Below are some notes from Mason Hawkins' speech at the Ben Graham Center for Investing he gave in 2005.
GOOD COMPANIES
Moats and hidden assets
Quantitative undervaluation and qualitative appeal - competitiveness of business and quality of management
Read trade journals.
Reprice most attractive companies so you have target prices
Read every word of the k/s and read the last five to six.
Read the no. 1 competitors' ks too.
Be careful of combining operating and financial leverage mixed together as you don't know when a recession will occur.
One or the other is reasonably handleable.
Most oil & gas companies have horrible economics.
Coca cola bottlers are good businesses. (Not too sure why?)
Ad companies good because of high FCF generation and ROIC ability
Look at the concentration of business in clients tho.
Saatchi & Saatchi got smacked coz Delta & BA were main clients and then came Gulf War and stock tanked.
Service companies assets are their people - you need LT contracts and no compete agreements in there to ensure you can keep generating high ROICs.
SEARCH STRATEGY
Some screens:
1. ROC over 12% and sell for less than 8x
2. Low price to FCF. i.e. below 10x (average of last 3 years capex and working capital charges is what you take out)
3. All companies below book after intangibles taken out
Look at:
- all companies on new low list
- 10 best investors 13-Fs, e.g. Peter Cundill, have stocks gone down since they bought them?
That warrants attention.
VALUATION
3-methods:
I. Balance Sheet valuations based on today's economics
Inventory adjusted for LIFO + tax liabilities
Receivables etc.
You need to make good adjustments
Intangibles can be incredibly valuable.
What you pay for intangibles should be DCF based.
Liabilities should be cross-checked with footnotes; litigation exposure, pension fund financing etc
What is debt coverage? Is debt manageable?
Buying even a poor business at 1.2 of adjusted book can be a great investment.
II. DCF
The five steps:
1. Use FCF this is cash flow minus working capital charges and maintenance capex
2. Grow out FCF for next 8 years, say they have been growing at 9%, then you wanna grow it out at 6%.
3. Your terminal multiple will be assigned at GDP figures.
4. Then discount at levels way higher than treasuries.
5. Then buy at 60c on the dollar of your valuation.
You do this five hurdles of conservatism and then chuck in qualitative factors, YOU WILL BE FINE.
You need this conservatism coz there are so many inponderables - what rates will be, what management will do etc etc.
Parsimony is also very profitable
Buying at 50c on $ gives you extra compounding effect as business grows.
(If it takes four years to realize value as Hawkins says some businesses can then the compound growth rate here will be 13.6%, this shows why steeper the MOS not only is it safer but the return potential is better)
Discount Rates
In March 2005 US 10-yr treasury yielded 4.5%
Treasury and a few points of risk premium.
But be cautious in low rate environments.
Historically yields have been nearer 6% if risk premium of a few % is tagged on this gives Southeastern's 9% DCF hurdle rate back in March 2005.
N.B. If a business looks too risky don't either bother running a DCF and valuing it, can it.
Terminal Multiple
Terminal multiple should gen be based on LT GDP growth figure and assumes very little/no growth.
So once you hit year nine you multiply projected FCF for year 8 by LT GDP growth rate and then multiply by inverse of your discount rate to get terminal multiple.
E.g. Say company is conservatively expected to grow FCF by 4%pa up to year 8. Year 8 FCF flow is estimated to be $100 and LT GDP growth rate is 2% pa, and you are using a 9% discount rate your terminal multiple is:
(100 x 1.02) x 1/0.09 = $1,133.33 for all cash flows out past year 8 into infinity.
This is then discounted back to present.
You can see more about how Southeastern do their DCF modeling here
(BTW - The various "discount factors" in the table in the linked article are just the discounts that the present value cash flows have compared to their future values)
Problems with DCF Models & Why Good Management Is Important.
The DCF model is essentially a FCF yield model for companies and is thus similar to YTM calculations for bonds.
YTM assumes all coupons occur under steady interest rate environment, this almost always false
You need to grasp what will happen with your coupons in order to gauge your returns.
Unlike a bond where the holder gets the payout and can invest it themselves it is up to company management to invest the FCF coupons on your behalf (this is why competent management is important).
Management needs to be able invest FCF intelligently.
Is working capital eating business up?
Has management done intelligent things like buying back shares when they were cheap e.g. below book?
