Tag Archives: management

The Two Sides Of Total Investment Return

By Quan Hoang I spend about 10-15% of my time crunching data. That sounds tedious but I actually enjoy this task. It forces me to pay attention to details, checking any irregularity I see in the numbers and trying to tell a story out of the numbers. My recent work on Commerce Bancshares (NASDAQ: CBSH ) led me to ponder the relationship between ROIC and long-term return. Over the last 25 years, Commerce Bancshares averaged about a 13-14% after-tax ROE, and grew deposits by about 5.6% annually. Over the period, share count declined by about 1.9% annually, and dividend yield was about 2-2.5%. Assuming no change in multiple, a shareholder who bought and held Commerce throughout the period would receive a total return of about 9.5-10%, which is lower than its ROE. Why is that? Chuck Akre once talked about this topic: ” Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at (what) the average return on all classes of assets are and then I (discovered) that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that? Audience A: Reinvestment of earnings. Audience B: GDP plus inflation. Audience C: Growing population. Audience D: GDP plus inflation plus dividend yield. Audience E: Wealth creation. Audience F: Continuity of business. Akre: …what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that (the) return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.” The restriction in Akre’s explanation is ” absent any distributions. ” In general, there are two sides of total return: the management side, and the investor side. Management can affect total return through ROIC, reinvestment, and acquisitions. Investors can affect total return through the price they pay and the return they can achieve on cash distributions. The Problem of Free Cash Flow Reinvestment into the business usually has the highest return (this post discusses only high quality businesses that have high ROIC). Problems arise when there’s free cash flow. Management must choose either to return cash to shareholders or to invest the cash themselves. Both options tend to have lower return than ROIC. Cash distributions don’t seem to give investors a great return. Stocks often trade above 10x earnings so distributions give lower than 10% yield. In my example, Commerce Bancshares wasn’t able to reinvest all of its earnings. It retained about 40% of earnings to support 5.6% growth and returned 60% of earnings in the form of dividends and share buyback. The stock usually trades at about a 15x P/E, which is equivalent to a 6.67% yield. The retained earnings had good return, but the cash distributions had low underlying yield. The average return was just about 10%. Unfortunately, many times returning cash to shareholders is the best choice. Hoarding cash without a true plan on using it destroys value. Expanding into an unrelated business for the sake of fully reinvesting doesn’t make sense. Similarly, acquisitions often don’t create a good return. The problem with acquisitions is that they’re usually made at a premium so the underlying yield is likely lower than the yield that would result from share buybacks. The lower underlying yield can be offset by either sales growth or cost synergies. Studies show that assumptions about cost synergies are quite reliable while sales growth usually fails to justify the acquisition premium. To illustrate this point,let’s take a look at 3 of the biggest marketing services providers: WPP, Omnicom, and Publicis. Omnicom is a cautious acquirer. It spends less and makes smaller acquisitions than peers. Its average acquisition size is about $25 million. Over the last 10 years, Omnicom spent only 16% of its cash flow in acquisitions while WPP and Publicis spent about 44% of their cash flow in acquisitions. Publicis is a stupid acquirer. It makes big acquisitions and usually pays 14-17x EBITDA. WPP is a smart acquirer. Like Omnicom, it prefers small acquisitions. When it did make big acquisitions, it paid a low P/S and took advantage of cost synergies. For example, it paid $1.75 billion or a 1.2x P/S ratio for Grey Global in 2005. That was a fair price as WPP was able to integrate Grey and achieve WPP’s normal EBIT margin of about 14%. To compare value creation of these companies over the last 15 years, I looked at return on retained earnings, a measure of