The science of compounding
A primer on capital allocation, ROIC and valuation.
I don’t know about you but charts like this make me smile. Sure, the modern world has its problems, but there is no other time in world history where anyone, regardless of class or status can partake in such magnificent wealth creation.
The image above is a chart of AAPL 0.00%↑ and I’ve been a happy owner since December 2018.
The only reason to invest
At the end of the day, every investor is doing the same thing regardless of the method chosen to do it. We sacrifice our time learning accounting, corporate finance and looking for our next big idea. This is time that could have been spent golfing, surfing or hanging out with friends but we sacrifice these things for a better future,
There’s a few things that dramatically shape the outcome of our investment efforts, Security selection and capital allocation. In this article I intend to break these down.
Key takeaways
Security selection- The investors job is to control his temperament and prudently wait for select opportunities.
Capital allocation- Managements job is to be good stewards of shareholders capital.
ROIC is the way.
Reinvestment rate and the math behind compounding.
Valuation does in fact matter.
Security selection
As a stock picker your returns will come from two different sources over the long term, your ability to pick stocks and the companies ability to allocate capital.
The success of your stock picking over the long term will be determined by your ability to do three things
Control your emotion nature
Buffet famously said that he doesn’t swing the bat until an investment is pitched right in his sweet spot. This sweet spot is dictated by his personality and what makes him comfortable. If he isn’t comfortable with an investment he doesn’t swing.
The best investors can anticipate and avoid situations that will contribute to irrational behavior and compromised decision making and they know their sweet spot and stick to it.
So the principal here is to learn from the experts but know yourself so you can use their wisdom to formulate a strategy that works for you and allows you to sleep well at night.
Manage your risk
This could mean many things, for some people risk management means owning stocks with solid bottom line earnings, to others it means only buying super cheap stocks and never overpaying, to others it means diversification or avoiding volatility.
For me risk management means constantly being a student of business, accounting and markets. It also means not concentrating any single investment above 20-25% of my portfolio because this causes me to lose sleep and I like my sleep more than I like my stocks.
Find great businesses with good management
I’ll get into this in more detail later but this is an important skill to develop.
Think in probabilities
You don’t need to be a statistics major to understand the importance of probabilistic thinking. It didn’t take a rocket scientist to see when META 0.00%↑ was trading at p/e of 10 in 2022 the chances of making money were probably a little higher than the chances of losing money. We should be looking for these types of opportunities that have favorable odds. As Monish Pabrai said
“heads I win, tails I don’t lose much”
Capital allocation
Capital allocation is the process of efficiently investing and managing a companies financial resources in order to maximizes shareholder value.
Obviously it’s natural for management to be good stewards of company resources when they themselves are owners of it. It’s no surprise that many of the best performing companies are run by management that owns a significant stake in the company.
Regardless, for every dollar that a business earns or borrows, management must choose to do 1 of 4 things with it.
Internal investment that will drive new organic growth.
Aquire other businesses.
Repurchase company stock.
Pay a dividend to shareholders.
Depending on your investment strategy, the preferred use of capital is usually in the order presented above. First and foremost, the most efficient and practical way to use capital is to grow the business organically through internal investment. Capital re-invested within a business can not only drive new sales but some of the investments will obviously be expensed against sales, lowering taxable income.
Compare this to dividends, sure the cash goes in our pocket but not before its taxed twice, once at the corporate level and once at the investor level.
Acquisitions can also be a great source of inorganic growth if done prudently. Acquisitions and internal investment are two methods of growth are generally the biggest drivers of shareholder value in the long term. If done successfully, these can produce returns on capital that are highly beneficial for shareholders, especially if done over long periods of time.
“It’s obvious that if a company generates high returns on capital and reinvests at high returns, it will do well. But this wouldn’t sell books” - Charlie Munger
Dividends and buybacks are the best use of capital when there’s no other obvious organic or inorganic opportunities to pursue.
