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Indicators Of A Good Business

By Quan Hoang I recently had a constructive debate with my friend about the return on invested capital (ROIC). I said that we don’t calculate ROIC for fun; we calculate it to know what return retained earnings can make. High return on retained earnings means good business. He shot back that See’s Candies has little volume growth and it’s still a good business. His point led me to the broader topic of what a good business is. In a nutshell, a good business can create value. In other words, it can generate more than 10 cents for each $ of earnings it retains – assuming a 10% hurdle rate. But there are special cases in which a company can make more profits by retaining zero or negative earnings. Exceptional Businesses Have Negative Invested Capital or Pricing Power One special case is negative invested capital. Omnicom (NYSE: OMC ) is a good example. It pays for advertising spaces slower than it bills clients. Working capital is about -20% of sales. The negative sign means that Omnicom gets 20 cents pre-funding from clients for each additional $ of sales. If growth is stable, a business with negative invested capital deserves a higher than average multiple of EBIT. Another special case is exceptional pricing power. See’s Candies has exceptional pricing power. From 1972 to 1998, See’s Candies raised price per pound by about 6.9% annually. Inflation over this period was about 5.4%. So, pricing power generates about 1.5% real growth each year. That leads to margin expansion. This magnitude of pricing power is rare because the product becomes more expensive relative to a customer’s purchasing power over time. That’s not sustainable in most cases. But See’s Candies has been able to do so for many years. Another good example of pricing power is luxury Swiss watches. Swiss watchmakers managed to reposition mechanical watches from a utility product to an emotional product. But after that repositioning, it’s difficult to raise price faster than inflation. To do so, a brand must move upmarket and become more exclusive. Omega, on the path to regain its past prestige, has raised price from Longines’s price range closer to Rolex’s price range. Without exceptional pricing power, value is normally created through volume growth. Volume growth normally requires additional investment in production/service capacity and working capital. Value is created only if return on investment is high. How to Calculate ROIC A practice that many analysts use is to say that a business is good if it consistently make a high ROIC. Joel Greenblatt’s formula for ROIC is EBIT/NTA. NTA is N et T angible A ssets, which is the sum of net fixed asset and net working capital. There are several versions of ROIC. But all versions use net fixed assets in calculating the denominator. And that creates some controversies. Joel Greenblatt explained why he uses net fixed asset: Why are we taking Net Fixed Assets (NFA)? It is not always right. Say we buy a hotel for $10 and it is going to last 10 years and we write it down over 5 years and now it is at $5. But if this goes down to zero, I might have to invest another $10. This would give me ($5) a skewed return (being too high) because of not considering replacement and reinvestment into the fixed assets. Say you have 100 hotels and they are all on different cycles, then on average, you will be correct in using NFA. 10% of your hotels will be refurbished each year over a 10 year normal cycle. That is my quick and dirty for an ongoing business.” And, Denominator is NWC + NFA – why using net and not gross fixed assets? On average that is the right thing to do. Because in general what happens to your fixed assets, you buy something and you depreciate the assets so the value of your asset goes down, but to maintain your asset, there has to be on-going capex. Depreciation and Capex cancel out (assume Deprec = Maint. Capex). If capex is more than depreciation, then FA will increase accordingly and you will be updated. If you are in expansion mode, you build new stores and the FA balloon before you earn on those assets, so your ROC will decline – so you must normalize or adjust for that. Fixed Assets minus depreciation plus Maint. Capex is why I use a Net number.” There’s some logic in his argument. But he didn’t examine how accurate EBIT/NTA is as a measure of ROIC for an ongoing business. If we own the 100 hotels in his example, we get cash flow roughly equal to EBITDA each year (assuming no tax). 