how much intrinsic value per share growth created by each percent of retained earnings. As these advertising companies have stable margins, sales per share is a good measure of intrinsic value. Retained earnings in this case is cash used for acquisitions and share buyback, but not for dividends. As expected, Publicis created the least value: It’s interesting that the smart acquirer WPP didn’t create more value than Omnicom. That’s understandable because acquisitions aren’t always available at good prices. So, it’s very difficult for management to generate a great return on free cash flow. Therefore, the value of a high-ROIC business is limited by the capacity to reinvest organically. Free cash flow tends to drag down total return to low double-digit or single-digit return. The Investor Side of Total Return It’s very difficult to make a high-teen return by simply relying on management. The capacity to reinvest will dissipate over time and free cash flow will drag total return down to single digit. However, there are two ways investors can improve total return. First, investors can shrewdly invest cash distributions. When looking at capital allocation, I usually calculate the weighted average return. For example, if a company invests 1/3 of earnings in organic growth with 20% ROIC and 1/3 in acquisitions with 7% return on investment, and returns 1/3 to shareholders, how much is the total return? It depends on how well shareholders reinvest the money. If we shareholders can reinvest our dividends for a 15% return, the weighted average return is 20% * 1/3 + 7% * 1/3 + 15% * 1/3 = 14%. This number approximates the rate at which we and the management “together” can grow earnings (actually if payout rate is high, combined earnings growth will over time converge to our investment return on cash distributions.) Second, an investor can buy stocks at a low multiple. The benefit of buying at a low multiple is two-fold. It can help improve yield of earnings on the initial purchase price. It also creates chance of capital gains from selling at a higher multiple in the future. Warren Buffett managed to make 20% annual return for decades because he was able to buy great businesses at great prices and then profitably reinvest cash flow of these businesses. Small investors can mimic Buffett’s strategy as long as the stock they buy distributes all excess cash. They can reinvest dividends for a great return. In the case of share buybacks, they can take and reinvest the cash distribution by selling their shares proportionately to their ownership. That’s how Artal Group monetizes Weight Watchers (NYSE: WTW ). Share Repurchase at Whatever Price This discussion leads us to the topic of share repurchases. I think many investors overestimate the importance of share buyback timing. It’s nice if management buys back shares at 10x P/E instead of 20x P/E. But what if share prices are high for several years? Would investors want management to wait for years – effectively hoarding cash – to buy back stock at a low price? Good share buyback timing can help build a good record of EPS growth but EPS growth doesn’t tell everything about value creation. It’s just one side of total return. What investors do with cash distributions is as important. So, I think management should focus more on running and making wise investments in the business and care less about how to return excess cash. I would prefer them to repurchase shares at whatever price. By doing so, management effectively shares with investors some of the responsibilities to maximize total return. Share buyback gives investors more options. Investors must automatically pay tax on dividends but they can delay paying tax by not selling any shares at all. If they want to get some dividends, they can sell some shares and pay tax only on the capital gain from selling these shares instead of on the whole amount of dividends. Or they can simply sell all their shares and put all the proceeds into better investments if they think the stock is expensive. Conclusion I do not believe in buying a good business at a fair price. If the management does the right things, holding a good business at a fair price can give us 10% long-term return. But great investment returns require a good job of capital allocation on the investor’s part: buying at good prices and reinvesting cash distributions wisely.