The company has five choices in how it will invest these FCF coupons:
1. Put in treasuries or pay off debt - usually the yield on treasuries and the cost of their debt will be below your discount rate.
(I.e. not a fantastic use of cash)
2. Put it in earning asset base - i.e. reinvest in business. This will probably earn more than discount rate if company is good.
(Good)
3. Buy shares - worth doing if shares are undervalued by more than the discount rate. (Good)
4. Go on acquisitions - this uses coupons and principal, this can be bad news. Have they made intelligent acquisitions?
5. Return as dividends - if YOU can reinvest at higher than YTM/discount then this is good.
3. Comparable Sales
You adjust comp sales for interest rates in period in which they occured.
Arms-length transactions etc
C/ Discipline and patience - specific price to value settings and ability to wait it out.
2% returns aren;t attractive but 50% losses are even worst.
Great investments are made when you have liquidity and others don't
MARGINS OF SAFETY
If you understand a business PERFECTLY then there is no need for MOS.
The more uncertain you are the more MOS you require.
The bridge 6" above the ground and bridge 2 miles above.
If you don't know how far you can fall, you want a hell of a lot of MOS - that means the bridge has got to be rock solid.
MOS revolves around spectrums of confidence:
The balance sheet at the top is your most confident so you can absolutely load up at this level.
But say with Coke you have to do a DCF so then you are going to be less confident than a company with a wedge of cash on the BS.
Remember the future requires way more MOS.
If there is doubt you can forgo an opportunity
WHEN TO SELL
You can sell when you are fully invested and you find 40c dollar then you sell your 80c dollar to buy into it.
It's the 100% rule you will only swap out if you think upside is 100% on replacement otherwise you stick with it.
Remember you get a ton of frictional costs when you sell.
Wednesday, April 30, 2008
Sunday, April 27, 2008
Francis Chou Speech notes
These are notes from two speeches given by Francis Chou of Chou associates at the Ben Graham Center for Value Investing of the Richard Ivey School of Business in 2006 and 2007.
I have merged the notes I took from both speeches together.
SEARCH STRATEGIES
When you are value investing you want to look at new lows.
Rejection rates are likely to be 90% for most companies you are looking at and that will be done in about a few mins.
Get to know an industry well.
It takes about six months to get to know an industry - high-tech is more time consuming as product cycle obsolescence means it requires a lot of and continuous work, retail is one of the easiest.
You don't have to be everywhere to have great returns, you just gotta know what you're good at. I.e. circle of competence.
Retailer Valuation
For retailing management has to be outstanding as it is a very tough business. (Keep your eye on the jockey)
Focus on:
i) Accts rec in days - 60 days is average for U.S.
ii) Inventory turnover vs. COGS
High inventory turnover is good.
VALUATION
Valuation doesn't have to be very precise - you are gonna take a range instead.
Just have a MOS on the value range
If you get close to 60% of your picks right you are doing extraordinarily well
You should also try and minimize the damage from the 40% that go wrong
How you minimize mistakes is what guarantees your performance
Be diversified when you begin investing.
Balance sheet analysis is very important - you want to look at inventory and receivables control, especially, for retailers.
Is this a good company or a bad company? Valuation approaches for the two categories will be different.
With crap companies if you pick them up at 5-6x earnings they have already priced in so much bad news that they can be quite profitable even when they do not grow.
For good companies the emphasis is on FCF generation, you don't wanna buy above 10x FCF.
GOOD COMPANIES
The holding period for will be longer for good companies than for cigar butts.
Good companies can grow intrinsic value at 10-15% pa so you can see your investments double or triple in about four or five years, and as long as they are compounding it is worth holding on to.
Achieving value for heavily discounted and downtrodden companies can take 2-4 years anyway.
When you 1st start off checklists are very useful.
Good company checklist:
Is the business simple and easy to understand?
Does it have consistent business history over the past 5-10 years?
Will it have favorable long term prospects?
Is management chasing revenue for the sake of revenue?
Is earnings all wrapped up in inventory, receivables etc?
Is it highly leveraged?
Good companies don't need leverage they can fund from equity - if it is highly leveraged then you may want to look at buying the debt.
Capital allocation by the management is very important if the management leaves that is a big concern.
Remember to focus on the jockey not just the horse.
What has the company been doing with shares?
Have they been buying back shares and hiking dividends? This is always a good sign.
Having cash on the bal sheet as a cushion for tough times.
10-20% of shareholder's equity as cash is nothing bad.
