Tag: compounding

How growth, return on capital, and the discount rate affects valuation

How growth, return on capital, and the discount rate affects valuation

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Michael Mauboussin has written countless white papers on this topic. His paper published on 9 Jun 2020 introduced the concept of how stock duration and interest rates caused multiples of high-quality companies to justifiably shoot up.

High-quality companies have the following characteristics: Return on capital is significantly higher than the cost of capital, able to grow, and has a competitive advantage (i.e. moat).

How is value created?

Before we jump into new concepts such as stock duration, it is important to quickly recap on how value is generated.

A company creates value only when its investments generate a return higher than the opportunity cost of capital (COC).

This means that having a large total addressable market (TAM) with huge growth prospects does not make a good investment. Revenue and earnings may show growth but it offers little with aspect to value creation.

If a company generates a return on capital equaling COC, then it does not matter whether they grow. They are both worth the same multiple.

Mauboussin refers to this group of companies as commodity businesses that deserves a commodity P/E multiple.

The commodity P/E multiple

The commodity P/E multiple is the multiple you would pay for $1 of earnings into infinity assuming no value creation (return on capital = cost of capital).

You can find out the multiple by taking the inverse of the cost of equity capital. If the COC is 8%, the commodity P/E multiple is 12.5 (1/0.08 = 12.5).

This multiple is not constant. The multiple a commodity business commands is derived from the cost of equity capital for each period.

The concept of duration

Duration is a concept that bond investors would be familiar with. It measures how a change in interest rates would affect the price of a bond.

The faster an investor is paid back, the lower the duration. The longer it takes to be paid back, the higher the duration.

Let’s take a look at a simplified example.

Assuming a five-year $100,000 bond at 5%. This means the bond will pay you $5,000 at the end of every year.

This would all be fine and the price would remain the same (at $100,000) if interest rates doesn’t change.

If interest rates shot up to 10%, investors would expect to be paid 10% for their investments.

To achieve this interest rate, the $100,000 bond paying $5,000 (5%) annually would have to drop its price to $50,000. Only then it will be able to match the 10% interest rates given by the current market ($5,000 interest on $50,000 bond).

Generally, the longer it takes for an investor to be repaid, the higher the duration will be. And the bigger the magnitude the change in price of the bond when interest rates shift.

How duration affects stock valuation

Similar to bonds, stocks of businesses that reinvest heavily in the short run to generate higher cash flows in the long run have longer durations than companies that lack the opportunities to reinvest.

Duration sheds important insight into understanding the magnitude of an asset price change when interest rates change. Mauboussin highlights, “Long-duration assets are more sensitive to changes in interest rates than are short-duration assets…companies that can invest a lot today at high returns on capital will not only grow faster than the average company, their stocks will have valuations that are more sensitive to changes in the discount rate.

Low interest rates

Low-interest rates are frequently associated with poor economic outlook and slow real earnings growth. This creates a conundrum where low-interest rates raises asset values (i.e. higher value for a stream of cash flows due to lower discount rates), but the prospects are reduced by slower expected cash flow growth.

Data from Robert Shiller suggests that the impact of slow growth will outweigh the former. The P/E multiple for the market has followed an inverted “U”.

Low median P/E multiples are associated with very low and very high interest rates while high median P/E multiples are associated with real interest rates in the middle of the range.

Mauboussin continues to explain, “Research shows that low Treasury yields allow industry leaders to generate excess returns and that the magnitude of those returns increases as yields approach zero. While the median P/E may come under pressure as a result of slower growth prospects, a handful of companies may continue to generate strong growth and return on incremental investment.

How the math works out

Impact of growth rates on valuation

Mauboussin demonstrated how low-interest rates leads to bigger shifts in valuation multiple with the following:

Assuming the base year’s earnings are $100, slowing earnings growth from 10% to 7% reduces next year’s earnings by only 2.7% (from $110 to $107). However, the P/E multiple dropped a steeper 22.9% (from 32.3 to 24.9).

“Investors often calculate the P/E multiple using the current price and next year’s earnings. As a result, they sometimes believe that the market overreacts to what appears to be modest changes in the near-term earnings. But if expectations for the trajectory of growth really do shift down, the large apparent drop in the P/E multiple is completely justified.

Here, next year’s earnings are revised down by 2.6% (from $115 to $112) but the P/E multiple decline is 25.3% lower. When return on incremental invested capital (ROIIC) is well above the COC, the value of the business is very sensitive to changes in the growth rate of NOPAT.

As we can observe in the following graph, growth and the P/E multiple have a convex relationship. In other words, small changes in growth expectations can lead to big changes in the P/E multiple.

This effect is amplified when the company growth rates are high.

“Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous.”

Warren Buffett

The key takeaway here is that growth doesn’t matter for businesses that generate returns close to the COC. However, for companies that are able to generate high returns on capital, it is a huge amplifier of value.