10 hotels are totally depreciated each year. We can choose not to make any refurbishment at all and let EBITDA decline by 10% next year. We can refurbish 10 hotels and maintain EBITDA. Or we can refurbish and build 10 more hotels to grow EBITDA by 10%. In either case, ROIC of each new build or refurbishment will be based on the $10 gross investment in each of these projects because that’s what we have to spend upfront. Let’s take another example. The Fresh Market (NASDAQ: TFM ) spends about $4 million in a new store, which generates about $10 million sales and $1 million EBITDA. TFM remodels its stores every 10 years. The remodel cost is lower than $4 million in real term, but let’s assume the remodel cost to be $4 million. So, annual depreciation is $0.4 million and EBIT is $0.6 million. A very optimistic assumption is that the store requires no remodel. So, the $4 million upfront investment results in $1 million annual cash flow forever. That translates into 25% annual return (25% = ¼). Realistically, there’s remodel cost every 10 years. So, 25% is the ceiling of ROIC. Generally, ROIC is always lower than EBITDA/Gross NTA. (Gross NTA = Gross fixed assets + Net working capital.) A very conservative assumption is that we set aside “DA” each year. In the TFM example, we set aside $0.4 million each year so that after 10 years we have $4 million to spend on remodeling. That way, we’ll have $0.6 million free earnings each year (the “free” part is borrowed from the term free cash flow). So, the $4 million upfront investment results in 15% annual return (15% = 0.6/4). Realistically, we don’t set aside $0.4 million each year but use that money to fund new store openings. So, 15% is the floor of ROIC. Generally, ROIC is always higher than EBIT/Gross NTA. If we open Excel and calculate IRR for various scenarios, we can see that IRR tends to be in the upper end of the range between EBIT/Gross NTA and EBITDA/Gross NTA. The midpoint of the range is quite a good estimate of ROIC. Using EBIT/NTA is dangerous when fixed assets are a big part of NTA. I made that mistake when I first looked at Town Sports International (NASDAQ: CLUB ). Median EBIT/NTA was 20%, which looks good. But median EBIT/Gross NTA was 9% and median EBITDA/Gross NTA was 19%. So, pre-tax ROIC is around 14% instead of 20%. That’s a mediocre return. We must be flexible when estimating return. We have to look at composition of NTA. It’s okay to use EBIT/NTA when PPE is a tiny part of NTA because the error is small. If PPE is a big part of NTA, using the midpoint of EBIT/Gross NTA and EBITDA/Gross NTA is preferable. If receivables are a big component, we should make adjustments. For example, America’s Car-Mart (NASDAQ: CRMT ) has $324 million receivables, $34 million inventories and $34 million PPE. However, Car-Mart doesn’t really lend money. Car-Mart lends cars. So we should adjust receivables to (1-gross margin) * receivables to estimate the total value of the cars it lend and use that number to calculate NTA. A better method to estimate ROIC is to look at the economics of each loan. Return on Incremental Invested Capital (ROIIC) What we really want to know is ROIIC rather than ROIC. We can calculate ROIIC by taking incremental EBIT or EBITDA over incremental invested capital over a 1- to 3-year period. That’s not a good approach. Sometimes a company has excess capacity, so growth doesn’t require fixed investment for a while. Or sometimes a company has excess working capital and it can take capital out. But these examples are short-term adjustments. In the long run, volume growth requires investment in new production/service capacity and in working capital. So, ROIC is a good starting point to estimate long-term ROIIC. Reinvestment in the same business tends to achieve returns similar to past ROIC. That’s why many businesses have ROIC within a certain range. However, we need to make some adjustments to ROIC to have a fair expectation of ROIIC. Margin expansion can make ROIIC higher than ROIC. Margin expansion is usually a result of volume growth that drives down unit cost. For example, when gross margin is high and SG&A is relatively fixed, volume growth will significantly increase EBIT margin. Tom Russo usually uses Brown-Forman to illustrate the concept of the capacity to suffer. Brown-Forman is willing to incur expenses today to build infrastructure for international growth tomorrow. And the next 50,000 bottles it sells