BAD COMPANIES
Net-net is nice and easy way to start investing -It's a brain-dead approach and it really works.
You must play these as baskets as they tend to be troubled companies
20 basket is ideal. 3/10 will probably explode.
Always start with the balance sheet in v.investing and particularly net-nets.
Make sure you are not buying a lot of inventory and receivables, cash is best
Look at tangible book value to share and EV to sales as well
Check on current and quick ratios and cash ratio
Be careful about accounts receivable and inventory measures too (in days) - these can be marked down, unlike cash
Income statement is impt but not that impt for net-nets
Look at capital structure is there debt coming due?
Perhaps they have really cheap debt worth buying or convertibles? Check out the YTM it may be fantastic.
Don't buy into companies about to liquidate as this entails loads of costs that eat up NWC.
I have merged the notes I took from both speeches together.
SEARCH STRATEGIES
When you are value investing you want to look at new lows.
Rejection rates are likely to be 90% for most companies you are looking at and that will be done in about a few mins.
Get to know an industry well.
It takes about six months to get to know an industry - high-tech is more time consuming as product cycle obsolescence means it requires a lot of and continuous work, retail is one of the easiest.
You don't have to be everywhere to have great returns, you just gotta know what you're good at. I.e. circle of competence.
Retailer Valuation
For retailing management has to be outstanding as it is a very tough business. (Keep your eye on the jockey)
Focus on:
i) Accts rec in days - 60 days is average for U.S.
ii) Inventory turnover vs. COGS
High inventory turnover is good.
VALUATION
Valuation doesn't have to be very precise - you are gonna take a range instead.
Just have a MOS on the value range
If you get close to 60% of your picks right you are doing extraordinarily well
You should also try and minimize the damage from the 40% that go wrong
How you minimize mistakes is what guarantees your performance
Be diversified when you begin investing.
Balance sheet analysis is very important - you want to look at inventory and receivables control, especially, for retailers.
Is this a good company or a bad company? Valuation approaches for the two categories will be different.
With crap companies if you pick them up at 5-6x earnings they have already priced in so much bad news that they can be quite profitable even when they do not grow.
For good companies the emphasis is on FCF generation, you don't wanna buy above 10x FCF.
GOOD COMPANIES
The holding period for will be longer for good companies than for cigar butts.
Good companies can grow intrinsic value at 10-15% pa so you can see your investments double or triple in about four or five years, and as long as they are compounding it is worth holding on to.
Achieving value for heavily discounted and downtrodden companies can take 2-4 years anyway.
When you 1st start off checklists are very useful.
Good company checklist:
Is the business simple and easy to understand?
Does it have consistent business history over the past 5-10 years?
Will it have favorable long term prospects?
Is management chasing revenue for the sake of revenue?
Is earnings all wrapped up in inventory, receivables etc?
Is it highly leveraged?
Good companies don't need leverage they can fund from equity - if it is highly leveraged then you may want to look at buying the debt.
Capital allocation by the management is very important if the management leaves that is a big concern.
Remember to focus on the jockey not just the horse.
What has the company been doing with shares?
Have they been buying back shares and hiking dividends? This is always a good sign.
Having cash on the bal sheet as a cushion for tough times.
10-20% of shareholder's equity as cash is nothing bad.
BAD COMPANIES
Net-net is nice and easy way to start investing -It's a brain-dead approach and it really works.
You must play these as baskets as they tend to be troubled companies
20 basket is ideal. 3/10 will probably explode.
Always start with the balance sheet in v.investing and particularly net-nets.
Make sure you are not buying a lot of inventory and receivables, cash is best
Look at tangible book value to share and EV to sales as well
Check on current and quick ratios and cash ratio
Be careful about accounts receivable and inventory measures too (in days) - these can be marked down, unlike cash
Income statement is impt but not that impt for net-nets
Look at capital structure is there debt coming due?
Perhaps they have really cheap debt worth buying or convertibles? Check out the YTM it may be fantastic.
Don't buy into companies about to liquidate as this entails loads of costs that eat up NWC.
Monday, January 7, 2008
Maintenance & Growth Capex
In my last post about rejigging Greenblatt ROIC someone asked about maintenance capex and growth capex in calculating free cash flow.
Maintenance capex is the spending a firm makes in its plant and equipment to maintain current output while growth capex is the spending in plant and equipment made to ramp up production. Free Cash Flow attempts to differentiate between the two and but as many companies do not issue a division between expansion & maintenance capex figuring it out is often necessary, and this requires making judgement calls.
