investing Archives | Steady Compounding

Return On Invested Capital

By Steady Compounder | November 8, 2020 | Comments 3 comments

Shot-termism runs deep when managers plan, execute, and report their performance in earnings per share (EPS). For example, when a company acquires a target, managers and investors often focus on whether the transaction will dilute EPS over the first year or two.

This is despite research demonstrating that increased EPS does not prove value creation. In other words, deals that increase EPS and deals that reduce EPS are equally likely to create or destroy value.

Note: Buffett’s 1984 letter is helpful in understanding the concept of value creation.

So what drives value?

Value is driven by 3 things: growth, return on invested capital (ROIC), and the cost of capital (COC).

Not all growth are equal.

Value creation happens when ROIC > COC and a company invests for growth.

*Mastercard is an example where ROIC significantly exceeds COC.*

Value is destroyed when ROIC < COC and a company invests for growth.

*Airlines is an example where ROIC persistently stays below COC*

Value doesn’t change when ROIC = COC, it doesn’t matter if the company invests for growth.

High ROIC companies create value by focusing on growth (i.e. expanding), while lower ROIC companies create more value by increasing ROIC (i.e. downsizing).

Here comes the formula for ROIC: after-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

Note that Joel Greenblatt applies the formula slightly differently: before-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

This method is helpful for comparing earnings power across different time periods, without being affected by varying tax rates.

Operating profits

Operating profits is also known as earnings before interests and taxes (EBIT).

It is a ‘cleaner’ figure to measure the true earnings power of a company when compared to net income. It includes all expenses needed to keep the business running.

Going below operating income, we can see items such as interest revenue/expenses and extraordinary items. For example, sales of business assets would come below the operating income.

This income from selling business assets is not conducted in the normal operations of a business and does not reflect the ‘true earning power’ of a business.

You may refer to my earlier post— Finding the next multi-bagger by understanding operating expenses for deeper understanding.

Invested capital

Invested capital represents what the business has invested to run its operations—largely PPE and working capital.

Let’s use Costco as an example for this.

Costco (COST) Hits Record High After 'Impressive' Earnings - Bloomberg — *Photo of Costco*

To open a new store, Costco will have to buy shelves, cashiers, and perhaps land to build its store. This would constitute its PPE investments.

Working capital is money a business need to operate its business.

Generally, having a new store would require the business to lock-in additional money to stock up inventory.

If it offers credit terms (i.e. allows customers to pay in installments), more working capital is required. This is because they would be required to pay suppliers first while waiting for customers to pay them or they would be waiting for the inventory sitting on the shelves to be sold.

Oh, but Costco is rather different.

In fact, they are quite the opposite.

Before its customers start shopping, they collect a membership fee. Their customers are effectively financing their growth by injecting cash into Costco even before they start buying its goods.

Because of their size, they are able to negotiate favorable terms by paying suppliers approximately 1 month after they get the inventory. On the other hand, customers have to pay immediately when they purchase from Costco.

This means that Costco’s suppliers are also financing their growth when they’re able to delay payment to their suppliers.

Their inventory turn—how fast they clear their shelves—is also one of the best in the industry.

Capital doesn’t stay locked up in Costco for very long.

And when cash isn’t locked up in a business, it can be distributed to shareholders, buy back shares, or be reinvested for growth!

Working capital needs or the lack thereof is one of the most overlooked metrics amongst others.

Starbucks in recent years is also showing early indications that it will benefit from working capital improvements. With its membership—prepaid cards gaining wide popularity.

Coffee ~~addicts~~ lovers are effectively financing Starbucks growth by putting in cash before they make their purchase.

If you think Apple Pay, Google Pay, and Samsung Pay is popular, wait till you see ‘Starbucks pay’.

Starbucks's mobile payments system has more users than Apple's, Google's - Vox

Conclusion

In conclusion, ROIC measures the earning power of a business. The lesser capital it requires to generate that additional amount of revenue, the more money is leftover to be distributed to shareholders.

