Asset Allocation

How I determine which assets to invest in 

A major part of my investment process is deciding how to allocate my capital to each asset class. I decide this simply by comparing the likely after-tax, real returns of each asset class. In doing so, I am mindful of the following fundamentals.  

Business earnings are largely real

The yield from cash or bonds is a nominal return while the yield from a business is largely a real yield. This is because the nominal value of a business’s assets, and its nominal earnings, are both likely to rise by a similar rate to the inflation rate.  

Costantini provides convincing evidence that business earnings are largely real. He says:  

 “Unlike bondholders, shareholders possess a claim on the earnings (of a business) by the dividend and have ownership of the underlying assets, whose replacement value will rise and fall with the level of inflation. Furthermore, the feed through effect of inflation in the profit and loss account has to be taken into account. Faced with rising input prices, businesses will initially accept a certain amount of margin compression, but will eventually pass on this cost inflation to their customers, and all the way to the bottom line. Indeed, our research suggests that there is a 93% pass-through of CPI inflation to earnings growth in the long run.” [1][2]  

Investing in a portfolio of businesses is likely to provide superior after-tax, real returns than cash

Cash or bonds has, historically at least, yielded poor returns compared to investing in listed businesses (equities). These poor returns mean that it has actually been riskier to invest in cash then to invest in businesses! Dreman provides an excellent example of how risky it has been to invest in cash. He points out that if a US investor, in a 50% tax bracket, invested $100,000 in long treasury bonds after World War II; he would have only $39,200 of his buying power left in 1996. Inflation and taxes would have destroyed over 60% of the nominal value of his investment.[3] By contrast, if the same investor, with the same tax rate, invested the $100,000 in listed businesses (equities) his portfolio would be worth $913,000 in 1996. His portfolio would be worth 23 times more than if he invested all his money in bonds. Thus, Dreman thinks investing in cash, considered by most to be almost riskless, is extremely risky.[4] I agree and I will try to maximise the after-tax real return on my capital by investing in a portfolio of cheap businesses.  

Owning a portfolio of businesses also provides better protection from the low risk (but disastrous impact) of high inflation or even hyperinflation. For example, in countries that have suffered hyperinflation, the value of cash or bonds become worthless while the value of business assets kept some value. Moreover, when those economies recovered the value of these business assets recovered while the value of the debt often remained worthless. (See the experience of the German and Japanese debt and equity markets during and after World War II)[5].  

There will be price volatility when seeking these better, after-tax, real returns 

Despite the long-term advantages of investing in businesses, there will be large short-term swings in their market value. However, I must accept this volatility because in the medium to long run investing in businesses is usually the best way of ensuring that I preserve the real value of my capital, and get a good return on this capital. As Mark Sellers points out:  

“Most people equate short-term volatility with risk. So rather than achieving optimal portfolio returns coupled with high volatility, people would rather achieve suboptimal portfolio returns coupled with low volatility.” [6]  

Simply put, I have to accept price volatility to get better long-term returns.   

I have to accept the risk of a severe recession or depression

There is always a risk there will be a severe recession, or even a depression, in the real economy. This would dramatically reduce the intrinsic value of most of the businesses I own. I will still invest my capital in businesses, despite this risk, because it is the best way of preserving the long-term real value of my capital. In addition, the cheap price I hope to pay for these businesses will provide a large ‘margin of safety’ from this risk.[7]  

 

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[1] P41: ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.  

[2] The best businesses at ‘passing through’ inflation are those with a sustainable competitive advantage. This is because they have a very strong ability to pass input price increases onto their customers.  

[3] P309, ‘Contrarian Investment Strategies: The Next Generation’, David Dreman, 1998.  

[4] Ibid, P309.  

[5] Ibid, P293.  

[6] Ibid.  

[7] I refer to the ‘discount’ between a cheap business’s market price and its intrinsic value as my ‘margin of safety’. This term was first used by Benjamin Graham and David Dodd in their hugely influential book; Security Analysis, First Edition, 1934.

When I Will Sell A Business

I have the following rules when deciding whether to sell a business     

I must sell a business when its price equals my estimate of its intrinsic value[1]

I have this rule because once a business’s price equals my estimate of its intrinsic value there is no ‘margin of safety’ in owning it.     

How the business’s price can equal my estimate of its intrinsic value

This can happen because:     

1. The market price of business has increased to its intrinsic value;
2. The intrinsic value of the business has fallen (for example the business’s competitive advantage has weakened); or,
3. I have changed my mind about the business’s intrinsic value and it is lower than I had previously thought.

What I must do if I want to sell a business because I think its intrinsic value has fallen

I must make a new estimate of its intrinsic value by doing a rigorous new valuation. In particular, I must:     

1. Make sure that I have calculated its intrinsic value based on normalised earnings, not cyclically low earnings; and,
2. Assume that if the business has had bad luck it will probably have better luck in the future.[2]

What I must do if want to sell a business because I think its intrinsic value  is lower than I had previously thought

I must explain my reasons for changing my mind to another value investor. I must do this to help stop me from acting emotionally and selling the business simply because its price has fallen.     

Other circumstances when I can sell a business

I can sell a business if a better investment opportunity arises with that capital.     

Tax Issues

I must decide whether it is worth delaying the sale of a business because of capital gains tax or income tax advantages. However, I will sell a business if its current price compensates for the tax advantages in delaying the sale (for example, its price is 120% of my estimate of its intrinsic value).     

