Tuesday, 07 October 2014 - 20:00

 

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Seed Weekly - Compounding at higher rates of return

Why do some companies seem to consistently move up in price, even though at face value they appear to be expensive when measured on typical measures such as price to earnings ratios, while others businesses constantly appear cheap but the price struggles to move up.

One answer is that these superior business are those that generate a high return on invested capital (ROIC) above that of the cost of capital and they also have the ability to reinvest a large portion of their profits at higher rates of return. By consistently doing this, these businesses generate above average compounding of their intrinsic value.

An investor that allocates capital to such a business will over time typically participate in the compounding effect of the higher rate of return on the company’s intrinsic value. The compounding is the product of two main factors; firstly return on capital and secondly the reinvestment rate. If a business can achieve a return of 20% on its invested capital and it reinvests 2/3 of its earnings, then the intrinsic value of the business will compound by 13,3% per annum, (20% x 66,6%). The excess not reinvested, can be paid back to investors as a dividend or by way of a share buyback.

Compare this to a business that only generates a return of 8% on its invested capital but has to reinvest 100% of its profits back into the business each year. It will only see the intrinsic value of the business compound at the 8% per annum.

An article by Deloitte found that ROIC is an understated but powerful metric, for the following reasons:

Persistence – Studies have shown that ROIC tends to persist over time in a given industry. One is likely to find that companies in sectors like utilities and construction have a relatively low ROIC while companies in, say, the pharmaceutical or beverage sectors have a relatively higher ROIC.

Robustness – the metric is extremely robust as it assesses the underlying performance of operating assets before being complicated by a company’s financial structure or non-operating assets. ROIC measures the investing decision, which is independent from the financing decision.

Comparability – It can readily be compared across industries, companies, early/late stage growth businesses or against an entity’s weighted average cost of capital (WACC).

In the long run it has been demonstrated that share price movements are determined primarily by growth in earnings. This is well illustrated in the following chart, which compares the ALSI’s price with this index’s earnings. Although the market fluctuates widely around the earnings line, it is clearly heavily influenced by long-term growth in listed company earnings.

Therefore companies that can compound their earnings at a higher rate because of a high return on capital and a higher reinvestment, should over time have a share price that moves up commensurately.

Earnings and equity performance

Therefore for an investor seeking a superior investment return, it is more than buying companies at low prices to current or one year forward earnings. More importantly it is about allocating capital to a business that has an ability to compound its earnings over time at a higher rate than others. Naturally if one can at the same time also buy such a business at a lower than market price, then this is a huge positive.
Kind regards

Ian de Lange

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 07 Oct 2014

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