High ROIC combined with growth and a strong moat will compound your capital nicely for years to come when you pay a fair price.

You read my earlier posts on this topic:

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Lessons learnt investing through market crashes

By Steady Compounder | April 19, 2020 | Comments 0 Comment

“Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
– Sir John Templeton

For the past two months, since Feb 2020, the S&P has been trading like a penny stock, making extremely volatile movements of more than 5% on many trading days. It took only 6 days for it to reach correction (a decline of 10%) and 16 days to become a bear market (a decline of 20%). It was one of the fastest drawdowns in the market ever since.

The upswing was as intense as the downswing, with the market rebounding 28.5% since its bottom on 23 Mar 2020.

“In fact, you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.“
– Charlie T. Munger

A look at previous crises

Historically, we experience a 10% market drop every 2 years. Since the 1950s, stocks have fallen 20% or more only 11 times (about once every 6 years). Including now, a decline of 30% or more has only happened 6 times; an opportunity that happens once every 12 years.

“The time to buy is when there’s blood in the streets.”

Investors should always expect the market to move up, down or sideways. We should not be surprised when the market has a sharp drawdown. However, when something this drastic happens, it will freeze most investors. Some of the most common statements I hear amidst this Covid-19 induced downturn include:

I may be catching a falling knife
Unemployment claims have never been so high before, there is too much uncertainty
Globally, the number of infected cases is still rising exponentially and we don’t see anyone travelling or dining out soon

These are all legitimate concerns, but in investing you either get a cheap valuation or a rosy outlook; you will never have both at the same time. You pay a very high price in the market for a cheery consensus. The important question investors should be concerned about is,

“Which companies will survive and do even better coming out from this crisis?”

Someone once said that the best time to buy is when your stomach starts to churn. And it is important for us to prepare a watchlist of high-quality companies so that we may take advantage of the downturn. As Howard Marks put it best in his recent memo: “The most important thing is to be ready to and take advantage of declines.”

The market has emerged higher from every crisis

Covid-19 is going to leave a mark, but it is going to come and go. If history is a good indicator, the stock market will increase over time as corporate profits rise. Despite ‘unthinkable’ disasters happening, America’s markets have displayed their resilience and it would be unlikely that Covid-19 will destroy their economic engine permanently.

As the saying goes, this too shall pass.

On average, US corporate profits rise 8% annually. But bear in mind that companies do not increase profits on a straight-line. There will be down years and up years, and what’s most important that we understand our companies to have the conviction to hold through downtimes.

Equally important is that we must not invest in cash that we need within the next 5 to 10 years and we must not invest our emergency savings. The market sometimes can stay irrational longer than you can stay solvent.

What do I do during a crisis?

I buy.

More specifically, I buy companies on my watch-list in tranches. There is no rule to this and I deploy my available funds based on probability of these events happening:

20% market decline: Likelihood of occurrence is 15%, I will deploy 50% of my available funds at this stage
30% market decline: Likelihood of occurrence is 8%, I will deploy 30% of my remaining funds at this stage
>40% market decline: It has only happened 3 times since 1950, I will be fully invested by this point.

Apart from deploying my available cash, I would also be selling lower-quality stocks in my portfolio and buying high-quality companies as the market throws them out. High-quality growth companies and cheap/ reasonable valuations seldom come hand-in-hand. And when the market gives the opportunity to be an owner of these companies, pounce on them!

As you sell your companies to buy high-quality companies in a downturn, it will inevitably be painful as you will likely have sold it at a discount. In moments like these, it is helpful to remember Warren Buffett’s saying:

“I’d committed the worst sin, which is that you get behind and you think you’ve got to break even that day. The first rule is that nobody goes home after the first race, and the second rule is that you don’t have to make it back the way you lost it.“ – Warren E. Buffett

To sum it up, markets will go up in the long run and during a crash, there will be a lot of commentators predicting what will happen next. The most important thing is to have a watch-list beforehand and follow your game plan as the market provides you with opportunities to own great companies. Never invest in cash you would need in the next 5 to 10 years, you must stay in the game for this to work.