will have better margin than the last 50,000 bottle. Frost (NYSE: CFR ) is another good example. Frost’s branches grow deposits faster than inflation. So, operating expenses per $ of deposit declines over time. Gross margin in the banking industry is net interest spread. Net interest spread is influenced by interest rates and demand for loans. It’s cyclical but very stable over a long period of time. So, lower operating expenses per $ of deposits improve ROA. Today, Frost makes lower ROA than it did in the past. But without the impact of low interest rates, Frost should be able to make much better ROA. We must be careful when volume growth is outside of current goodwill. In such case, high ROIC in the past doesn’t guarantee a high return on reinvestment. See’s Candies wasn’t able to grow profitably in other states because it failed to replicate the mindshare it had in California. TFM is a current example. TFM is a gourmet food chain. Consumers shop at traditional grocers most of the time. But in some special occasions, they may go to TFM for very good foods. Consumers on average go to TFM only once a month. TFM wants to be the first choice retailer for “special.” So, unlike other grocers, TFM relies on mindshare instead of habit. TFM is very strong in the Southeast. It got into trouble in recent years when it expanded into new markets. It’s very difficult to create mindshare in a totally new state. But perhaps it’s easier to open the next store in that state because the first store helped build some awareness and word of mouth. Conclusions The term “good business” is perhaps too broad. A firm that achieved high growth and great return but have little growth potential in the future isn’t as good as its past success suggests. Firms that barely made profit in the past might now be done with the investment phase and will enjoy great profitability in the future. What investors care about is perhaps more specific: a good business to buy. I propose 3 indicators of a good business to buy. The first is negative invested capital. The second is exceptional pricing power. The third is high ROIC. Past ROIC is a good benchmark for ROIIC. But to have a fair expectation, we need to consider other factors like whether margin of additional units will be higher and whether volume growth is inside current goodwill. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

ETFs For An Ongoing Stimulus Bubble

At this moment in time, nearly every significant central bank (excluding the U.S. Federal Reserve and the Swiss National Bank) is engaging in some form of rate lowering and/or currency devaluation. Clearly, “stimulus fever” is sweeping the globe, suppressing interest rates and bolstering risk assets. The question an investor may wish to ask, however, is whether or not the efforts are doing anything beyond creating temporary “wealth effects” for the investing class. Canada, India, Turkey, Australia, China and Denmark. What do all of these countries have in common? The central bank of each nation has eased monetary policy to stimulate respective economies in 2015. What’s more, none of these actions had been anticipated; rather, the media described rate cuts as “surprising” or diminished reserve requirements as “unexpected.” In the case of Denmark, recent stimulus has been creative as well as startling. For the fourth time in less than three weeks, the Danish central bank lowered its deposit rate to keep its krone in line with the weakened euro. Maintaining the peg of the Danish krone to the severely weakened euro is a means by which Denmark can spark export-driven growth. Depositors are now being charged 0.75% (what is known as a negative deposit rate) to let money sit at a financial institution. In effect, Danish depositors are now paying for the privilege of “hoarding” the krone – a risk some might be willing to take in order to preserve capital from rapid euro depreciation. At this moment in time, nearly every significant central bank (excluding the U.S. Federal Reserve and the Swiss National Bank) is engaging in some form of rate lowering and/or currency devaluation. Perhaps ironically, even the Fed has merely telegraphed a shift towards tightening the monetary reins. In actuality, it has been more than six years of zero percent interest rate policy (ZIRP) with no specific measure taken to raise overnight lending rates. So Switzerland, which removed the franc’s cap against the euro on January 15, is the only warrior in the “currency