The Two Year Rule 

If none of these reasons for selling a business applies, I must only sell a business after holding it for a minimum of two years.[3]     

Why I have to wait at least two years

Other investors (‘the market’) can undervalue the businesses I own because of irrational fear, or because they have not properly assessed the probability that the business’s fundamentals can improve (that is why they were ‘cheap’ when I bought them!). I must wait for a minimum of two years before selling a business I own because it can take months or even years for this fear to subside, or for the business’s fundamentals to improve. As Pabrai points out you usually need to wait for a business’s fundamentals to improve because:        

“While valuations of public businesses can go through dramatic change in a matter of minutes, real business changes take months, if not years…”[4]       

Why I can sell after two years

If a business’s price has not increased to my estimate of its intrinsic value after two years I can, irrespective of whether the above reasons apply, sell the business. I can sell it because this length of time suggests that I may have overestimated its intrinsic value. In addition, there may be better opportunities for me to invest this capital. This is only an option to sell. I do not have to sell the business if I think it is still a good investment.     

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[1] Except for tax exception explained below.     

[2] As Pabrai points out, businesses are entities that go through ups and downs just like humans, see P153, ‘The Dhandho Investor: The Low – Risk Value Method to High Returns’, Monish Pabrai, 2007.     

[3] This idea, and the reasons for it, are those of Monish Pabrai. See Chapter 15, ‘The Dhandho Investor: The Low – Risk Value Method to High Returns’, Monish Pabrai, 2007.     

[4] P155, ‘The Dhandho Investor: The Low – Risk Value Method to High Returns’, Monish Pabrai, 2007.

Technology and Competition

As previously discussed, I have a rule that I will not buy a business unless it is highly likely to still exist in 10 years time.[1] The reason for this rule is simple. If the business does not exist in 10 years time it is likely to be a very poor investment. However, it is hard for me to predict whether a business will be around in 10 years time. Therefore, I simply assume that businesses in industries that change the least have the highest probability of surviving. The industries that change the least are usually low technology product or service industries. However, I do think that some high technology companies with very strong competitive advantages (think Microsoft) are likely to last. 

The graphs below show the low probability that the average business in a fast changing technology industry will still exist in 10 years time. The number of businesses in both of these technology industries rose and fell dramatically over a short period. 

[Click on the image for a better view] 

Source Michael Mauboussin[2] 

There is a lot of other evidence that the failure rate of businesses in technology industries is much greater than other industries.[3] The really interesting question is why. Bronte Capital (an Australian hedge fund) has written what I think is a very good explanation of why this failure rate is so much higher:

In technology the competition is remorseless. In most businesses the competition might be able to do something as well as you – and it will remove your excess profit. People will build hotels for instance until everyone’s returns are inadequate but not until everyone’s returns are sharply negative. Even in a glutted market a hotel tends to have a reason to exist – it still provides useful service. And someday the glut will go away so the hotel will retain some value.[4] In most businesses the game is incremental improvement. If you get slightly better you can make some money for a while. If the competition gets slightly better you will make sub-normal returns until you catch up.

In technology the threat is always that someone will do something massively better than you and it will remove your very reason for existence. Andy Grove – one of the most successful technologists of all time (Intel Corporation) – titled his book “Only the paranoid survive”. He meant it.

If your technology is obsolete the end game is failure – often bankruptcy. Palm will fail because Palm no longer has a reason to exist. If we wait 20 years Palm will be even more obsolete – but the hotel glut will probably have abated. Nothing left in Palm is likely to have any substantial value.

This is a crucial point. In most industries a reasonably efficient business will be able to manage its assets to make a return on its invested capital which is at least close to its cost of capital. That is often not the case in technology industries. Irrespective of how efficiently you run your business if your technology becomes obsolete you will make little or no return on your capital. Moreover, your operating assets will usually have no value to any other business. If your technology becomes obsolete your operating business will usually be worth nothing.  

Bronte Capital point out that the key to survival for technology businesses is keeping out the competition:

Surprisingly, changing the world looks like the easy bit. Plenty of companies do it. The problems are in keeping the competition out. Only a few do that (Microsoft, Google are ones that seem to)…

A simple example is Garmin…Garmin has over a billion dollars cash on the balance sheet – and that cash represents past profits. It has changed the world – and thus far it has been well remunerated.

The only problem is that they can’t keep the competition out. Nokia has purchased a mapping company. Iphone now has a Tom-Tom app, downloadable for $80 in Australia. Soon sat-nav will be an expected application in every decent mobile phone. Google has mapping technology too and will embed it into their android phone. Eventually the maps will be given away because people might book hotels using their sat-nav device whilst they are travelling. [It is darn useful to know where a decent hotel with a spare room is when you are on the road.]

Garmin has a great product. They have improved my world. The only problem is that they can’t sell their product at any price that competes with “free”. Garmin’s business is going the same direction as Palm. Bankruptcy however is only a remote possibility – they have a billion dollars on the balance sheet and unless they do something really stupid on the way down they will remain a profitable avionics business.

This raises the very important question of why do some technology businesses survive (for example Microsoft’s operating system software). Is it because of the strength of their competitive advantage?  Does Microsoft’s economies of scale and customer captivity with its Windows software allow it to spend so much on research and development that it can keep most competitors at bay? Or is it the nature of the technology they are selling? Are some technology products or services likely to only change incrementally and, thus, not become obsolete overnight? (i.e Windows Office software).[5] I think some technology businesses survive because of one, or both, of these reasons.

Nevertheless, the risk of obsolescence with technology businesses remains. I deal with this risk simply. I only invest in them if I think the business is highly likely to still exist in 10 years time. I assume that the only technology businesses which are likely to still exist in 10 years time are those which have a product or service which is likely to change only incrementally, and which have a very strong competitive advantage.

