Next - The king of share buybacks

Next PLC (LSE: NXT.L) are a company most people in the UK will be familiar with as they are a large clothes retailer with over 500 stores and a FTSE 100 constituent. Perhaps what most people won't be aware of though is the phenomenal success of the shares over the past two decades. Since 1999 (as far back as I can see on Google Finance) the shares have compounded at a rate of 15.3% p.a., and that figure doesn't include dividends. Given other figures I've heard anecdotally from other investors, that figure is even higher if you go back further, rising above 20% p.a.!

Their latest financial report is a brilliant read and it's refreshing to have a company explain what they've done and what they intend to do so clearly without the usual waffle and management speak that's so common. In places they are brutally honest, even to the point where it's slightly comical! Check out this passage:

Planning remains a problem, though often more of a delay than a brick wall. We are actively working with planning officers, councillors and local communities to deliver new shops, investment and jobs. We continue to make a greater investment in the external architecture of our new stores, particularly on Retail Parks. Our aim is to transform the quality of construction associated with out-of-town retail and create the sort of buildings that communities will see as an asset, not an eyesore.

In our dealing with local councils it is noticeable that some are much more pro-growth and pro-jobs than others. Many local councils are enthusiastic and efficient; but a few remain an unhealthy mix of Luddite intransigence and incompetence. Going forward, in areas where councils traditionally have got away with just saying “no”, we will be more active in harnessing the law and the full weight of public opinion to campaign for growth

The part of the report that really surprised me though was the section where they explain their philosophy around share buybacks. Most companies don't really think very hard about share buybacks and when to do them but Next are explicitly clear that they see it as just another re-investment opportunity to be analysed alongside others. It's the kind of thing one expects to read in the Berkshire Hathaway annual letter and reminds me a lot of Outsiders (one of my favourite business books).

It's well worth reading the whole thing yourself, but here's some choice paragraphs:

Despite their increasing popularity, share buybacks are still widely misunderstood. There are still those who wrongly believe that they are some sort of share support scheme. This, of course, would be futile as any attempt to support a share price would evaporate as soon as the money ran out.

The only reason share buybacks can deliver long term value is because they permanently reduce the number of shares in issue and so increase the amount of profit attributable to each share (EPS). An important part of the logic of share buybacks is the implied link between growth in EPS and growth in share price. Whilst, in the short term there might appear to be no link, in the long run share prices tend to reflect the fundamental value of the earnings and dividend stream. If the share price did not rise with EPS, the buyback programme would eventually leave a single share owning all the profits and dividends!

Over the long term, we have been following these rules when considering buybacks:

1. Share buybacks must be earnings enhancing and make a healthy Equivalent Rate of Return (see below).

2. Only use the cash the business does not need. NEXT has always prioritised investment in the business over share buybacks.

3. Use surplus cash flow, not ever-increasing amounts of debt. We have never allowed our share buyback programme to threaten our investment grade credit status and will not do so going forward.

4. Maintain the dividend at a reasonable level through growing dividends in line with EPS. NEXT will continue to increase dividends in line with EPS.

5. Be consistent. NEXT has been buying shares every year for more than 10 years, reducing the shares in issue by more than 50%.

6. For share buybacks to be an effective use of shareholder cash, the core business must have the prospect of long term growth.

I'm not a shareholder myself as I focus exclusively on smaller companies (there's greater share mispricings to exploit) but for the LTBH large cap crowd I'd take a serious look at any company that has such a great record of capital allocation.

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

Tracsis - Late to the party

In the past few days I've been researching a company which I've just added to my portfolio called Tracsis. This is one I've heard mentioned before on the zulu thread on ADVFN, amongst other places, but never got round to investigating it properly - sadly one of the constraints of only investing part time means I don't get a chance to do the amount of research for new investments as I'd like.

Now, I'm pretty late to the Tracsis party. The shares went from ~55p to ~160p last year - wow! Shareholders of 2012 are dancing hard but I still reckon the party has a way to run yet and I'm getting involved. Now I'm not going to do a full write up of TRCS as thankfully, as part of the NFSC on TMF, TheKingsGambit has done a brilliant, comprehensive write up here. What I will do is highlight a few aspects and themes of the investment I think are important.