The 60/40 Portfolio Is Dead; Here Is Its Replacement

The following is a proposal I put together for a new client: Click to enlarge As you can see, we do things a little differently around here. Traditional stocks make up less than 40% of the portfolio, with the rest sitting in non-correlated assets outside of the stock market. We invest in everything from options-writing funds to medical accounts receivables and everything in between. The result is that we get most of the safety you would expect from a 60/40 stock/bond portfolio but without the loss of expected return. Our goal is to give you stock-like returns with the risk profile of a blended portfolio. Why Invest in Alternatives? You probably have a good grasp of why diversification is important. Throwing out the financial jargon, it essentially boils down to not putting all of your eggs in one basket. But it also gets a lot more sophisticated than that. Many investors feel that they have adequate diversification because their assets are spread across several stocks or mutual funds. And to an extent, they are right. Owning multiple stocks reduces the risk of downside from any single position. But there is also a major problem with this: Correlation. If Apple (NASDAQ: AAPL ) and Microsoft (NASDAQ: MSFT ) stock prices move together in lockstep, you’re not really getting much in the way of diversification by owning both. And in a real bear market, virtually all stocks drop together. True diversification means owning assets that do not move together. Investment A can go up, down or sideways, and it should have little or no impact on Investment B. This is where the beauty of an alternative portfolio comes into play. We can achieve “stock like” returns in the range of 7%-10% per year without the volatility that comes with stocks. Why the 60/40 Portfolio is Dead Alternative assets weren’t particularly popular in 1980. There is a reason for that. Back then, traditional bonds offered a respectable return. A blended 60/40 portfolio of stocks and bonds offered a solid expected return. Flash forward to present day. At current bond yields, investors will be lucky to get a 2% return in bonds. And compounding the situation, stocks are also expensive by historical measures and priced to deliver sub-par returns. Click to enlarge Accepting a traditional asset allocation is accepting disappointing returns in the years ahead. If you want better performance, we need to look elsewhere. Introducing the New 60/40 Portfolio Sizemore Capital Management custom builds portfolios based on the client’s preferences and eligibility. The following is a sample allocation: Click to enlarge With the market looking overpriced and expected to deliver below-average returns, we need better alternatives. And thankfully, we have them. The following represent Sizemore Capital Management’s expected returns of the assorted asset classes in our model: Click to enlarge We should be clear that these are only estimates. Realized returns will vary and may be significantly higher or lower. But based on current valuations and historical performance, we consider these estimates reasonable. We’re Not Alone While ordinary investors have traditionally invested in stocks, bonds and CDs, wealthy investors and institutions have always had a broader allocation. Consider the case of the Harvard University endowment fund. As of 2015, the Harvard endowment fund had only 3% of its funds in stocks. It has another 18% in private equity and 12% in real estate. The rest is spread across everything from timberland to absolute returns hedge funds. Let’s stop and ask an obvious question: If it’s good for trustees of Harvard, would it not also be good for you? Source: Harvard Endowment Allocation Not all of the alternative investments discussed will be appropriate for all investors. But we believe strongly that every investor can benefit from a proper allocation to alternative investments. Disclaimer: This article is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results. Original Post

Value Investor Interview: Huzaifa Husain

Note: This interview was originally published in the December 2015 issue of our premium newsletter – Value Investing Almanack (VIA) . Mr. Huzaifa Husain is the Head of Indian Equities at PineBridge Investments based in Mumbai. Since he joined the asset management company in 2004, Mr. Husain has been a key member of the team advising the PineBridge India Equity Fund (a Dublin domiciled India offshore fund). Prior to this, he was an Equity Analyst at Principal Mutual Fund and SBI Mutual Fund. Mr. Husain received a Post Graduate Diploma in Management (PGDM) from Indian Institute of Management (IIM) Bangalore and a B.Tech from the Institute of Technology (Banaras Hindu University). In this interview for the Value Investing Almanack , Mr. Husain shared how he found his calling in value investing, and reveals key insights about his investment strategy and the underlying thought process. Safal Niveshak (SN): Could you tell us a little about your background, how you got interested in investing so much to choose it as a career? Huzaifa Husain (HH): In 1997, when I completed my management education at IIM Bangalore, SBI Mutual Fund offered me a role as an equities analyst. Thus, began my career in equity investing. My management education did not prepare me for equity investing. We were taught how to mathematically manipulate numbers, especially daily stock prices, most of which had no conceptual backing. I remember in my first year on the