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[1] I make an exception to this rule for businesses that I think are ‘cheap’ compared to the value they will realize in liquidation or in run off. 

[2] P108, ‘More Than You Know: Finding Financial Wisdom in Unconventional Places’, Michael Mauboussin, 2007.

[3] See P108, ‘More Than You Know: Finding Financial Wisdom in Unconventional Places’, Michael Mauboussin, 2007 for references.

[4] “Unfortunately the hotel is usually mortgaged – and the value often reverts to the debt holder.” Footnote from the Bronte Capital Article.

[5] There is obviously the longer term risk from cloud computing systems.

What is a Customer Captivity Competitive Advantage?

A customer captivity competitive advantage is where a business has ‘captured’ a customer. This can be because the customer has high costs in ‘switching’ to an alternative product or service provider, or high costs in ‘searching’ for this alternative, or simply because the customer has developed a strong ‘habit’ in buying the product or service.[1] It is a competitive advantage because if a business has ‘captured’ a customer it means that its competitors will not be able to prise these customers away by offering the same terms. Competitors will have to lure ‘captured’ customers away by cutting prices to the bone or even giving away the product or service to induce people to try it. However, this is usually not profitable and is, thus, unsustainable. Moreover, the business with the competitive advantage can match its competitors and, thus, usually retain its customers. 

I will discuss the three main types of customer captivity in more detail below.  

Customer Captivity – Habit

What is the competitive advantage?

The customer has become captive to a business because they have developed a strong ‘habit’ in buying the business’s product or service. This usually occurs when the customer buys the product or service frequently and in a non-reflective way. The classic example is customers who buy Coca Cola.    

How this competitive advantage can be strengthened

A business who has this competitive advantage can strengthen it by reinforcing the habit. It can do this in a number of ways, for example, it can make annual style changes to the product or service, accept trade ins, introduce periodic payment schemes, introduce leasing programs, introduce customer loyalty programs, or sell the base product (i.e. the razor) cheaply and encourage regular purchase of refills (i.e. razor blades).    

How this competitive advantage can be lost

A business with this competitive advantage can lose it by generational change. That is existing customers die, or age, or move into different markets. New customers, by definition, are unattached and are available to any competitor.[2]    

Customer Captivity – High Switching Costs

What is the competitive advantage?

The customer has become captive to a business because they will have high costs if they ‘switch’ to an alternative product or service provider. Switching costs are usually high when a product or service is complicated, customised, and crucial to the customer (for example legal services).    

These switching costs are numerous and include the following:

1. The time spent in learning how to use the new product or service (for example retraining staff to use new software);
2. An increase in errors while learning how to use an alternative product or service. The product or service may be critical to the customer’s business operations and they are unlikely to want to abandon a functioning system, even for one that potentially increases productivity, if it could lead to major systemic problems for the business (for example a bank changing its trading software);  
3. The time spent in outlining the customers’ needs, preferences and other details to a new service provider, and the time required for the service provider to master this information (for example a client/lawyer relationship);
4. Adverse consequences if the customer selects the wrong product, or service provider (i.e. a poor brain surgeon!); and,
5. Adverse contractual consequences such as: 
   • The customer will incur damages from breaking a contract;
   • The customer will lose accrued benefits (i.e. bonus points etc); and,
   • The customer will lose the advantages of having a product ‘bundle’ (for example, a lower price, less bills or less hassle).

How this competitive advantage can be strengthened

The main ways a business can increase its customers ‘switching costs’ is by:    

1. Adding new features to the product or service. For example banks may offer their customers automatic bill payment, pre-established lines of credit, direct salary deposit and Internet banking; or,
2. Making the task of mastering the product or service more difficult (for example Microsoft often adds new features to its office product suite).

How this competitive advantage can be lost

The business can lose this competitive advantage by:    

1. Competitors reducing these switching costs (for example credit card companies may offer switching customers pre approved credit balances and rewards on any credit balances that are transferred);
2. The business’s product or service becomes more reliable or easier to use. Thus, its customers will be more willing to try a competitor’s lower cost alternatives, and will be less reliant upon using the original supplier to support and service the product or service;
3. The product or service becomes more compatible with products or services offered by its competitors (for example, Cisco network hardware is now compatible with many other network suppliers); or,
4. There is a generational change in its customer base. That is the business’s customers die, or age or move into different markets.

Customer Captivity – High Search Costs

What is the competitive advantage?

The customer has become captive to a business because they will have high costs in ‘searching’ for an alternative product or service provider. Like switching costs, search costs are usually high when the product or service is complicated, customised, and crucial to the customer (for example, legal services).    

The main search costs are the time it takes to find and assess a new product or service, and, the risk that something could go wrong during a trial period of an alternative product or service.    

How this competitive advantage can be strengthened

The business can increase search costs by introducing more features to the product, and, thus, making comparisons to alternative products or services difficult (for example mobile phone plans).    

How this competitive advantage can be lost

The business can lose this competitive advantage because competitors have reduced these search costs significantly or because the Internet has made price and quality comparisons easier. This can occur even for complicated products or services.    

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[1] Most of this post is based on the work of Bruce Greenwald and Judd Kahn in their seminal book, ‘Competition Demystified’, and their excellent paper ‘All Strategy Is Local’.      

[2] Thus, the business with the customer captivity competitive advantage must do everything it can to attract the unattached new generation of customers. That is why Coca Cola spends so much money on advertisements that appeal to the youth market.

What is an Economies of Scale Competitive Advantage?

