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Financial Times - Sorting the wheat from the chaff

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I ended my last article about market timing, which can be encapsulated by the mantra “buy low, sell high”, by saying that if you buy shares in good companies at reasonable prices, you’ll still make money even if you forget the “sell high” bit.

But what do I mean by “good companies”? If you read investment research you will see a great deal about earnings growth, growth in earnings per share or valuations based on earnings per share. You will rarely read much about a company’s return on capital employed (“ROCE”).

That’s a shame, because ROCE is important. If you invest your capital in a fund, a bond or a bank account, you will be very interested in the expected rate of return you will get. If you buy a share in a company you are in effect purchasing your share of its capital. Why aren’t you interested in the return it will earn on it? After all, you own part of it. Return on capital employed is usually calculated as cash operating profit divided by the sum of shareholders’ equity and long-term liabilities – all numbers that can be found in a normal set of company accounts.

If, as individuals, we borrow money at a rate of say 5 per cent each year and we invest it at a return of 10 per cent a year, we will become richer. But if we earn a return of 2.5 per cent we would become poorer. The same is true of companies. Those that make a return above their cost of capital create value for their shareholders, while those that make a return below their cost of capital destroy value.

But assessing companies on this basis is less easy than just looking at earnings because of the cost of capital concept. We can easily assess the cost of a company’s debt – a description of the debt profile and interest costs is usually included in the notes to a company’s annual accounts – but what is the cost of its equity capital? This is the subject of much research and in reality it can only ever be an estimate. But don’t let that put you off, because as an investor you should only be truly interested in companies whose returns are so high that they exceed any feasible cost of capital.

There’s no need to need to accept my word for this. In his 1979 annual letter to Berkshire Hathaway shareholders, Warren Buffett described return on capital as the primary test of performance in managing a company. It has often puzzled me why such a clear statement from such a successful investor is so widely ignored.

You may think that your fund manager is busy using metrics such as ROCE to dig out great investments. Not in my experience. Managers will often invest in companies in industries with endemically poor returns. Why? Because they think that they can pick a point to buy the shares at which the performance of the company will improve. Maybe they expect the business cycle to pick up, or a new management team will take over, or the company itself will be taken over.

A good example of this is the airline industry, where consolidation has long been a great white hope. The International Air Transport Association and the consultancy McKinsey published a report in 2011 called Vision 2050. It showed that there was $500bn of capital invested in the airline industry in 2010. Iata/McKinsey reckoned the industry had an overall cost of capital of 7-8 per cent a year. Comparing the returns generated with this cost of capital over the previous decade, they found that the airline industry destroyed value at the rate of about $20bn a year. During the 2002-09 business cycle, airlines’ return on invested capital averaged just 2.8 per cent a year. Even in 2007 – the best year for the industry during that decade – the industry still destroyed more than $9bn of investor value on this basis. And airlines are far from alone.

The problem is that while fund managers who buy these low-return companies wait for the events which they think will change the situation, the companies destroy value. But the reverse is true when you own shares in a company that generates returns well above its cost of capital. You don’t need to hold out for a takeover, a boardroom coup or a change in the business cycle, because you can be assured that its intrinsic value is growing practically every day. Time is on your side. 

This is the second of a five-part series about the fundamentals of investing.

Click here for the full article on 

Terry Smith

Financial Times