Impact of ROIIC on valuation

ROIIC indicates how much a company is required to invest to attain an assumed growth rate. A high ROIIC means that the company don’t need to invest heavily to grow, leaving a lot of cash on the table for shareholders and vice versa.

Take for example company A and company B, both of them aim to generate a 10% growth in earnings for the next year. From current year earnings of $100 to $110, an additional $10 in earnings.

All else constant, A generates 50% ROIIC while B generates only 25%.

A is only required to invest $20 of the current year’s earnings to achieve an additional $10 ($20 x 50%) in earnings the following year. This leaves $80 of the remaining earnings for its shareholders.

While B is required to invest $40 of the current year’s earnings to achieve an additional $10 (25% x $40) in earnings the following year. Leaving only $60 of the remaining earnings for shareholders.

Thus, a company generating higher returns on capital would rightfully command a higher multiple, assuming growth rates are constant.

Impact of discount rate on valuation

The cost of equity is comprised largely of 2 components – the risk-free rate (i.e. common referred at the yield on the 10-year Treasury note) and the equity risk premium (i.e. how much investors expect in return for assuming risk).

As of 1 Jun 2020, Aswath Damodaran’s estimate of the cost of equity dropped to 6%. The 10-year Treasury note offering historically low yields at 0.7%, while the equity risk premium accounts for 5.3%.

Mauboussin observes “Nearly 90% of the expected return from equities now comes from the risk premium, up from about 75% at the beginning of the year.”

Importantly, long-duration assets are highly sensitive to changes in the discount rate. In today’s environment of low expected returns, the valuation of these companies are substantially higher than before.

Conclusion

Nobody will know where interest rates are headed, but it is important to appreciate the relationship between the discount rate and long-duration assets. In other words, we should be mindful that an increase in interest rates will bring down the valuation of companies that are investing heavily today for higher future cash flows tomorrow.

It is also important to bear in mind that for most companies, return on capital will eventually drift lower with competition, maturation, obsolescence, and disruption. Without a moat protecting its returns, the company will suffer a multiple contraction as observed above.

You may find all of Michael Mauboussin’s work here.


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Why pay up for quality businesses?

Why pay up for quality businesses?

Fundsmith performed an exercise looking at 25 quality compounders, and what an investor could have paid for a compound annual growth rate (CAGR) of 7% between 1973 and 2019. Over this period, the MSCI World Index produced a CAGR of 6.2%.

“An investor could have paid 281 times earnings for L’Oreal, 156 times for Colgate, and 147 times for Brown-Forman and still beat the market.”

Terry Smith, Fundsmith

What this means is that the market continuously underpriced these great businesses over time. Giving investors the opportunity to achieve market-beating returns by sticking to these compounders.

For Fundsmith, quality companies have the following characteristics: high returns on invested capital, strong margins, good cash conversion, defensive business models and long growth runway.

“Provided you have the patience, these quality stocks do tend to produce the sort of performance over long periods of time that makes their valuation fade into insignificance.”

Terry Smith, Fundsmith

The origin of the above statement comes from Charlie Munger “Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.”

Take some time to let the quote above sink in.

Let’s look at what Munger said with an example. We have company A earning 6% and company B making 18%, both with an intrinsic value (IV) of $100 today.

The market price of company A is half of IV, at $50. While company B is commanding a premium and the market is demanding twice of IV at $200.

Now let’s see what happens when Company A compounds its intrinsic value at 6% while Company B compounds its intrinsic value at 18% over 40 years.

Over a long period, the power of compounding will drive Company B’s IV through the roof!

Let’s be conservative and assume that Company A is trading at double of IV at year 40. While Company B is trading at half of IV at year 40.

Even if Company A’s valuation jump by 4 times (from half of IV at year 1 to double of IV at year 40), it’s returns did not deviate far from its ability to generate 6% return on its business.

For company B, even if you paid an expensive looking price (double of IV), and subsequently valuation gets cut (half of IV), it still generated satisfactory returns of 16% for its investors. Close to its 18% return on business.

Key takeaway

The key takeaway is to understand value. Undervalued companies might not come in the form of low P/E or P/B. If these companies are generating returns on capital below their cost of capital, they would rightfully deserve the low multiples.

For companies that are able to sustainably generate returns above cost of capital, they would rightfully deserve a higher multiple.

Especially in today’s environment, its important to shift our mindset away from solely buying companies that are trading at low multiples. Focus on companies that are able to generate market beating returns instead.

Here is an excellent video of Terry Smith explaining the importance of investing in companies that are able to continuously reinvest their earnings at a high return on capital:


Thank you for taking the time to read my blog.

If you’re enjoying the content so far, I’m sure you’ll find 3 Bullet Sunday helpful. As an extension to the regular posts, I send out weekly newsletters sharing timeless ideas on life and finance.