As previously discussed, I think the most sustainable competitive advantages are, in descending order:  

1. Economies of scale combined with customer captivity;
2. A network effect;
3. A government licence;
4. Patent protection; and,
5. Customer captivity[1].

In this post I will explain when I think a business has an economies of scale competitive advantage.  

When does a business have an economies of scale competitive advantage?

A business has an economies of scale competitive advantage when:  

1. It has a much larger market share with a product or service than its competitors in a:
   • Geographic area; or,
   • Product or service space (for example Intel with computer CPU’s); and,
2. Fixed costs make up a large share of total costs.[2]  

If this occurs the dominant business’s average cost per unit will be lower than its competitors. Its smaller competitors will have higher average costs because they cannot reach the same scale of operation. The dominant business’s lower average cost per unit means it can keep competitors at bay by using one or more of the following tactics. It can have:   

1. A lower price for its product or service than its competitors; [3]
2. A more technologically advanced product or service than its competitors (it can spend more on research and development); or,
3. Better marketing for its product or service than its competitors (it can spend more on advertising and sales promotion).[4]

However, as Professor Greenwald points out, pure size is not the same as economies of scale.[5] It is the share of the relevant local market rather than size by itself that creates economies of scale. Economies of scale coincides with large businesses in only a relatively few products, for example, in Boeing’s airframes, Microsoft’s operating systems, and Intel’s CPU. Even these global businesses are dominant in only a few product lines, and are, thus ‘local’ in the sense of ‘product space’.[6]  

Why a business with an economies of scale competitive advantage also needs some customer captivity

Economies of scale by itself is not enough for a business to keep a competitive advantage. If a business has only an economies of scale advantage, its competitors will be able to take some of its customers and will eventually be able to capture enough market share to remove its scale advantage. The business with the economies of scale advantage needs to be able to keep its larger market share. It does this by keeping its customers. The way to do that is to have at least a mild form of customer captivity.  

How a business keeps this economies of scale competitive advantage

The overwhelming priority of a business with an economies of scale advantage is to protect its market share and, thus, keep its large size relative to its competitors. It can do this by matching the moves of an aggressive competitor price cut for price cut, new product for new product, niche by niche. If it does, then its customer captivity will secure its greater market share. Its competitor’s average costs will be higher than its average costs at every stage of the struggle. While this will reduce the profit of the business with the economies of scale advantage, its competitors will usually make very low returns on capital, or a loss, and will eventually stop competing.  

Another priority for a business with an economies of scale advantage is to increase this advantage. The best way to do this is to increase the proportion of fixed costs relative to the variable costs that is needed to produce the product or service. For example, the business can spend more on research and development to speed up product development cycles, or it can increase the number of features with the product or service.  

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[1] Customer captivity refers to how a business has ‘captured’ a customer. This can be because the customer will have high costs in ‘switching’ to an alternative product or service provider, or high costs in ‘searching’ for this alternative, or simply because the customer has developed a strong ‘habit’ in buying the product or service. I will discuss this form of competitive advantage in much greater detail in a later post.  

[2] Fixed costs can be capital investments on plant, equipment, or information technology, or it can even be operating expenses like advertising or managerial supervision. See p32, ‘Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation’, Michael Mauboussin, 16 December 2002.  

[3] The dominant business can be highly profitable at a price level that leaves its smaller competitors, with higher average costs, losing money.  

[4] Even if its competitors can spend the same proportion of revenue on R& D, or sales promotion, they cannot sustainably spend the same dollar amount as the dominant business.  

[5] See, ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.  

[6] Also a business selling services is more likely to have an economies of scale competitive advantage than a business selling products, because services are usually provided ‘locally’. See, ‘All Strategy Is Local’, Bruce Greenwald and Judd Kahn, Harvard Business Review, 2005.

Normalising a Business’s Earnings

Why normalising a business’s earnings is so important

A crucial part of valuing a business is determining what is the likely future earnings, and earnings growth, of the business.[1] I think the best way to do this is to simply look at the business’s historical earnings data and make a naive prediction about what I think its earnings and earnings growth are likely to be in the future. However, when I make these estimates it is critical that I do not overestimate the business’s future earnings because its historical earnings have been boosted by an economic boom, high secular profit margins or some other reason. Therefore, I must attempt to normalise the business’s earnings when making these estimates. Robert Bruce explains how important normalising a business’s earnings is when he said in 2007 (pre the credit crunch): 

“Perhaps the most surprising thing to me is the inability of even market professionals to adjust for profit margins. People will talk about how the P/E ratio is reasonable at 19 times without mentioning that it is 19 times the highest profit margins ever recorded. The least we can do, as professionals, is to normalise between economic boom and economic bust, between low profit margins such as those in 1982 when they were ½ normal and very high profit margins such as those of today. A lot of people think profit margins can be sustained. Profit margins are the most mean-reverting series in finance.”[2]    

But can I normalise the business’s earnings? 

Before I normalise a business’s earnings I have to decide that I can normalise them. This is a very important decision.[3] As Joel Greenblatt says: 

“To figure out what (a business) is worth requires you to figure out what are normalised earnings down the road… Most of the time you will not be able to do that. Maybe the business is too uncertain or too tough or you do not really know (my emphasis). But if you can do that in the businesses you do know, than that is the whole analysis.”[4] 

If I think the business’s earnings can be normalised, I will use the following process to do so. I will normalise the business’s earnings for economic cycles, product life cycles and commodity cycles. 