job, I tried every possible trick – charts, CAPM, etc. – in the textbook to figure out how to predict which stock will do well. I failed miserably. One day a friend of mine told me to read the letters of Warren Buffett. That is possibly the best advice I ever got in my life. After that day, my investment philosophy has relied entirely on understanding the company, the people managing it and its prospects. Stock prices do not have any information other than what one can buy or sell the stock at. SN: Do you believe in the concept of circle of competence? If yes, how have you built it over the years? HH: Yes, of course. The success rate of doing an activity which is within the circle is much higher than that which is outside the circle. The circle is not a rigid one, though, and keeps expanding, albeit rather slowly. My first task in the late nineties was to research equity stocks in the pharmaceutical sector. So, I bought a drug index book and catalogued nearly all major diseases and the drugs used to cure them. These drugs were then mapped onto the companies which produced them to understand company fundamentals. Then, when Indian pharmaceutical companies started targeting generic markets in US in early 2000, I studied the Hatch-Waxman Act, various generic court case judgments, etc., to understand the potential opportunity and risks. Thus, I gained expertise into the pharmaceutical sector. Slowly I expanded it to another industry – telecoms – and studied the various technologies such as CDMA (Code-Division Multiple Access), GSM (Global System for Mobile Communications), etc. I also then brushed up my accounting knowledge as it plays an important part in understanding financials. In those days, there was a heavy debate on ESOP (employee stock ownership plan) accounting in the US and so I read and understood the corresponding accounting standards (FAS 123). Slowly and steadily the circumference of the circle expanded to include more industries, different accounting policies and different ways to evaluate management. The only way the circumference of the circle expands is by constantly accumulating experiences – either directly or by learning from others. SN: What are some of the characteristics you look for in high-quality businesses? HH: A high-quality business should require very little capital but generate a lot of capital and it should be able to maintain these favorable economics for a long time. The reasons for a business to achieve these economics are numerous. Most important is the management’s focus on improving its competitive advantage compared to its peers. A pertinent question here would be why are such practices not copied by others? One big reason is the culture of an organization. A culture of success is not as common as one would assume. There may still be cases where the best efforts of the management to succeed may still come to nothing. This can happen when competitors are irrational. This can also happen when the business itself is very complex. It is easy to estimate the costs and risks of making and selling shoes. It is probably not so easy to estimate the costs and risks of constructing a dam. SN: How do you assess a management’s quality, especially given that disclosure levels are not high and standardized in India? HH: Management quality is assessed on two dimensions – ability and integrity. Ability encompasses the way the management deploys the cash it generates. It could invest back into the business to strengthen the competitive positioning of the business, it could buy another company in the same business, it could invest in a new business or it could buy a company in a different business. One should be able to assess the ability of the management by evaluating the management’s actions of deploying cash. Integrity encompasses the way it treats shareholders. A management with high integrity will return excess cash back to shareholders. It generally would not overstate its financial numbers; most probably, it will understate them by reporting its numbers conservatively. In my experience, there is a high correlation between usage of conservative accounting policies and high integrity. I think disclosure levels in India are generally quite high and I have not faced any problem in judging the past history of management decisions. A simple discipline can be observed here – if the management is not willing to be transparent and honest, move on. SN: Well, let’s talk about valuations. How do you think about them, and how do you differentiate between ‘paying up’ for quality versus ‘overpaying’? HH: Good opportunities in investing are rare. A good opportunity is like searching for a needle in a haystack. One can, of course, wait for a day when there is a strong wind which will blow away the hay and make it very easy to find the needle. But then one has to be very patient as such days are few and far between. On the other hand, one typically will find opportunities to buy either a lousy business at cheap valuations or a good business at fair valuations. I would go for the latter. How much should one pay for a good business? Of course, I do not believe in overpaying because I can always put my money in a fixed deposit without risk. So, one should carefully evaluate various scenarios in which the investment can make money. I can try and put in some numbers for the future, find out cash flows, discount them with the next best alternative rate you can get and finally add a buffer to the price. It is quite educational if one does this