You can also follow my Facebook page for updates here!

Facebook’s Incredible Business Model – Part II

By Steady Compounder | April 16, 2020 | Comments 0 Comment

In the second part of Facebook’s write-up, we will examine how its moat enables it to generate a high Return on Invested Capital (ROIC). We will also discuss its growth runway and what has changed for Facebook since the Cambridge Analytica incident.

A Compounding Machine

Facebook has consistently generated ROIC of ~30% on a before-tax basis. What this means is that every $100,000 invested in the business, it will give you $30,000 in operating income. Comparing this with buying a Condo for $1 million and it gives you $40,000 in operating income (rent less all expenses before tax), that would give you an ROIC of 4%.

There are many ways to calculate a company’s ROIC. Personally, I prefer Joel Greenblatt’s method of calculation. By using Earnings before Interest & Taxes (EBIT), it allows us to compare the true earning power of a company across time (different tax rates) and capital structure.

*Joel Greenblatt’s ROIC formula* from his book “The Magic Formula”

Interestingly, Facebook holds a lot of cash ($50 billion) in its Net Working Capital, indicative of its cash-generative capabilities. If we were to strip off that cash, its ROIC would go above 70% consistently for the past 5 years

A high ROIC is one factor that is important that I focus on when looking for quality companies. However, for it to be meaningful, a high ROIC must be accompanied by growth. The company must have sufficient opportunities to deploy capital at high rates for compounding to work its magic.

Can Facebook still grow?

Over the past 5 years, Facebook’s revenue growth per has averaged ~42%. It has since given guidance that growth would be expected to range around 20%, which is still an amazing feat given its size.

On a macro level, Facebook benefits from the tailwind of digital ad spending growth. Companies find that they are able to get a better bang for their buck by advertising on Facebook, compared to traditional media platforms such as newspapers and TV. Digital ad spending is now 53.6% of total ad market and it is expected to grow at an ~8% Compounded Annual Growth Rate (CAGR).

Facebook currently seized about 20% of the market share and that figure has been stable over the years. Apart from a growing pie, Facebook has room to seize market share from other players in the digital ad market as they roll out new features (e.g. Stories, Watch Party, Dating etc) which increases their competitive advantage.

Facebook, Google and Amazon’s % share of digital ad spending

Cambridge Analytica Scandal

In 2018, the company was fined $5 billion for the misuse of users information during the Cambridge Analytica scandal. But what has happened since? Since then, the management has aggressively increased spending on R&D by 75%, Marketing & Sales by 109% and General & Admin by a whopping 315%, a pace far greater than revenue growth 73% over the same period.

These numbers are attributed to Facebook’s efforts to hire a lot more staff & increase its investment in security. I take the management’s willingness to act and invest in the long run very positively.

Increased regulation may sometimes inadvertently strengthen a company’s position. Like in the case of Philip Morris (otherwise known for its product Marlboro cigarettes), the regulation in the cigarette industry effectively prevented competition from entering. This protected their profit margins and allowed them to consistently generate high returns for their investors.

Likewise for Facebook, increasing regulatory requirements for social media may increase the barrier of entry for new entrants. As regulators and users increasingly demand higher security features and greater oversight from the platform.

To sum it up

As the leader in social media with a strong network effect, Facebook has successfully navigated the pivotal changes from desktop to mobile, and from posts to stories.

Whether Facebook is able to compound wealth for investors would very much depend on whether it is able to continuously widen its moat, generate high ROIC and continue to grow.

Before we end off, this how profitable Facebook is compared to its FANG peers:

And this is because the content on its platform are free.

Facebook’s Incredible Business Model – Part I

By Steady Compounder | April 15, 2020 | Comments 0 Comment

This write-up will be broken down into 2 parts. In this first part, we will discuss Facebook’s business model and metrics for measuring its success.