I do not share these content elsewhere.

Join others and subscribe to our newsletter today to receive a free investment checklist!

How to filter for high-quality compounders?

How to filter for high-quality compounders?

A high-quality compounder is a business that is highly profitable, has a strong competitive advantage (i.e. moat) and the ability grow (i.e. huge total addressable market). Companies such as Ferrari, Mastercard, Facebook, Berkshire, Amazon, Monster and Starbucks are great examples.

A key characteristic of a high-quality compounder is a high Return on Invested Capital (ROIC). The problem is that ROIC is a function of operating income and invested capital. For example, many high-growth companies spend heavily on marketing and R&D. Filtering by ROIC may cause you to miss many high-quality compounders.

A great solution to overcome this is to use the gross profitability as a first-level filter instead of ROIC. Professor Novy-Marx defines gross profitability as revenues minus cost of goods sold, measured against the book value of total assets. In other words, it measures the amount of gross profit a company generates for every dollar of assets.

Reasons gross profitability is a great filter

Gross profitability is highly persistent in both the short and long term. This allows investors to make a reasonable estimate of future profitability based on historical records. Research shows that businesses with higher gross profitability generally deliver better total shareholder returns.

Gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more ‘polluted’ profitability measures become. Gross profitability doesn’t ‘penalize’ companies for investing heavily in growth.

Many of the investments (largely marketing and R&D) that companies make for their long-term future growth can cause short-term hits to reported operating income.

A good gross profitability benchmark

So what is a good benchmark for gross profitability?

In Novy-Marx paper, gross profitability of 33% or higher is considered attractive. A look at Amazon’s gross profitability shows that it surpassed this level easily.

It is also worth noting that in Novy-Marx back-testing, a dollar invested in the market between 1973 to 2011 grew to over $80. While the same dollar invested in businesses that have high gross profitability (i.e. above 33%) grew to $572 in the same period.

Similar results were shown in a more recent study conducted in 2018 here. By investing in companies with high gross profitability of over 20%, it would produce returns in excess when compared to the overall market.

Conclusion

The gross profitability ratio is a great way to do a first-level filter. With growing revenue and gross profitability of over 20%, it is a great indication that the company could be a high-quality compounder which warrants further investigation.

In our future article, we will discuss in detail the issues with ROIC and how we may adjust the reported earnings figure to use this metric.

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Winning the ovarian lottery

Winning the ovarian lottery

If you are born into a “good” family, navigating adulthood is much easier. You can copy what your parents did and benefit from their connections. For kids who come up rough, even if they are bright – are going to face uphill challenges.

It is much tougher to figure out how to live, earn, love, parent, etc. People who manage to do so break the cycle and chart their future family history on a different course.

Winning the “ovarian lottery” is a term coined by Warren Buffett. Where he attributed much of his success to luck – by being conceived in the right place and the right time.

“The ovarian lottery is “the most important event in which you’ll ever participate,” Buffett continued. “It’s going to determine way more than what school you go to, how hard you work, all kinds of things.”

Warren E. Buffett, 1997 Berkshire Hathaway’s AGM

While luck plays a significant role in determining the probability of your success, there are actions we can take to put ourselves in a better position to chart our future.

With the internet and library, the tools for learning are abundant. With the desire to learn, I believe that today’s generation are in a better position to break the cycle than at any time in history.

Here are some of my experiences at doing so. While not perfect, I hope it is useful for you to build on my experience and chart your own future.

Unlearn bad money habits

Growing up, there were many concepts about money that I had to unlearn. And many more that I had to pick up. Here are some concepts which I had to unlearn:

Real wealth is not measured by how much you spend or how much material goods you own. Live life according to the inner scorecard. Your worth is not determined by what you own or your place in the social hierarchy.

“Wealth is having assets that earn money while you sleep: businesses, products, media, robots, investments, land. Wealth is for freedom, not conspicuous consumption.” – Naval

Investments are risky and should be avoided. Risk is the probability of losing money. With bank interest below 1% and inflation at 2 – 3%, not investing guarantees that you will “lose money”. Start learning how to invest. Indexing is a great way to start.

Insurances are a waste of money. The purpose of insurances is to protect against risks – death, terminal illness or crippling accidents. Many don’t feel a need for it because it offers no tangible benefit when all is well.

The main enemy of life is uncertainties. When life throws you a curveball in the form of a gigantic medical bill, insurance will protect you from suffering a gigantic setback.

The phrase “confirm make money!” Never believe anyone who says this or offers any get rich quick scheme. Always question the incentives and learn the potential downside of any investments.

“Over the years, a number of very smart people have learned the hard way that a long string of impressive numbers multiplied by a single zero always equals zero.