How I normalise a business’s earnings

I largely follow the normalising process outlined by Richard Pzena.[5] I think Pzena has an excellent way of using a business’s earnings history to make a normalised earnings forecast. He makes a naive earnings prediction after looking at the main drivers of the business’s earnings, namely its unit demand and operating margins over 10 years. An example of how Pzena does this is when he normalised Hewlett Packard’s earnings: 

“Hewlett-Packard has grown its revenues 10.6% per year over the last 10 years. Its margins have averaged 8.1% over the last 10 years, and 4.5% for the last three years. We use an average weighting to come up with a naive margin projection. Our naive margin projection in this case is 6.7%. So if the business continued to grow at 10% a year and produce 6.7% margins, five years from now it will earn $2.40 a share.”[6] 

However, the one major problem with this approach is that the business’s 10 year earnings history may have been during a period of economic boom or during a period when there were no recessions. When I normalise a business’s earnings I try to adjust for economic cycles. 

How I normalise a business’s earnings for economic cycles[7]

Trying to normalise a business’s earnings for economic cycles is difficult because some businesses may be too young to have been through a recession (unlike most of the developed world the last severe recession in Australia’s was over 17 years ago). In addition, even if a business has been through a recession a future recession may be of a different length and severity as previously. Despite these problems, I think the following approach is a reasonable way to normalise a business’s earnings for economic cycles. 

If the business has not been through a recession in the last 10 years

I will use logic[8] to guess at the likely impact of a future recession on the business’s earnings. The following factors will influence this estimate: 

a) The length and severity of a future recession. I will assume, unless there are good reasons otherwise, that any recession will be of average length and severity; and, 

b) The business’s operational leverage.[9] 

If the business has been through a recession

I will normalise its earnings by mainly looking at the impact a previous recession had on the business’s earnings.   

How I normalise a business’s earnings for product and service life cycles

The earnings of some businesses will be cyclical, not just because of economic cycles but also because of life cycles for the product or service the business sells. For example, the Australian ‘bionic’ hearing aid manufacturer Cochlear has a life cycle with its cochlear hearing aid. Its earnings will increase when they bring out the latest version of their Cochlear hearing aid, and will fall as their product ages (and their main competitor brings out a newer product). If a life cycle affects the business, I will normalise its earnings by averaging its earnings over the life cycle. 

How I normalise a business’s earnings for commodity cycles

A business’s earnings may also be cyclical because they are heavily impacted by the price of a particular commodity. If this is the case, I will normalise the business’s earnings by assuming that the price of the commodity will be its 30-year price average[10], unless there are good reasons to do otherwise. 

How my normalised earnings estimates, and scenarios fit together

As previously discussed, I estimate an upside, central case and downside scenario for a business depending on what I think are the major risks for the business, or upside factors likely to affect the business. I do not include the risk of a recession, a change in commodity prices, or where the business is in its product life cycle, as risk or upside factors. I do this because I think it is easier to deal with these risks when normalising the business’s earnings. 

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[1] I use this normalised earnings estimate in my valuation to estimate the ‘central case’ value for a business. 

[2] P4, ‘Robert Bruce Lecture Transcript’, ‘Value Investing Class’, Bruce Greenwald, Columbia University, March 27, 2007. 

[3] This problem is usually taken care of by only valuing businesses in my ‘circle of competence’. However, even if a business is within this ‘circle’ I may decide that I cannot normalise its earnings. 

[4] P7, ‘Greenblatt Special Situations Class Transcript’, Value & Special Situation Investment Course, Joel Greenblatt, Columbia University, November 30, 2005. 

[5] See P99, ‘The Market Masters: Wall Street’s Top Investment Pros Reveal How to Make Money in Both Bull and Bear Markets’, Kirk Kazanjian, 2005. 

[6] P99, ‘The Market Masters: Wall Street’s Top Investment Pros Reveal How to Make Money in Both Bull and Bear Markets’, Kirk Kazanjian, 2005. 

[7] I could try to protect myself from the risk of buying businesses with cyclically high earnings by buying index puts. I do not do this because they provide limited protection for any business that has more cyclical earnings than the average of businesses in the index. 

[8] I must never use inductive logic without deductive logic. As Taleb explains: “the following inductive statement illustrates the problem of interpreting past data without logical method: I have just completed a thorough statistical examination of the life of President Bush. For 55 years, close to 16,000 observations, he did not die once. I can hence pronounce him as immortal, with a high degree of statistical significance.” See P103, ‘Fooled by Randomness’, Nicholas Taleb, 2001. 

[9] A business has operating leverage when its cost structure has a high proportion of fixed costs. Having a high proportion of fixed costs means the business’s profit margins will be highly sensitive to changes in sales volumes. For example, for every 10% increase in sales, the business will report a greater than 10% increase in earnings and vice versa. 

[10] This is arbitrary period chosen because it is likely to capture a commodity price cycle. However, I will shorten or lengthen this period if I think 30 years does not capture the particular commodity’s price cycle.

My Quantitative Valuation Model – Part 2

Why my valuation model assumes a business will only have profitable asset growth for five years  

Searching for the ‘Holy Grail’

I think the most difficult part of valuing a business is deciding what value, if any, to attach to the business’s earnings growth prospects. In this post, I discuss how I value a business’s potential growth. This post is unavoidably quite technical.   

Why profitable asset growth is important to a business’s valuation

As previously discussed, a business’s earnings growth will only be profitable to me if the business earns more on these new assets than the minimum return I need to provide the capital (my discount rate) to fund this growth. For example, when a business’s ROIC is equal to my discount rate, asset growth by the business will have no value to me because the return the business will earn on the new capital will just equal the opportunity cost to me for letting the business use my capital. Thus, while the business has increased in size, simply because it has more assets, the net return to me is zero.   