simple exercise which some call reverse discounted cash flow (DCF). One important factor in doing this calculation is to make the right assumption of how much capital is required in the business. Generally, a good business which can generate high returns will not require a large amount of capital. Hence, such a business will have to pay the cash out, which means in applying a DCF model, the benefit of compounding will be absent and that would make a huge difference to the value. SN: How do you determine when to exit from a position? Are there some specific rules for selling you have? HH: One would exit for basically two reasons. First, if the original hypothesis itself turns out to be incorrect. One example is when we bought a company which was a market leader in the domestic industry and was generating a lot of cash flows. The industry was growing very fast and so was the company. It was available at reasonable valuations. Then one day, the management decided to take the cash on the books plus take on debt and buy a company internationally which had poor economics. The management thought it could take such a company and make it competitive. Unfortunately, it paid a price which presupposed that it would succeed in doing so. Hence, there was no upside left even if they succeeded. And the existing domestic business cash flows were now being used for this purpose instead of investing in the domestic business which needed enormous capital to grow. Since, this was a ‘game changing’ event, we decided to sell it. Second, something better can be done with the sale proceeds. This is tricky. It requires two decisions – selling an expensive name and buying a cheap name. We do it rarely as we do not think there are so many good companies out there that one can keep churning without lowering the quality of the portfolio. If we do it, we ensure that the valuation differential between the stock being sold and the stock being bought is quite significant. SN: Do you believe in investment checklists? If yes, what are the most important points in your checklist? HH: I do have a checklist. Broadly, there are three main items on my checklist – quality of business, quality of management, and price of the stock. An important aspect of this checklist is that it is applied sequentially. The reason is because a good manager may struggle to generate good profits out of a bad business. Paying a low price for a lousy business may also not turn out great. Hence, only when a business is deemed to have strong economics and quality management, is the price evaluated for attractiveness. SN: Apart from the qualitative factors, what are few of the numbers/ratios you look for while assessing the business quality? HH: A reasonable idea of how much capital is required to run the business is critical. The nature of capital employed – fixed versus working – makes a huge difference to the way the business is run. The returns generated on the capital employed irrespective of the leverage employed will demonstrate the quality of the business. Aggregating 10-20 years of financials gives one a good idea of how the money has been utilized. Cash flow efficiency (cash flow divided by profit) demonstrates the conservative nature of management in reporting their numbers. SN: When you look back at your investment mistakes, were there any common elements of themes? HH: Among the three things I look for in an investment – business, management and price – most mistakes happen in evaluating management. This happens especially if the management does not have a public history which can be evaluated. The typical management behavior which hurts investors is their overconfidence. Business managers rarely will admit that they cannot deploy the cash which the business is generating. They will find some or other use for cash and eventually deploy it in a poor business. Hence, it is best to use a higher threshold for management quality in case the business has historically retained most of the cash it generates. Also, public history of management is a very good guide. Don’t expect the management’s behavior will change because you bought the stock. It almost never will. SN: What tricks do you use to save yourself from behavioural biases? What are the most common behavioural mistakes you make? HH: Most mistakes in investment stem from lack of knowledge. When one is walking in the dark, other senses become heightened. Similarly, when one is operating in the field of investments and one does not know what one is doing, the basic human survival instincts (being with the crowd – herd mentality, avoiding danger – loss aversion, etc.) kick in. These instincts sometimes may mislead one in stock markets which is a massive melting pot of human emotions. Many advocate changing behavioural responses. I think if you try to do that you are up against thousands of years of evolutionary survival strategies. Instead, focusing energies on accumulating knowledge is a more reasonable task. SN: That’s a wonderful insight, so thanks! Any specific behavioural biases that have hurt you the most in your investment career? HH: Nothing specific. Over time, a better understanding of how incentives drive human behavior has helped me decipher the happenings around me. SN: How can an investor improve the quality of his/her decision making? HH: If the investor’s knowledge of the company is among the top 0.001% of people who have some kind of understanding of the company he/she is investing, the chances are that the decisions would be