The best management teams reward shareholders when they are good stewards of company resources.
Return on invested capital ROIC
Focusing on returns on capital, there are a few things that need to go right in order to produce a return.
Capital is invested to produce goods or services
Goods and services produce sales
Costs are expensed against sales to produce some kind of earnings
Capital is re-invested to produce goods and services again
If we are interested in the efficiency of a business, the natural question is how much capital is being invested and how much profit is being earned from it? Obviously the ideal business would consume nothing at all and produce endless earnings, but in reality it takes capital to produce capital, so what we want to know is how much capital is consumed relative to how much is produced. This will determine a businesses ROIC.
The drivers of high returns on capital are
Low capital requirements (asset/capital light business)
Outsized earnings compared to capital requirements (strong competitive position/high margins)
It’s either one or both of these that drive high returns on capital. There are a few ways to calculate ROIC but the idea is basically the same regardless of the formula. Earnings/total invested capital. Here are some of the different formulations of this
(earnings-dividends) / (debt + equity)
(earnings) / (debt + equity - goodwill)
(NOPAT) / (fixed assets + working capital)
(EBIT) / (fixed assets + working capital)
(EBITA) / ( fixed assets + working capital)
You get the picture, its some form of earnings divided by some formulation of invested capital.
A business that invests $10 and produces $2.5 has an ROIC of 25%. We shouldn’t stop our analysis here because this doesn’t explain how much money is being reinvested year after year. This brings us to reinvestment rate.
Reinvestment rate
Note: John Huber does an amazing series on ROIC and reinvestment rate in his notes at sabercapitalmgt.com. It’s all worth reading. Much of the following is just expounding on/ re-working his (and his friend Connor Leonards) ideas concerning return on incremental capital and re-investment rates.
As a simplistic thought experiment lets assume a company begins in year one by investing $10 and is able to generate a $2.5 profit which is a 25% ROIC. Then the company reinvests 90% of that profit at the same rate of return and this repeats until year 10. The two forces at work are
A. How much money is re-invested (reinvestment rate)
B. What are the returns on that investment (ROIC)
If you are able to determine these two things and multiply them, it will reveal the firms “intrinsic compounding rate” The formula is
Intrinsic compounding rate = (reinvestment rate * returns on invested capital) as seen below in row 8 (B7*B4)
Below is an outworking of this hypothetical 10 year scenario. As 90% of earnings are re-invested at a 25% ROIC, the companies intrinsic value compounds at 23%. The companies earnings per share EPS are represented at the bottom as the company earnings grow.
Valuation
Identifying a good business that can generate high returns on capital for a long period of time is a very important factor in compounding, another very important factor is buying at a reasonable price.
To continue this thought experiment from above, we are going to examine the importance of valuation. Imagine you invested $1,000 in year 1, as noted above when EPS was $0.025. You bought at various P/E multiples of 10x, 15x and 20x, which yielded a share price of $0.25, $0.38 and $0.50. Then the company compounded EPS at 23% as indicated above, and by year 10 the multiple had expanded to 30x. The results would be as follows
It’s clear that the combination of valuation expansion and earnings growth are a recipe for incredible returns. Although it’s not often you’ll find a company reinvesting at 90%, generating 25% ROIC for long periods of time and trading at a p/e of 10. You also don’t need this setup to do very well as an investor. This same company trading at 25-45x earnings can still do very well so long as capital is compounded at similar rates.
A 17-25% return is a great return over time. It’s important to understand this is a simplified example of compounding, businesses in excel is not like business is real life. Real returns are messy, lumpy and more unpredictable and invested capital is difficult to determine because capital requirements are different for each company.
It’s also important to note that share repurchases increase compounding on a per share basis. The same result may be amplified by share buybacks.
I will do another article in the future on the science of share buybacks and how they affect returns. For now I hope this was helpful in understanding the importance of compounding.
Thanks for reading!