Often it is easiest to identify maintenance capex.
HOW TO RECOGNIZE MAINTENANCE CAPEX:
1. Typically for mature businesses most capex will be maintenance capex; depreciation should generally be about equal to capex.
2. Continuously high or stable capex over a number of years that does not lead to increased revenues is also probably all maintenance capex.
3. For rapidly growing firms in fast-changing industries (i.e. tech) most capex will actually be maintenance as is it is unlikely such companies could safely cut capex and maintain market position and cash flows. (Cash flow though may not be a good way to value these businesses though, especially start ups.)
RECOGNIZING EXPANSION CAPEX
1. You can read the management discussion and analysis and see if the firm is embarking on new business lines. If capex has been steady for many years, and suddenly spiked up this difference probably indicates new growth capex.
It is important to read what management is doing though as some companies scrimp on capex for a no. of years and then suddenly end up having to rush to make a load of new capex to keep the business humming along. Calculating the average age of equipment and depreciation policies of the firm and benchmark to industry norms is another way to confirm this.
2. If cap ex is significantly higher than depreciation it could indicate new growth cap ex. (Again caveats about management that has been less than generous on capex in the previous years applies to this).
Still, some people - like Whitney Tilson on this post - ignore the difference between the two types of capex completely and deduct the whole lot. The argument being this is generally a conservative way of arriving at FCF.
However, even if you do this there is still the question of how one treats acquisitions. Acquisitions fuel the growth of some companies and should be considered capex.
In particular, if a company is a serial acquirer acquisitions will be part of its strategic business operations... therefore, for these firms acquisitions are capex. How do you figure this out? Read the company literature and make your call.
Deducting Depreciation and Amortization Rather Than Cap Ex
If companies are investing heavily in growth, then the lower D&A figure should be closer maintenance capex costs than the full blown capex numbers. So you may want to go for the D&A number to get normalized FCF, especially, if you foresee the expansion phase ending soon.
D&A can also be useful to approximate FCF when capex is highly lumpy and erratic as the D&A figures tend to be smoother. Alternatively, you can create a normalized capex figure over a period of time to calculate FCF.
Maintenance capex is the spending a firm makes in its plant and equipment to maintain current output while growth capex is the spending in plant and equipment made to ramp up production. Free Cash Flow attempts to differentiate between the two and but as many companies do not issue a division between expansion & maintenance capex figuring it out is often necessary, and this requires making judgement calls.
Often it is easiest to identify maintenance capex.
HOW TO RECOGNIZE MAINTENANCE CAPEX:
1. Typically for mature businesses most capex will be maintenance capex; depreciation should generally be about equal to capex.
2. Continuously high or stable capex over a number of years that does not lead to increased revenues is also probably all maintenance capex.
3. For rapidly growing firms in fast-changing industries (i.e. tech) most capex will actually be maintenance as is it is unlikely such companies could safely cut capex and maintain market position and cash flows. (Cash flow though may not be a good way to value these businesses though, especially start ups.)
RECOGNIZING EXPANSION CAPEX
1. You can read the management discussion and analysis and see if the firm is embarking on new business lines. If capex has been steady for many years, and suddenly spiked up this difference probably indicates new growth capex.
It is important to read what management is doing though as some companies scrimp on capex for a no. of years and then suddenly end up having to rush to make a load of new capex to keep the business humming along. Calculating the average age of equipment and depreciation policies of the firm and benchmark to industry norms is another way to confirm this.
2. If cap ex is significantly higher than depreciation it could indicate new growth cap ex. (Again caveats about management that has been less than generous on capex in the previous years applies to this).
Still, some people - like Whitney Tilson on this post - ignore the difference between the two types of capex completely and deduct the whole lot. The argument being this is generally a conservative way of arriving at FCF.
However, even if you do this there is still the question of how one treats acquisitions. Acquisitions fuel the growth of some companies and should be considered capex.
In particular, if a company is a serial acquirer acquisitions will be part of its strategic business operations... therefore, for these firms acquisitions are capex. How do you figure this out? Read the company literature and make your call.
Deducting Depreciation and Amortization Rather Than Cap Ex
If companies are investing heavily in growth, then the lower D&A figure should be closer maintenance capex costs than the full blown capex numbers. So you may want to go for the D&A number to get normalized FCF, especially, if you foresee the expansion phase ending soon.