wars” that believes a strong currency is beneficial as opposed to detrimental. U.S. and Switzerland: The Only Countries In A Tightening State Of Mind Approx YTD % CurrencyShares Swiss Franc Trust ETF (NYSEARCA: FXF ) 7.9% PowerShares DB USD Bull ETF (NYSEARCA: UUP ) 3.3% CurrencyShares Japanese Yen Trust ETF (NYSEARCA: FXY ) 1.9% CurrencyShares British Pound Sterling Trust ETF (NYSEARCA: FXB ) -1.7% CurrencyShares Australian Dollar Trust ETF (NYSEARCA: FXA ) -4.4% CurrencyShares Euro Trust ETF (NYSEARCA: FXE ) -5.2% CurrencyShares Canadian Dollar Trust ETF (NYSEARCA: FXC ) -6.2% The Swiss consumer may benefit from a stronger franc. Yet Swiss businesses have been bemoaning the fate of their exports. Additionally, investors appear more intrigued by the prospect of euro-zone asset price gains than the possibility of Swiss company success as demonstrated by the Vanguard FTSE Europe ETF (NYSEARCA: VGK ): iShares MSCI Switzerland Capped ETF (NYSEARCA: EWL ) price ratio. VGK:EWL since January 15 shows that the early money is betting on asset price reflation occurring in the euro-zone where the European Central Bank (ECB) is engaged in a large-scale electronic money printing program (a.k.a. quantitative easing) to revive the economies of member nations. Clearly, “stimulus fever” is sweeping the globe, suppressing interest rates and bolstering risk assets. The question an investor may wish to ask, however, is whether or not the efforts are doing anything beyond creating temporary “wealth effects” for the investing class. In other words, is Switzerland onto something by refusing to play the game, or is the U.S. blueprint for economic revival worthy of imitation? Until the global investment community gives up on the notion that any stimulus is good stimulus – that any financial engineering designed to inspire risk taking will reward risk takers – expect the uptrends in respective stock markets to continue moving higher. I prefer removing the currency aspect from the equation with funds like the iShares Currency Hedged MSCI Germany ETF (NYSEARCA: HEWG ), the WisdomTree Europe Hedged Equity ETF (NYSEARCA: HEDJ ) and/or the Deutsche X-trackers MSCI Asia Pacific ex Japan Hedged Equity ETF (NYSEARCA: DBAP ). Yet I am equally convinced of the necessity to hedge against a monumental shift in central bank sentiment. There’s a reason that negative yields on sovereign bonds in Europe – Netherlands, Austria, Germany, Finland and Switzerland are becoming increasingly common. For one thing, negative yields can become even more negative, extending price gains for buyers of the debt. For another, there’s a remarkable demand for safe storage. Government bonds, even with negative yields, might be considered safer than cash deposits, particularly when those cash deposits are substantial. (Think Cyprus!) I am by no means recommending that an investor rush out to purchase negative -yielding sovereign debt; rather, I anticipate the U.S. bond rally to stay the course on relative value . If the U.S. 10-year yields 1.82%, but German 10-year’s offer 0.3% and Swiss 10-year offers a negative yield, is there any reason to suspect that a fund like the iShares 10-20 Year Treasury Bond ETF (NYSEARCA: TLH ) will fail to find buyers? Consider incremental purchases of an exchange-traded fund like TLH when it revisits its 50-day moving average. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

Best And Worst ETFs Of January

The year 2015 began on quite a volatile note and in fact saw the worst start to the New Year since 2008. Standard & Poor’s 500 index fell 3.1% in January while the Dow Jones Industrial Average lost 3.7% – marking its biggest monthly loss in a year. Concerns about the impact of a stronger dollar and lower oil prices on corporate earnings growth continued to bother investors. Moreover, global growth uncertainty also played foul with both the World Bank and International Monetary Fund having slashed their global growth forecasts. The three factors – oil, the strengthening U.S. dollar and lackluster global economic growth – worked in tandem pushing down corporate profitability for Q4 and the estimates for the current and subsequent quarters. Meanwhile, the Swiss National Bank dropped its long-standing exchange rate of the Swiss franc against the euro adding to the current market volatility. At the same time, the political situation in Greece worsened as the Syriza party won the country’s general elections, raising worries about Greece’s exit from the