good. Hence, read everything you can lay your hands on relating to the company and its business. We actually do that when we buy a consumer durable or an automobile. I remember even though my father was no engineer, he used to ask people on two wheelers at a traffic signal what the mileage was before buying one. It is absolutely astonishing how much information one can glean if one puts in a slight amount of effort. The next aspect is that the investor should realize markets are not always rational. I feel this is easier said than believed. Investors while buying believe that the price is mispriced but once they have bought they forget that it can remain mispriced for a long time. Many would want the mispricing to be corrected as soon as they complete their purchase. Many would also pat themselves on the back if it does happen. But short-term movements of a market are near random. Hence, be prepared for the worst. For example, the investor should be prepared for a huge drop in the stock price post his purchase. It may or may not happen but if it does, he should be mentally prepared to act rationally. SN: How do you avoid the noise and the overload of information that is available these days? HH: If you carefully analyze the information overload, most of it is very short-term focused. Hence, if the time horizon of the investment is long, one needs to employ a filter which can eliminate short-term noise. After all, a company publishes only one annual report and declares four quarterly results every year. That is not much. SN: How do you think about risk? How do you employ that in your investing? HH: As an equity holder, one would lose all one’s money if the company goes bankrupt. Hence, avoid companies which have large debt loads. Avoid investing in a poor business. It is bad to lose money investing in a poor company. But it is worse to make money investing in them. The reason is, once you make money playing with fire, the chances are you will be attracted to it more often, and sooner rather than later, it will burn. Hence, avoid investing in such companies irrespective of the valuations. Remember no matter how well you think you can guess the future, it will not be as you predict. Hence, be prepared. SN: What’s your two-minute advice to someone wanting to get into stock market investing? What are the pitfalls he/she must be aware of? HH: Making money by equity investing is very difficult. Treat the stock market as a bazaar. Go with a list of things to buy. Make the list at home just as one would make a grocery list based on your nutritional needs. Don’t make decisions by watching the changes in the prices of stocks just as one would not decide to buy lemons because their prices are going up. Spend a lot of time deciding what to put on that list. One way to do it is to inculcate a phenomenal amount of curiosity in researching companies. SN: Which unconventional books/resources do you recommend to a budding investor for learning value investing and multidisciplinary thinking? HH: It is dangerous to read books especially on investing without reading about business history. It may cloud one’s view. Hence, I would recommend all budding investors read annual reports of companies for as far back as they can find. Read them across various companies over various time frames. They should be able to understand how companies have behaved over business cycles, how their valuations have changed, why did they succeed, why did they fail, etc. Once a vast amount of business history is read and understood, all one needs to read are the letters of Buffett and Poor Charlie’s Almanack to build a framework. Beyond that, remember what our vedas say on multidisciplinary thinking – आ नो भद्राः क्रतवो यन्तु विश्वतः (Let noble thoughts come to us from all sides). SN: What a wonderful thought that was! Any non-investment book suggestions you have that can help someone in his overall thinking process? HH: I find books written by Malcolm Gladwell quite interesting. Living Within Limits by Garrett Hardin has many interesting concepts on growth. The Corporation that Changed the World : How the East India Company Shaped the Modern Multinational by Nick Robins literally chronicles the birth of capitalism. Reading judgments from the Supreme Court of India helps one understand how our Constitution works. An example would be the Kesavananda Bharati case which I believe should be a must read for every citizen of India. Reading various government ministries’ annual reports, regulatory reports (RBI as an example), global central banker speeches, global anti-trust filings – all these help one understand how different aspects interact. Finally, a study of human history is quite important. I would recommend Glimpses of World History by Jawaharlal Nehru. SN: Which investor/investment thinker(s) so you hold in high esteem? HH: Warren Buffett. Many have generated good returns in investing, but he has done it over larger and larger sums of money. He has never paid a dividend since 1967. That is what makes him a genius. SN: Hypothetical question: Let’s say that you knew you were going to lose all your memory the next morning. Briefly, what would you write in a letter to yourself, so that you could begin relearning everything starting the next day? HH: Personal life: Everything Professional life: Nothing SN: What other things do you do apart from investing? HH: Spend time with my family. SN: Thank you Huzaifa for sharing your insights with Safal Niveshak readers! HH: The pleasure was mine, Vishal.