10 minute read
Introduction
Intelligent investing is not about determining the most profitable business. That’s not hard and the market mostly prices it in already. It’s about figuring out which stocks offer the most value and will grow your capital at the highest rate over time.
Today, I think the market is very focused on finding the fastest growing businesses and paying whatever price. These two ideas are simbiotic. You can justify the price of most investments by modeling a really high earnings growth rate.
In some ways, I think the sound ideas of Charlie Munger and Nick Sleep of buying a few great companies and holding them for a long time, have been taken to the extreme. There is very little talk about whether the price of something actually makes sense. SpaceX for me is a perfect example. There is also not a lot of talk about durability. I doubt many investors can genuinely say how Nvidia’s earnings will look 10 years from now.
In my opinion, growing your capital safely over time requires a focus on both quality of earnings and price.
An interesting idea I recently came across that sustains my belief on investing with a margin of safety are companies with high FCF yields and low growth rates.
Why low growth rates? It helps to be clear about where growth actually comes from. Growth is not something a business simply has. It comes out of two things: the return it earns on its money, and how much of its profit it puts back in. Earn 15% and reinvest half your profit, and you grow at about 7.5% a year. Reinvest nothing and you grow at zero, no matter how good the returns are. So low growth covers the situation of a company that has durable earnings and no place to reinvestment, so they pay most of it out to shareholders.
This vertical is unexciting and largely ignored, but this is the opportunity for us as investors. A 20% FCF yield that is durable is just as good as a company growing at 20%. It can even be better, as growth is a prediction and the future is uncertain.
This article shines light on how businesses with low growth and low ROIC can still be great investments.
A conversation about ROIC
First, it’s important to remember that the capital on a business’s balance sheet is the money that someone else invested (i.e. shareholders in past years).
In mature businesses, if there is no place to reinvest capital going forward, then what matters going isn’t the ROIC (which is based on a historical balance sheet figure that is no longer relevant). What matters in the FCF that we as investors collect going forward and the price we have to pay to acquire that FCF (i.e. the FCF yield).
A great example are hospital operations. A well run hospital earns a lot of FCF, but has no place to reinvest it. You could calculate the ROIC to determine if someone else’s investment made sense, but as an incoming shareholder that is irrelevant to you. Your return will be the cash flow from the hospital relative to the price you pay for it.
Another good example is buying a real estate apartment building. Imagine a developer spends $5 million to build a new apartment building that produces $200,000 of annual cashflow. This is a 4% FCF yield – pretty mediocre. So we have a 4% ROIC business that isn’t creating value. Lets assume the market goes south and the developer offers you the building as a valuation of just $1.5 million. Let’s look at your result: you invest $1.5 and now have a $200k of cash flow. This means that your return on the capital you invest is not 4% but rather 13.3%.
How does this apply to stocks? ROIC does not matter if the business is no longer reinvesting its earnings to replace assets or expand, and pays most of the earnings out to shareholders.
Your return, as a new investor, will come from the cashflow generated relative to the price you have to pay.
Great article. Sometimes (maybe most of the times) low growth, high fcf yield cos simply accumulate cash on their B.s and don’t pay out as dividends. Would u classify those as value traps or what’s ur thought on them
You are talking about CROIC:
CROIC = ROIC × Earnings Quality