D&A can also be useful to approximate FCF when capex is highly lumpy and erratic as the D&A figures tend to be smoother. Alternatively, you can create a normalized capex figure over a period of time to calculate FCF.
Tuesday, December 25, 2007
GREENBLATT ROIC
Greenblatt's ROIC formula in The Little Book That Beats The Market is
ROIC = EBIT/Net Working Capital + Net Fixed Assets
For the 20-30 stock TLBTBTM portfolio this is a good quick and dirty calculation. But if you run more concentrated portfolios and do single stock selection then I think it may need tweaking.
Firstly, Greenblatt notes in TLBTBTM's epilogue his version of Roic is unsuitable for utilities or financials. Beyond this McKinsey's observations (see last post) on low capital base firms apply.
The next issue with Greenblatt Roic is it assumes EBIT is approximate to FCF, i.e., Depreciation and Amortization are equal to capex. This should be so most of the time but there are cases when it is not.
Some companies also may have different depreciation policies, e.g. DDB versus SLD, which may distort EBIT comparisons and may need adjustment.
Companies where capex is higher than D&A are investing increasing amounts in their business (assuming the line item for D&A is mostly depreciation). By itself, this is neither good nor bad -- it depends on how wisely the firm deploys the money.
Actually, Mr. Greenblatt himself thinks EBITDA - Maintenance capex
may be a more useful metric for pre-tax discretionary free cash flow.
Acquisitions used to grow or run the business may also need to be factored in as capex.
Another issue may also arise when companies utilise capital leases as opposed to operating leases, their 'lease expense' will instead appear as an interest expense lower down the P&L, distorting EBIT. Here one needs to go into the cash flow statement and find the real lease expense and adjust accordingly.
These issues should have a minor impact but they are worth being aware of.
Finally, the denominator of the formula may not account for all capital and assets required in the line of business. Some companies will rely on off-balance sheet arrangements, such as, operating leases, take-or-pay agreements, use of subsidiaries, sales of receivables and so on.
For companies with large amounts of operating leases McKinsey's criticisms of Roic may apply or one could correct the net fixed asset figure. This can be done either via conversion of the operating lease payments to a capital lease or seeing what other similar companies' asset bases are and the cost of those assets.
Sale of receivables without recourse (revealed in the footnotes) will distort net working capital, profits from such sales should be added back into current assets.
Take-or-pay/throughputs. Best to look at similar companies here and see how widespread these funding agreements are. You may want to take the present value of these payments and add them into the company's fixed asset or working capital base.
Perhaps an improved Greenblatt Roic calculation for picking single stocks would be;
EBITDA adjusted for capital leases - (capex + relevant acquisitions)/Net Working Capital + Net Fixed Assets
Where in the denominator
Net working capital = (current assets - liquidity on hand + funds from sale of receivables) - (current liabilities - short term borrowings)
and
Net fixed assets = tangible fixed assets adjusted for use of operating leases & throughput agreements- construction in progress.
ROIC = EBIT/Net Working Capital + Net Fixed Assets
For the 20-30 stock TLBTBTM portfolio this is a good quick and dirty calculation. But if you run more concentrated portfolios and do single stock selection then I think it may need tweaking.
Firstly, Greenblatt notes in TLBTBTM's epilogue his version of Roic is unsuitable for utilities or financials. Beyond this McKinsey's observations (see last post) on low capital base firms apply.
The next issue with Greenblatt Roic is it assumes EBIT is approximate to FCF, i.e., Depreciation and Amortization are equal to capex. This should be so most of the time but there are cases when it is not.
Some companies also may have different depreciation policies, e.g. DDB versus SLD, which may distort EBIT comparisons and may need adjustment.
Companies where capex is higher than D&A are investing increasing amounts in their business (assuming the line item for D&A is mostly depreciation). By itself, this is neither good nor bad -- it depends on how wisely the firm deploys the money.
Actually, Mr. Greenblatt himself thinks EBITDA - Maintenance capex
may be a more useful metric for pre-tax discretionary free cash flow.
Acquisitions used to grow or run the business may also need to be factored in as capex.
Another issue may also arise when companies utilise capital leases as opposed to operating leases, their 'lease expense' will instead appear as an interest expense lower down the P&L, distorting EBIT. Here one needs to go into the cash flow statement and find the real lease expense and adjust accordingly.
