Imagine a hypothetical company that is able to grow its earnings by 20% each year. At this rate of earnings growth, $100 of earnings will increase to $250 in just 5 years. This is a fantastic rate of earnings growth, but is this company a good business? The answer is “maybe”, and to arrive at the correct conclusion it’s necessary to consider the level of investment required to achieve that earnings growth.
Growth in earnings viewed in isolation is not helpful. Rather, there are a few moving parts to remember when making a quality assessment about a business: (i) the level of capital required to achieve growth in earnings; (ii) the return on incremental invested capital; and (iii) the cost of that capital. There are three broad categories businesses fall into when using this framework.
1) Businesses with minimal reinvestment needs and high returns
The first category involves businesses that are capable of earning high returns, yet are able to achieve this growth with only minor incremental investments. These are typically businesses with pricing power, and a business that can routinely put through price increases to customers usually possesses some sort of competitive advantage.
Let’s use the example of a business that operates a toll road located on a bridge that people use to drive into town. The business effectively has a monopoly over this traffic, given that it is the only bridge to access the town. The lack of an alternative for these motorists, and the fact that they need to use the bridge each day to commute to work, means that this business has pricing power. It can increase its prices by 15% per year and motorists will be forced to pay this (but only if the benefit of traveling to town continues to outweigh the cost).
The price increases require no incremental capital, and thus fall through to the bottom line. The table below illustrates the enormous incremental ROIC for a business such as the toll road which can grow with minimal capital reinvestment.
These businesses spin off a lot of cash and the 5% reinvestment rate implies that 95% of the company’s earnings are available for distribution to shareholders. This is an attractive investment to the extent that an investor has additional investment opportunities where that free cash flow can be deployed. This brings us to the second category of businesses.
2) Businesses with some reinvestment needs, but good returns on incremental investments
These businesses require a portion of their earnings to be reinvested each year, and they are able to earn decent returns on this incremental invested capital. A key difference between category 1 and category 2 is the degree to which there are opportunities within the business for capital to be put to work.
Category 2 businesses might be growing their revenues and earnings through a combination of volume growth and price increases, whereby reinvestments must be made in say, new plants and machinery to support the extra volumes. Consider the table below, where Business #2 is growing NOPAT by the same 20% as Business #1, but it requires a greater amount of capital to achieve this growth. It is worth noting the higher reinvestment rate as well as the more moderate returns on incremental capital for Business #2.
An important point to note is that for a business that is achieving a 23% return on incremental capital, and one that has adequate reinvestment opportunities, it is sensible to continue to reinvest earnings back into the company. Using the example above, investors have the choice of investing 70% of their earnings back into the business at a 23% return, or taking all of the earnings in the form of a dividend. If investors choose the dividend, but are unable to reinvest these earnings in other investment opportunities where they can earn 23% on their capital, then they are making a sub-optimal investment choice.
The third category of businesses is one that should be avoided, unless one is looking for short opportunities.
3) Businesses with heavy reinvestment needs which fail to earn adequate returns on incremental investments
Category 3 businesses destroy shareholder to the extent that they continue to invest in the business at a rate where their ROIC is below the business’ cost of capital. These are typically businesses in highly competitive industries where it is difficult to earn a satisfactory return on capital. Airlines are good examples of category 3 businesses, whereby the industry has an insatiable demand for capital in the form of additional airplanes, yet the competitive dynamics amongst airlines as well as input cost volatility make it difficult to eke out adequate returns through the cycle.
The example below shows the paltry 4% incremental return on invested capital for Business #3, a number surely below the company’s cost of capital. To achieve the same 20% earnings growth as Businesses #1 and #2, Business #3 needs to invest an extraordinary amount of additional capital. Interestingly, the reinvestment rate in this businesses over 2006 to 2016 is 365% of the cumulative earnings over that period. This implies that this business would need to tap external sources of capital to fund its growth, given that it is reinvesting more than it earns over an extended period.
These sorts of low-returning businesses that fund their capital investments with debt can run into trouble down the line if these low returns on capital persist and the debt-servicing ability of the firm becomes compromised. Category three businesses are a fertile hunting ground for short opportunities and the Montaka team plays close attention to the abovementioned factors when assessing candidates for the portfolio.
The above framework is crucial when considering investment opportunities, and may help investors avoid the pitfalls of seemingly “cheap” companies that are actually destroying shareholder capital as they grow, as well as support the identification of businesses with superior economics that are able to compound capital over time.
George Hadjia is a Research Analyst with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.