Warren E. Buffett

Property is a great investment, it will only go up! Many justify buying an expensive home as its an investment. Always think in terms of opportunity costs, could the money be better deployed elsewhere?

Retirement is still far away. Understand that compound interest is a function of time and returns. Start today. Just because the problem is further down the road does not make it less important.

Not all debts are bad. As a rule of thumb, debt taken to finance your education or home are alright. In fact, with interest rates at rock bottom, it’d be wise to have a longer loan tenure.

Pick up good money habits

Apart from unlearning the above, I found picking up the following concepts helpful:

Never fund today’s lifestyle with tomorrow’s income. Never take on debt to live an expensive lifestyle. Living modestly frees you to make appropriate choices.

Don’t do mathematically unsound things. Such as buying the lottery. The probability of each set of 4 numbers in the right order winning is 1 in 10,000. One person occasionally gets lucky and appear on the news. Many others don’t.

Automate, automate, automate. Have different accounts, for spending, saving and investing. Make the transfer of funds among accounts automated once your income is credited.

Focus first on building up your savings, then on investing. Your savings rate is going to matter much more than your investment returns at the start. A 100% return on $2,000 is $2,000 while a 2% return on $100,000 is also $2,000. Focus on cutting expenses and increasing your income first.

Invest like a business owner. Think about what kind of business you want to own for the long-term. Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.

Invest in high-quality compounders. Don’t focus only on income investing (i.e. dividends) or ‘cheap’ stocks, focus on total returns. I really wish I had known this one earlier. It pays well to study the following Munger quote:

‘Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.’ 

Charlie T. Munger

Redesign your environment

We tend to construe that success is a product of our effort, motivation, and talent. These are characteristics certainly important. But over time, success is nearly impossible without supportive people at your side.

Never be the smartest person in the room. Hang out with people better than you, and you cannot help but improve. Have the humility to acknowledge that you don’t know everything and allow others to fill the gaps.

“Nothing, nothing at all, matters as much as bringing the right people into your life. They will teach you everything you need to know.”

Guy Spier

Be the person you want to attract. The best way to surround yourself with successful people is to uphold yourself to high standards. Buffett shared a useful mental model in 1998 with MBA students:

“Think for a moment that I granted you a right — you can buy 10% of one of your classmate’s earnings for the rest of their lifetime.”

The decision should be based on merit, Buffett advised, so it’d be unwise to pick the person with the highest IQ, the richest parents or the most energy.

“There’s nothing wrong with getting the highest grades in the class, but that isn’t going to be the quality that sets apart a big winner from the rest of the pack,” said Buffett.

He continued: “You’d probably pick the person who has leadership qualities, who is able to get others to carry out their interests. That would be the person who is generous, honest and gave credit to other people for their own ideas.

And here comes the hooker: In addition to this person, Buffett told the students they had to sell short another one of their classmates and pay 10% of what they do.

“You wouldn’t pick the person with the lowest IQ,” he said. “You’d think about the person who turned you off, the person who is egotistical, who is greedy, who cuts corners, who is slightly dishonest.

If you see any of those qualities in yourself, you can get rid of them. “It’s simply a question of which you decide,” he said.

Find role models and mentors in life. Choose the right people, then learn their behaviors, thinking, and processes.

Avoid anchoring effect when picking a partner. Studies have shown that children with a dysfunctional childhood are likely to pick partners and have a relationship that resembles their parents’. Be aware of the traits you are looking for in your partner.

Calibrating your mindset

Always read. A book is a person’s live-work condensed into its essence. Good books have the ability to shape your mind and change your life.

“The reading of all good books is like a conversation with the finest minds of past centuries”

René Descartes

Develop the habit of writing. Writing forces you to engage with what you’re reading on a deeper level. Writing online can build your network and create opportunities for yourself.

“People who write a lot, also listen a lot. They also change their mind a lot. Not necessarily with new data, but sometimes re-analyzing the same data. They also work hard to disconfirm fundamental biases.”

Jeff Bezos

Learn to ask. Sometimes all we need to do is ask, and opportunities will be created – internships, careers, advice, etc.

The best way to overcome an addiction is to not start one. I have seen lives and relationships ruined by addiction to alcohol and gambling, and often they come hand-in-hand. While extreme to some, I have a rule to not touch either.

Take great care of your body. When you’re healthy you have 10,000 needs, but when you’re sick you only have one need. Have at least 7-8 hours of sleep. Exercise regularly and avoid sugar.

If you need tips on diet and working out, my buddy Kah Qi generates great content backed up by research papers. You can follow him on IG @kah.fitness or Youtube.

Conclusion

While some of us were less ‘lucky’ than others in the ovarian lottery, all of us have the opportunity to create our own luck. Because luck simply comes down to a series of choices. As the saying goes “chance favors the prepared mind.” Start inviting lady luck by learning about money, changing your environment and calibrating your mindset.

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