growth and return on capital

With one or two exceptions most of our holdings consist of medium and smaller-sized companies that investors have ignored in their pursuit of high-profile, fast-growing mega-cap Technology companies.

Despite their sometimes exotic or obscure geographies and market niches, most of our investments are in decidedly “boring” businesses, with a number of them showing only modest revenue growth. That characteristic has earned them an immediate “pass” from most investors.

Due to the considerable investment success of Growth investing over the past decade, the allure of the two birds in the bush has completely overshadowed the value of the bird in the hand.

In their infatuation with growth investors are ignoring what really matters when it comes to corporate financial performance, and that is the return a business earns on the capital entrusted to it, and management’s ability to intelligently allocate capital. Revenue and earnings growth is certainly nice to have, but we find the market tends to excessively reward growing businesses, whereas those with more limited top-line prospects but which nevertheless earn very high returns on capital employed are frequently overlooked. One of our best performing investments since starting Phronimos has been a business whose revenue has grown by only 2% p.a., but with a five-year average return on invested capital (‘ROIC’) of around 40% and with 21% of revenues converting to free cash flow, management has reduced the number of shares on issue by nearly 40%.

Ideally we look for businesses that have opportunities to reinvest at those high rates of return, but if they don’t, management that repurchases shares at sensible prices can create very substantial value for shareholders.

It is rare to find an investment offering a rate of return of 20% and able to put substantial additional capital to work. A business that can is very attractive indeed. Even if we have to pay a substantial premium over the value of that capital when buying small portions of a business in the stock market, we still benefit from the compounding effect of reinvestment at a high rate of return. A short example should help illustrate why that is the case.

Take a company that can generate a return of 20% on equity capital employed (“ROE”) and which pays out half of its earnings as dividends. The company’s equity value will grow by 10% per year, and even if the company’s stock trades in the market at twice the book or accounting value of equity, we still get the benefit of 10% compound annual growth in book value as long as the multiple in the market remains the same (we use price-to-book for illustration purposes but you could insert the valuation multiple of your choice). We also get the benefit of a 5% dividend return (half of the 20% return on equity paid as a dividend, where we paid two times the value of equity), for a total return of 15%.

Note that if less of the company’s earnings are paid out as dividends the higher the rate of growth in book (or overall intrinsic) value. Contrary to many other investors, if a company can reinvest substantial capital at a high rate of return, we would prefer management pay little to no dividend at all. Given higher rates of tax on income versus capital this is also more tax efficient.

Return on invested capital involves slight modification to the calculations above, but the principal is the same.

Looking through the top eight holdings that make up half of our investment portfolio the five year average ROIC is 20%. We use ROE rather than ROIC for Financials and make adjustments for goodwill in our calculation of invested capital where appropriate (i.e. we include it where acquisitions represent an ongoing component of reinvestment, and exclude the amounts resulting from mergers of equals).

With these returns on capital we feel confident we will do fairly well over time having acquired these businesses at what we believe to be reasonable prices.