When a business’s ROIC is lower than my discount rate, asset growth by the business will actually destroy value for me. This is because the business earns less on the new assets than the opportunity cost to me for letting the business use my capital.   

Only when a business’s ROIC is higher than my discount rate is asset growth by a business profitable to me. It will be profitable because the business earns more on the new assets than the opportunity cost to me for letting the business use my capital. As a shareholder, I will receive these additional earnings. I will receive these additional earnings directly, either by dividends, or indirectly, by the business increasing in value because it has retained all or part of these earnings.     

This is a very important point for investors to understand. Many investors think earnings growth by a business is unambiguously good. It is not. In many cases earnings growth will reduce the business’s value.     

What is a business worth without asset growth

A business can be highly profitable and, thus, have a very high ROIC[1] (well above the average return for a commodity business) without asset growth, however, as Costantini points out:   

“If assets do not grow and are not expected to grow, then the asset multiple of any business, however outstanding it is, should be in line with its… relative return” (that is its ROIC/Discount Rate).[2]    

In other words if a business cannot grow its assets the maximum the business should be worth is its Earnings Power Value (Earnings/Discount Rate). This is equal to the business’s replacement value multiplied by the business’s ROIC/Discount Rate.   

Why my valuation model assumes a business can only have profitable asset growth for five years

How do you value growth?

Costantini says:   

“We recommend that any valuation work should always start without any reference to growth … it is always possible to refine the analysis further. However, even if one did nothing else and selected stocks on that basis, the worst that could happen is that genuinely high-growth businesses would be more expensive than they should. Granted, this could be an opportunity cost, but would never lead to a situation where growth stocks are entered at the wrong price in a portfolio or, worse, some stocks are taken for what they are not… Yet we know that growth in assets significantly influences the valuation of high return (ROIC)[3] businesses in particular. There will be, therefore, certain instances where it is necessary to (incorporate growth).”[4]   

Therefore, asset growth is arguably important only for valuing high ROIC businesses. That is Costantini’s view. He says:   

“Growth only really matters for the valuation of the smaller universe of high CROCI[5] (ROIC) businesses… the reason why economic growth only matters to the valuation of high CROCI businesses is easily explainable… only high CROCI businesses can fund growth internally.” [6]   

So what evidence is there that asset growth is only important for high ROIC businesses? Costantini refers to a study by Tobin, which showed the impact of asset growth on the market price of businesses. The study found that:   

“The effect of growth on valuation was marginal, up to 10 times less important than that of economic earnings… the overwhelming marginal factor contributing to the asset multiple is CROCI (ROIC)… this measure accounts, on average, for 77% of the q ratio[7] (asset multiple) in the US from 1989 to 2004. In contrast, growth has a mere 12% weight in the makeup of the q ratio.”[8]   

In fact Costantini believes investors do not usually attach high asset multiples to even high asset growth businesses. He says:   

“At some point, additional growth does not produce additional valuation. Investors in aggregate know better. They know that businesses routinely attempt to get near the sun (i.e. grow very fast) and burn their wings, mainly by accumulating too many financial liabilities. They also know that a real trend growth of more than 10% per annum is already close to three times GDP, which may be called breakneck speed…the market’s conservatism in the price of growth is properly entirely justified… investors seem to be incredibly cautious about the sustainability of above GDP growth rates”.[9]   

I think Costantini is right when he points out:   

“In the end, growth (in assets) of course matters, but nowhere near as much as the average investor thinks…[10]    

How I value growth

Based on this evidence my valuation model is conservative and assumes that a business will only have profitable asset growth for five years. This means that asset growth will, except for high ROIC businesses, only have a small impact on my valuation of a business. I think this is a prudent assumption to make.   

Of course, if a business can sustain an ROIC above my discount rate, and high asset growth, it will, because of compounding, dramatically increase in value and be a wonderful investment. This compounding effect is why Buffett says:   

 “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”[11]   

However, I am no Warren Buffett and I recognise how hard it is to predict which business’s will be able to sustain a high ROIC, and asset growth, over the medium to long-term. If I buy these types of businesses, and I am wrong about the sustainability of their ROIC, and asset growth, these businesses will be a very poor investment. That is why my valuation model is conservative and assumes there will only be profitable growth for 5 years.[12] [13] For most businesses, this means I will value them at close to their earnings power value (Earnings/Discount Rate).   

In conclusion, I think Costantini is right when he says:    

“The asset multiple (Enterprise Value/Replacement Value) …can be used in an efficient and successful way for (valuing) most of the investment universe, despite ignoring growth in assets, in a manner most disturbing for growth reliant investors.” [14]   

 

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[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit.   

[2] P176, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.   

[3] All words in brackets in the quotes on this post are my comments. They are not comments from the authors of the quote.   

[4] Ibid at P117.   

[5] See the CROCI definition at: http://www.investopedia.com/terms/c/croci.asp. I use ROIC as a proxy for CROCI.   

[6] P117, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.    

[7] See the definition of the ‘q ratio’ at: http://www.investopedia.com/terms/q/qratio.asp.   

[8] Ibid at P115.   

[9] Ibid at P120.   

[10] Ibid P116.   

[11]‘Letter to Berkshire Shareholders’, Warren Buffett, 1989.   

[12] As Montier points out, theoretically investing in great (high growth) businesses, “… is a good investment. However, identifying growth ex-ante is very difficult. We are all too confident and too optimistic about our ability to pick winners. Growth investing often means buying expensive stocks. Value investing is an admission of our limitations. It offers protection against mistakes, and it outperforms!”, P307, ‘Behavioural Investing’, James Montier, 2007.   