These issues should have a minor impact but they are worth being aware of.
Finally, the denominator of the formula may not account for all capital and assets required in the line of business. Some companies will rely on off-balance sheet arrangements, such as, operating leases, take-or-pay agreements, use of subsidiaries, sales of receivables and so on.
For companies with large amounts of operating leases McKinsey's criticisms of Roic may apply or one could correct the net fixed asset figure. This can be done either via conversion of the operating lease payments to a capital lease or seeing what other similar companies' asset bases are and the cost of those assets.
Sale of receivables without recourse (revealed in the footnotes) will distort net working capital, profits from such sales should be added back into current assets.
Take-or-pay/throughputs. Best to look at similar companies here and see how widespread these funding agreements are. You may want to take the present value of these payments and add them into the company's fixed asset or working capital base.
Perhaps an improved Greenblatt Roic calculation for picking single stocks would be;
EBITDA adjusted for capital leases - (capex + relevant acquisitions)/Net Working Capital + Net Fixed Assets
Where in the denominator
Net working capital = (current assets - liquidity on hand + funds from sale of receivables) - (current liabilities - short term borrowings)
and
Net fixed assets = tangible fixed assets adjusted for use of operating leases & throughput agreements- construction in progress.
Monday, December 10, 2007
Return On Invested Capital (ROIC) measures the levels generated by each dollar of capital invested in a company's operations and how profitably management is able to allocate capital to generate cash flow over its weighted cost of capital (WACC).
ROIC-WACC spreads are KEY to value creation. Firms whose ROIC exceed their WACC generate positive net cash flow, creating value; while a company whose ROIC equals its WACC neither creates nor destroys value.
Generally, companies with higher ROIC-WACC spreads are more valuable and command higher multiples.
If a company is selling for, or below, book you can be fairly sure it has not earned its WACC in the recent past.
Firms can create value by one of three avenues:
1. Reallocating/improving use of existing capital to increase the spread.
2. Deploying more invested capital into current operations or investing in new projects provided returns generated by either generate marginal ROIC in excess of WACC.
3. Lowering their WACC.
CAN YOU SEE THE FIRM YOU ARE INVESTING IN DOING THIS? AS THIS WILL BE KEY TO CREATING SHAREHOLDER VALUE!
Increasing industrywide and extraordinarily high ROICs are hallmarks of young, strong and growing sectors. In contrast, sequential declines, or marginal ROICs below historical ROIC (barring seasonal factors), may indicate a mature industry where long-term investment opportunities are waning.
Consistently high ROIC-WACC spreads generally equate to the 'moats' that many investors seek. One very rough way of gauging a 'moat' would be to look to see whether a company maintains a high ROIC-WACC spread for several years.
Again, as a rough rule of thumb, WACCs for most U.S. companies range between 9-13%, so ROICs consistently in the mid to high teens allude to something Moat-like and worth digging into.
PROBLEMS WITH ROIC IN GENERAL
ROIC solves some of the P/E ratio's pitfalls, particularly, PER fails to illuminate whether firms are producing value, or how much capital firms consume to produce earnings. But like all metrics ROIC has its pitfalls.
First off, you obviously need to monitor the trend. ROIC in the high teens may be great, but less so when its come off a base in the 20% range.
More critically, ROIC can be problematic for companies with very low invested capital bases. E.g., companies that outsource production, like software development firms, and most services firms, like advertising agencies, will have very low invested capital bases.
McKinsey & Co. point out for companies with invested capital below 25% of revenue ROIC may not be a fantastic benchmark as small changes in capital requirements can cause the ROIC to be both very large and volatile from period to period.
Some solutions would be to;
1. Normalize capex over a period to smooth out volatility
2. Or not use ROIC altogether, McKinsey offer an alternative calculation for those interested, in the above link.
It is also not helpful to compare ROIC across industries. In 2004, system software development companies' median invested capital as percentage of revenue was -3% compared to 163% for hotels, resorts and cruise liners, according to McKinsey.
ROIC CALCULATION
There are two equations used for calculating ROIC that I have seen used most frequently:
1. The standard ROIC formula
Net Operating Profit After Tax/ Average Invested Total Capital
2. The Greenblatt Method
EBIT/Net Working Capital + Net Fixed Assets
I'm going to focus on the second method in my next post as it seems to have captured value investors' attentions recently. Handily, the Greenblatt method is, I think, more intuitive than the traditional method and easier to calculate.