Euro zone. On the other hand, news that the U.S. consumer sentiment rose in January to its highest level in 11 years on better job and wage prospects and consumer spending in the fourth quarter expanded at the fastest pace since 2006 failed to bring in the much need relief to the U.S. markets. Adding to the woes, the U.S. economy expanded at a slower-than-expected pace of 2.6% during the final quarter of 2014. The pace signaled a slowdown in growth after an expansion of 5% in the third quarter and the 4.6% pace in the second. Given the huge market volatility, ultra-safe bond funds emerged as one of the biggest winners in January as investors rushed in for safety. Not surprisingly, some of the commodity and oil & gas ETFs emerged as losers shedding in the double digits. Best ETFs Volatility ETFs Volatility ETFs were the major gainers amid the ongoing turbulence, as these tend to outperform when markets are falling or fear levels are high for the future. The iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA: VXX ) has been leading the space with a 17% return in January, closely followed by 16.89% for the C-Tracks Citi Volatility Index ETN (NYSEARCA: CVOL ). VXX is the most popular volatility ETN on the market with an asset base of $937.7 million and average trading volume of 43.1 million shares. The fund tracks the S&P 500 VIX Short-Term Futures Index to provide exposure to a daily rolling long position in the first and second months of VIX futures contracts. The expense ratio came in at 0.89%. Bond ETFs Given the uncertainty in the global market, investors are flocking to safe haven long-term government bonds to protect their portfolio from losses. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ), the Vanguard Extended Duration Treasury ETF (NYSEARCA: EDV ) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) emerged as some of the biggest winners in this space gaining in excess of 9%. ZROZ tracks the BofA Merrill Lynch Long US Treasury Principal STRIPS index and holds 21 securities in its basket. The effective maturity and effective duration of the fund stand at 27.38 years. The fund manages an asset base of $164.2 million and charges 15 bps in annual fees. ZROV has a 30-day SEC yield of 2.30% and is up 16% quarter-to-date. iShares Residential Real Estate Capped ETF (NYSEARCA: REZ ) In the current ultra-low environment, investors in search of juicy yields are continuing to pile up real estate funds which offer attractive payouts. The fund follows the FTSE NAREIT All Residential Capped Index and provides exposure to 37 U.S. residential real estate stocks and real estate investment trusts (REITs). REZ manages an asset base of $347.2 million with a 30-day SEC yield of 3.18% and has returned 8% in the past one month. ETF Losers SPDR S&P Metals & Mining ETF (NYSEARCA: XME ) XME was the biggest loser last month dragged down by weakness within the broad commodity space. The fund lost 12.1% in January and is down 31% in the past one year. XME is the largest and most popular fund in the metals and mining space with an asset base of $370.6 million and is highly liquid with an average trading volume of 2 million shares. The fund tracks the S&P Metals & Mining Select Industry Index to provide exposure to a basket of 35 stocks. The ETF charges 35 basis points a year. SPDR S&P Oil & Gas Equip & Service (NYSEARCA: XES ) The persistent decline in oil prices over the past six months has taken a toll on the overall energy sector as well as on the growth prospects of a number of oil producers. XES tracks the S&P Oil & Gas Equipment & Services Select Industry Index providing exposure to a basket of 52 stocks. Sector-wise, Oil & Gas Equipment & Services occupies 72.3% of fund assets followed by 27.7% to Oil & Gas Drilling. The fund manages an asset base of $169.5 million and has lost 11.5% last month. The fund currently has a Zacks ETF Rank #5 or Sell rating. First Trust ISE-Revere Natural Gas Index Fund (NYSEARCA: FCG ) The fund offers exposure to the U.S. stocks that derive a substantial portion of their revenues from the exploration and production of natural gas. It follows the ISE-Revere Natural Gas Index and holds 28 stocks in its basket, which are well spread out across each component with none holding more than 7% of assets. The fund has gathered an AUM of $240 million so far and sees good average daily volume of over 1.3 million shares. The fund has shed 10.5% in January and currently has a Zacks ETF Rank #5 or Sell rating.