[13] A further problem with assuming that a business’s prior asset growth rate is sustainable is that its historical asset growth rate may reflect rapid consumption of available franchise opportunities. Once exhausted the potential for profitable asset growth can decline dramatically. See P10, ‘Growth delusions’ in ‘Franchise Value: A Modern Approach to Security Analysis’, Martin Leibowitz, 2004.   

[14] Ibid.

My Quantitative Valuation Model – Part 1

I have spent a lot of time on this blog discussing a number of qualitative factors that I think are very important in determining the value of a business. In this post I will discuss how I ‘quantify’ the value of a business.

My quantitative valuation model is a basic ‘Economic Value Model’. I determine the ‘central case’ intrinsic value of a business based on my estimate of its future ROIC[1], and asset growth.[2] My model assumes a business can sustain this predicted ROIC, and asset growth, for five years. After five years, I assume the business’s predicted ROIC will slowly revert to my discount rate and that there will be no further profitable asset growth.[3] I discuss why I assumed this further below. But firstly I want to make some general points about my quantitative model.

How I limit the risks of forecasting, in my valuation model

Using a valuation model requires me to make predictions about a business’s future. The major risk with making such predictions is that I may value a business for far more than it is probably worth. I try to limit this risk by:

1. Assuming the business’s ROIC, and asset growth, will never be higher than it has been historically; [4]
2. Assuming that the business will only sustain its predicted ROIC, and asset growth, for five years; and,
3. Most importantly, having a large ‘margin of safety’[5].

Despite the risks of using a valuation model, I think Damodaran is correct when he says:

“Those who disdain valuation models for their potential errors end up using far cruder approaches (such as comparing P/E ratios or applying EBIT multiples)… they choose to sweep the uncertainties (of valuation) under the rug and act as if they did not exist”.[6]

Why I do not use comparable market valuations

I do not value a business by using ‘comparable’ private or public market valuations because market sentiment can heavily influence these valuations.

Why my valuation model assumes that a business will only sustain a high ROIC for a maximum of five years before it slowly falls to my discount rate

I assume this because of competition and ‘reversion to the mean’.

My valuation model assumes that a business with both a sustainable competitive advantage and a high ROIC, will only sustain its high ROIC for a maximum of five years before it slowly falls to my discount rate.[7] I have assumed this because I could easily overestimate the strength and sustainability of a business’s competitive advantage. If I am wrong, and I do not make this assumption, I could dramatically overvalue the business.

I will discuss the more detailed issue of why my quantitative valuation model assumes a business will only have profitable asset growth for five years in my next post.

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[1] A business’s ROIC is its Return on Invested Capital. It tells you how profitable a business has been. It does this by telling you the amount of capital the business needed to produce its profit.

[2] These are determined on both quantitative and qualitative criteria.

[3] My valuation model is very similar to the one used by Deutsche Bank’s CROCI model. The good news is that Deutsche Bank’s research has shown that their CROCI based valuations closely approximate the market’s valuation of a business, over the medium term. This means that my valuation of a business is a good proxy for the price that the market will ultimately pay for a business. See P203, ‘Cash Return On Capital Invested: Ten Years Of Investment Analysis With The CROCI Economic Profit Model’, Pascal Costantini, 2006.

[4] Except for the last year.

[5] For a detailed discussion of the concept of ‘Margin of Safety’ see: http://thefallibleinvestor.com/2010/02/17/my-investment-process-the-basics-part-2/

[6] Chapter 23 P 30, ‘Investment Valuation’, Aswath Damodaran.

[7] Many business’s with a high ROIC will have this return driven down to the average ROIC for a business in 5 years or less, see ‘Great 10-year Record = Great Future, Right’, Tweedy, Browne Company.

The linkage between ROIC, Market Value, Replacement Value, and a Sustainable Competitive Advantage

I define the replacement value of a business as what the business’s assets would be worth if it’s ROIC was equal to its cost of capital.

The market value of a business with a high ROIC and no sustainable competitive advantage should (assuming the market eventually prices a business at its intrinsic value[1]) fall to its replacement value. This should happen because if an incumbent business has a high ROIC, and no sustainable competitive advantage, other businesses will enter this industry, or expand within the industry, to seek these higher returns. These competitors will drive down the incumbent business’s profits until its ROIC declines to the average return of a commodity business. Once this occurs, the incumbent business can only be worth the cost of replacing the business’s assets.

Professor Greenwald has another way of describing this process. He points out that if an incumbent business, with no competitive advantage, has a replacement value of $100 million and its market value is $200 million[2], competitors will drive its market value down to $100 million. Competitors will calculate that by spending $100 million to reproduce the assets of that business they can also create an enterprise with a market value higher than $100 million. These competitors will think, correctly, there is no reason for why they should have a different economic experience from the incumbent because there is nothing it can do that they cannot. Remember the incumbent business has no sustainable competitive advantage. Competitors, by reproducing the assets of the incumbent business, will increase the supply of products or services in the industry. There will now be more competition for the same business. Either prices will fall or, for differentiated products, each producer will sell fewer units. In both cases, the incumbent’s profits will decline and the market value of its business will decline with them. This process, capacity continuing to expand, and the profits and the market value of the incumbent’s business falling, will continue until the incumbent’s market value falls to the replacement value of its assets ($100 million). Its competitors will suffer the same fate.

