Judges Scientific (LON:JDG) best display these properties and it's the reason it's my number one position despite not being dirt cheap on any valuation multiples. Management repeatedly make acquisitions of wonderful companies at ridiculously low multiples. The inevitable result of this is CAGRs of sales and earnings at rates of 32% and 49.7% respectively over the past five years. The company currently trades on a multiple of expected 2012 earnings of only 14x. I'm not saying the company is a Coca Cola or a Berkshire and worth gigantic multiples of current earnings but I'm willing to bet it's significantly above the current market price. I'm happy to sit back, wait, and let intrinsic value grow for me. The market can do what it likes in the mean time.


Disclosure: Long JDG

14 comments:

  1. Hi Mark

    A very interesting article and I will add JDG to my watchlist to research later. The idea of investing in companies/execs that have a track record of outstanding capital allocation is an intriguing one, however, we should distinguish between that and the potential of excellent capital allocation as that would bring a whole bunch of 'blue sky' companies into the equation.

    A thought provoking angle, thank you.

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    Replies
    1. Thanks Simon, glad you enjoyed it. I agree in that I much prefer companies where I can see hard evidence of them executing on good capital allocation rather than just one with good prospects or a good story. Also, I still think price is highly important in determining whether a company is a good investment (there are no bad assets, just bad prices) but I think the value of good compounding can sometimes make great companies look expensive but still be good long term value.

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