High quality of earnings

I'm a strong believer in the power of the accrual anomaly. I'm going to steal Stockopedia's description of it for their screen because it's so good:

"This screen is loosely based on the influential work of Richard Sloan from the University of Michigan, published in 1996 documenting what is referred to as the “accrual anomaly”. A pound of earnings can be comprised of assumed non-cash earnings called “accruals.” His landmark 1996 paper revealed that shares of companies with small or negative accruals vastly outperform (+10%) those of companies with large ones His paper found that investors focus too heavily on earnings and not on cash generation. They value the earnings of a high accrual company just as highly as the same earnings of a low accrual company, even though the high accrual company’s earnings are more likely to reverse in future years. When future earnings reverse, investors are “surprised” and sell off the stock causing the stock price to decline. Similarly, when a low accrual company’s earnings accelerate in future years, they are surprised in a good way."

Tracsis have very high cash generation from their profits and hence very low accruals. In fact, if you ignore the one-off acquisition earn-out payment, they generated £3.57m of cash last year compared to a reported profit of £2.42m. Now part of this is due to improved working capital management which can't be a long term source of cash but even before working capital movements they generated £2.78m of free cash flow (excluding the acquisition payment, because I'm trying to work out the current 'steady state' cash flow production going forward).

This is very different to a number of software companies who love using capitalisation of software development costs to boost profits. Too many investors ignore the cash flow statement and treat all profits as being equal. I can tell you right now, I'd take hard cash over an intangible asset any day. You can't spend intangibles. This keeps me away from investing in companies like Globo (GBO), a software company that makes lots of accounting profits and so many investors go "Low P/E, good profit growth, must be cheap!" but this logic is flawed. Free cash flow has been negative for many years, so for GBO to be cheap it must demonstrate that the present value of the FCF it can generate in the future is greater than the market cap. It may well be that Globo's investment in it's software will generate these cash profits in the future and the intangibles are justified, but it hasn't proved it can go FCF positive in it's results - yet. This is the kind of situation I find hard to appraise and so I avoid.

Niche markets as a source of competitive advantage

I like companies that address small, niche markets. That sounds a bit counter intuitive, as surely investors want to find the next Facebook which have the potential to grow in to giants? Possibly, but I think it's far easier to identify companies that operate in markets in which only a very small number of companies can operate in. This specialisation allows for high returns as it generates pricing power - if you're the only guy with the best rolling stock planning software for railways then you can capture a lot of the value you create. Also, niche markets aren't necessarily low growth - they are just small in absolute terms relative to wider economy. It's also a highly defensive proposition if you're a niche, non-commodity product business. It'd be hard for someone to come along and win Tracsis's current contracts unless their software is of at least a vaguely comparable standard (which is hard to achieve given how specialised the knowledge base is) and a decent cost saving to the existing deal TRCS have.

Good capital allocation ability is under-rated

What I really, really like about Tracsis is how much they emphasise how disciplined they are in the acquisition process and make an effort to outline their approach. They also mention in their annual report about how they've looked at many potential acquisitions this year but none met their strict criteria. This makes me even happier that they a) have excess cash on the balance sheet and b) are retaining most of their earnings for growth. I strongly believe that investors under-estimate the power of good capital allocation (which is a skill surprisingly few managements tend to be good at) and the power of compounding - companies that can reinvest their earnings at high rates of return will do very well for shareholders in the long run and are worth a premium. I'm going to do a blog post about this topic at some point as I think it's a very, very important investment lesson many investors under-estimate even if they are aware of it.

I'll end this blog post with an update of my portfolio as it now stands. I trimmed some PVCS as well as adding funds to buy TRCS - still need to get around to adding more MGNS!

EDIT: Just realised I've missed off JD. from my Stockopedia portfolio, here's my updated list:

Disclosure: I own shares in TRCS