Greenwald points out that while this process does not happen smoothly or automatically it will eventually turn out this way. It happens because the incentives for businesspeople to take advantage of the market’s excessive valuation of the incumbent’s business are too powerful.[3]

The market value of a business with a sustainable competitive advantage can, by contrast, stay much higher than its replacement value simply because it can sustain a high ROIC.

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[1] The intrinsic value of a business is what I think the business is worth to a rational businessperson.

[2] Assuming the business has a high market value because it has a high ROIC.

[3] P38, ‘Value Investing: From Graham To Buffett And Beyond’, Bruce Greenwald et al, 2001.

What factors are not a sustainable competitive advantage

As previously discussed, I want a business, which I have predicted will have a high ROIC, to have a sustainable competitive advantage. However, I think a sustainable competitive advantage is limited to a small number of competitive advantages.[1] I think it is very useful, when deciding whether a business has a sustainable competitive advantage, to understand what is not a sustainable competitive advantage.

Greenwald and Kahn in their seminal book, ‘Competition Demystified’, have outlined the following factors, which they think, and I agree, are not a sustainable competitive advantage. They think these factors will only temporarily allow a business to have a high ROIC.[2]

Having a cost advantage based on superior technology, which cannot be patented

A business with superior technology, which cannot be patented, does not have a sustainable competitive advantage. This is because the technology will usually be either rudimentary, which its competitors can easily reproduce,[3] or technology developed by specialist third parties (like Accenture or IBM), which is likely to be sold to its competitors.[4]

The inability to make this superior technology a sustainable competitive advantage is a major problem for businesses in the services sector.

Having a cost advantage based on lower labour costs

A business with lower labour costs (for example it uses cheap labour in China or India) does not have a sustainable competitive advantage because its competitors can, and usually will, source the same cheap labour.

Having a cost advantage based on lower capital costs

This usually means getting cheap capital from a Government. Having access to cheap capital from a Government is not a competitive advantage. It is a subsidy.

Having product differentiation

Product differentiation is not a sustainable competitive advantage because if a business has a high ROIC, due to product differentiation, competitors can, and will, enter that market and sell their own differentiated product. This will cause the business’s sales volume to fall and, because its fixed costs remain the same, the lower volume will mean its profit margin also falls. Its profit margin and sales volume will continue to fall until its high ROIC disappears.[5]

Having a strong brand

Having a strong brand is not a sustainable competitive advantage.[6] Brands are assets just like property, plant, and equipment. A business must spend cash to build or buy the brand, and cash each year to offset the depreciation of the brand. A competitor can easily spend its own cash to create a brand. If a competitor has an equal opportunity to create its own brand, the business with the brand has no competitive advantage. Brand investments are, thus, no different from many other investments: they return the cost of capital and do not provide any excess return to shareholders.[7]

Being the first mover in an industry

Being the first mover in an industry is not a sustainable competitive advantage. Being the first mover may give that business learning curve cost advantages. This means that as the business moves down the learning curve it becomes more efficient and can produce the product with lower variable costs than businesses just learning how to produce the product. However, as the industry matures, and its competitors learn to be efficient, this disadvantage usually disappears. The business may even find itself at a competitive disadvantage because it now suffers from vintage effects. That is it has less efficient plant and equipment than later entrants into the industry.

Being the latest entrant in an industry

Being the latest business to enter an industry and, therefore, usually having the latest technology or the ‘hottest’ product design will not give the business a sustainable competitive advantage because these advantages are, by their nature, only temporary. Moreover, once the business enters the industry it becomes an incumbent. The same advantages it enjoyed, when it first entered the industry, will now apply to any new entrant.

Having lower variable costs from new capital expenditure

A business (in a commodity industry) which reduces its variable costs by undertaking new capital expenditure has not created a sustainable competitive advantage because its competitors can easily do the same thing.  

Good operational efficiency

Good operational efficiency is usually only a temporary competitive advantage (there are exceptions). It is usually only temporary because this operational efficiency can naturally decline, or a competitor can reproduce it.

 A business’s good operational efficiency can naturally decline because:

1. Management dies, or retires, or is poached by other businesses; or,
2. Management becomes sidetracked by some major internal or external issue (for example they make a takeover offer, or are involved in a major lawsuit); or,
3. Management simply loses its drive.

 A competitor can reproduce another business’s good operational efficiency by copying the successful business’s operational practices, or by recruiting better management.

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[1] Economies of Scale combined with Customer Captivity; a Network Effect, a Government Licence; Patent Protection;  and, Customer Captivity.   

[2] See Chapter 2, ‘Competitive Advantages 1’ in ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[3] Rudimentary technology (simple products and simple processes) is hard to patent because this technology will often look like common sense. Thus, a business with this technology will often have its competitors duplicate the technology by hiring away its the employees.

[4] Technology developed by specialist third parties (such as Accenture and IBM) is likely to be sold to any business that wants to buy it. These third parties make their living by disseminating their innovations as widely as possible. See P 29, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[5] Businesses which only rely on product differentiation must also be very efficient. Not only must they be very efficient with their production costs (which obviously applies to any business without a competitive advantage) but they must also be very efficient in those aspects of the business which allows it to differentiate its product (advertising, product development, service, distribution channels and a host of other functions). Inefficient businesses selling differentiated products will struggle to remain viable. See P23, ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[6] Greenwald and Kahn believe that while a brand is not a competitive advantage, it can lower the cost of entry into another market because the business may not have to build a brand from scratch. See ‘Competition Demystified’, Bruce Greenwald and Judd Kahn, 2005.

[7] See P39, ‘Measuring the Moat, Assessing the Magnitude and Sustainability of Value Creation’, Michael Mauboussin, 16 December 2002.