Facebook probably has one of the best business models in the world. Even before it went public, the company grew its revenue by 57% and had 36% operating margins. Its business model is similar to a traditional media company, with advertising revenue as the key driver. Facebook has the largest readership base in the world (2.5 billion people) and to top it off, the readers are the ones providing the content for free.

What does Facebook Owns?

Facebook properties consist of 5 products. Most of us are familiar with them and would use 4 out of 5 products on its properties – Facebook, Instagram, Messenger and Whatsapp.

Among all the properties Facebook owns, the company’s 2 main revenue drivers are Instagram (acquired at a bargain price of $1 billion) and Facebook. Facebook’s priority is to continuously invest in these social media platforms.

Messenger and WhatsApp (acquired for $16 billion) are mainly for messaging and are more difficult to monetize. Especially for WhatsApp when they are trying to brand it as less intrusive with its encryption capabilities. However, it does make the platform ‘stickier’. The more functions your users rely on your platform for, the more engagement you will receive, and revenue will follow. Facebook currently has plans to integrate Messenger, WhatsApp and Instagram to increase its platform’s ‘stickiness’.

Oculus was acquired back in 2014 for $2 billion because Zuckerberg believes that Virtual Reality (VR) would be the next major computing platform. Though its success has yet to bear fruits in terms of widespread adoption, Zuckerberg believes that VR could be the next big revolution. It is comforting to know that the management is on its toes preparing for the next big wave. This parallels their massive pivot in strategy during 2011 as users shifted their preferences from surfing Facebook on desktop to smartphone devices browsing.

Network Effect – Exactly how many people are on Facebook?

Across the globe, Facebook splits its business into four geographies:

Rest of World
Asia-Pacific
Europe
US & Canada

With a rising MAU, the company now has approximately 2.5 billion active users on its platform. To put Facebook’s incredible reach in perspective, the world’s population is 7.8 billion, of which 4.6 billion have access to the internet. Due to censorship, let’s remove China’s population of 1.4 billion from the 4.6 billion pool of internet users. That would leave us with 3.2 billion people who could be users of Facebook.

This means that Facebook has captured 78% market share of its total possible users. Think about the amount of data they could collect on its users based on sign up details, photos, likes, friends, and when you log in to other platforms using your Facebook account (e.g. Spotify). It is no wonder their targeted advertisements generate much better returns for their advertisers.

And about 66% of its users check their App at least once a day.

Facebook properties have huge network effects, and the great thing about networks is that as the user numbers grow, their moat widens exponentially as it grows. The size of the platform acts like a magnet for both users and businesses to join. It is able to retain users because that is where all our friends are and likewise, it is difficult for businesses to leave because that is where all its customers are.

How valuable are you to Facebook?

Out of the 2.5 billion users, only 10% are from US and Canada, yet they generate close to 50% of Facebook’s revenue.

From here, we can see that US & Canada’s ARPU is at least 4x the worldwide average.

This leaves a lot of potential for revenue growth from its market outside of the US & Canada. The reasons Facebook gets a higher revenue from US & Canada are largely due to:

Price increases, this is likely attributed to the purchasing power of consumers. The recent article by WSJ suggested that ad rates may have fallen by 25% in Mar 2020 due to COVID-19 induced economic downturn, even though usage has increased by 50%.
The number of ads shown, mature markets tend to have a higher ad load.
Higher engagement, US & Canada users are more likely to share, like and comment. We can expect to see this increase as Facebook rolls out more features such as Live Stream, Watch Party, etc.
More ads clicked, with more targeted ads leads to more clicks and higher cost per click.

Interestingly, we can see that we as Singapore users “brought in” at least USD12.63 worth of revenue for the platform in 2019 and this figure is expected to grow over time.

In my next article, I will further discuss Facebook’s profitability, growth potential and the challenges it faces, including regulatory concerns surrounding the Cambridge Analytica incident. Stay tuned for Part two!

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