By Martin Lord, Chartered Wealth Manager & Senior Investment Director – Investec Wealth & Investment
At Investec, we help our clients build and maintain their wealth. The ability to take a long-term view is a key asset in a world focused on the short term. We aim, to take advantage of the compounding of returns that accrue within businesses as they reinvest profits in wealth-creating projects. An asset-owner mind-set also requires that we engage with the management teams of the businesses in which we invest. When making investment decisions we prioritise the quality of the businesses we invest in. We aim to buy excellent businesses at fair prices, not fair businesses at excellent prices.
There are four key aspects of quality that we consider:
(1) Value Creation
(2) Persistence of Value Creation
(4) Balance Sheet Strength
VALUE CREATION IS KEY
We define value creation as the ability of a business to generate returns on invested capital that are greater than its cost of capital. Such a business then has a choice of what to do with this surplus return, to reinvest in the business or distribute to its shareholders by way of dividend.
THE FOUNDATION STONES – CASH FLOW RETURN ON INVESTED CAPITAL (CFROIC) AND COST OF CAPITAL
CFROIC is the cash flow generated by a business in a single calendar year divided by the capital invested in the business. By invested capital, we mean the capital that a company’s management has chosen to invest in the productive capacity of the business. This can be tangible or intangible. For example, we count the cost of building the factory as a capital investment; we count the full cost of buying the company as a capital investment, including goodwill; where a company utilises intellectual capital that is, intangible and we count the cost of research and development spending as capital investment.
Companies have a choice in how they fund (or “capitalise”) themselves: they can either use debt or they can use equity by selling shares in the business. Both choices of capital have a cost. For debt, it is the interest cost. For equity, it is the opportunity cost of the equity capital. This is best thought of as the rate of return the investor could have made had they invested their capital as an equity investor in an alternative project of similar risk.
PERSISTENCE OF VALUE CREATION IS ALSO IMPORTANT
It requires resilience to the forces of economic competition. Some may enjoy patent protection for their products, some may have a strong brand, others exceptional business processes and management, while size may give some insurmountable scale benefits.
GROWTH – DIFFERENTIATE BETWEEN GOOD GROWTH AND BAD GROWTH
We believe that the stock market only rewards value-creating growth. A company which vastly overpays for an acquisition so that the cash flow returns it earns on that investment are below the cost of capital (and potentially finances that acquisition with debt) may see its accounting earnings grow, however, because the company has destroyed value through the acquisition, it is likely it will see its share price fall (most probably when the acquisition is announced to the market).
We expect our companies to grow by investing capital in projects that will earn returns above the cost of capital, ideally that growth should be organic. In order to grow its economic profits in a given time period, a business needs to (1) increase the capital it has invested in the business, (2) increase its CFROIC, or (3) reduce its cost of capital. Sometimes it will be able to do all three simultaneously.
BALANCE SHEET STRENGTH
Given our long-term asset-owner mind-set, value-creating companies with ample growth opportunities can still be ruined by choosing an inappropriate capital structure for the business. Using debt finance if an indebted company is experiencing tough trading conditions, it may not generate enough cash to make payment on its debt, and so be forced into financial distress and ultimately bankruptcy.
Had the company used equity finance instead, it would not need to make regular payments to its providers of capital, and therefore could make it through tough trading conditions without distress. Increased leverage means increased risk for stock holders.
At this stage of the investment process, we have a number of potential investments which share similar characteristics: persistently high returns on capital, ample growth opportunities, and an appropriate capital structure. Businesses with excellent qualities like these are rare, and as such don’t often trade cheaply on traditional valuation metrics.
Our valuation discipline is based upon discounted cash flow analysis. This allows us to specifically include in that analysis the qualities of persistent value-creation combined with growth opportunities. The important point to note is that we should not expect quality to come cheap. Balancing this, however, we must be careful that we don’t overpay for the qualities we see in the business. Great companies aren’t always great investments.
The value of investments and the income derived from them can go down as well as up and you may not get back your initial investment.
Contact Martin Lord – Senior Investment Director, Investec Wealth & Investment
Martin.firstname.lastname@example.org – 07864 602995