ROIC-WACC spreads are KEY to value creation. Firms whose ROIC exceed their WACC generate positive net cash flow, creating value; while a company whose ROIC equals its WACC neither creates nor destroys value.
Generally, companies with higher ROIC-WACC spreads are more valuable and command higher multiples.
If a company is selling for, or below, book you can be fairly sure it has not earned its WACC in the recent past.
Firms can create value by one of three avenues:
1. Reallocating/improving use of existing capital to increase the spread.
2. Deploying more invested capital into current operations or investing in new projects provided returns generated by either generate marginal ROIC in excess of WACC.
3. Lowering their WACC.
CAN YOU SEE THE FIRM YOU ARE INVESTING IN DOING THIS? AS THIS WILL BE KEY TO CREATING SHAREHOLDER VALUE!
Increasing industrywide and extraordinarily high ROICs are hallmarks of young, strong and growing sectors. In contrast, sequential declines, or marginal ROICs below historical ROIC (barring seasonal factors), may indicate a mature industry where long-term investment opportunities are waning.
Consistently high ROIC-WACC spreads generally equate to the 'moats' that many investors seek. One very rough way of gauging a 'moat' would be to look to see whether a company maintains a high ROIC-WACC spread for several years.
Again, as a rough rule of thumb, WACCs for most U.S. companies range between 9-13%, so ROICs consistently in the mid to high teens allude to something Moat-like and worth digging into.
PROBLEMS WITH ROIC IN GENERAL
ROIC solves some of the P/E ratio's pitfalls, particularly, PER fails to illuminate whether firms are producing value, or how much capital firms consume to produce earnings. But like all metrics ROIC has its pitfalls.
First off, you obviously need to monitor the trend. ROIC in the high teens may be great, but less so when its come off a base in the 20% range.
More critically, ROIC can be problematic for companies with very low invested capital bases. E.g., companies that outsource production, like software development firms, and most services firms, like advertising agencies, will have very low invested capital bases.
McKinsey & Co. point out for companies with invested capital below 25% of revenue ROIC may not be a fantastic benchmark as small changes in capital requirements can cause the ROIC to be both very large and volatile from period to period.
Some solutions would be to;
1. Normalize capex over a period to smooth out volatility
2. Or not use ROIC altogether, McKinsey offer an alternative calculation for those interested, in the above link.
It is also not helpful to compare ROIC across industries. In 2004, system software development companies' median invested capital as percentage of revenue was -3% compared to 163% for hotels, resorts and cruise liners, according to McKinsey.
ROIC CALCULATION
There are two equations used for calculating ROIC that I have seen used most frequently:
1. The standard ROIC formula
Net Operating Profit After Tax/ Average Invested Total Capital
2. The Greenblatt Method
EBIT/Net Working Capital + Net Fixed Assets
I'm going to focus on the second method in my next post as it seems to have captured value investors' attentions recently. Handily, the Greenblatt method is, I think, more intuitive than the traditional method and easier to calculate.
Wednesday, December 5, 2007
Back Again and some stuff to come on ROIC
Sorry for being away for almost six months. Have been studying for the CFA level one, which was quite time consuming.
Anyway, thankfully it is now all over and done with and its december, which means stuff has quitened down and Xmas rolls around... and I now have some more time on my hands to post. I will be posting some stuff on Return On Invested Capital calculations over the next few days....
Anyway, thankfully it is now all over and done with and its december, which means stuff has quitened down and Xmas rolls around... and I now have some more time on my hands to post. I will be posting some stuff on Return On Invested Capital calculations over the next few days....
Thursday, June 28, 2007
Spac Structure
Below is a rundown of the typical Spac structure, variants do exist though: be sure to check the S-1. In fact, it’s usually Spacs with unusual features that make good investments. That's why Baupost probably went for Star Maritime Acquisition (SEA) (links to Value Investor Club write up, membership required).
Spacs are sold in “units”, which are composed normally of one common stock and one or two in-the-money warrants. Check in what kind area the Spac is looking to make a deal in, what the composition of the units are, and how many are being sold to the public. You also want a solid management team; that’s who you are betting on to go get an acquisition together.
You can find what Spacs are coming to market by going to the SEC website and doing an Advanced Search under S-1 filings in Form Type. In “Search for Text” type “blank check company”.
Sometimes, the underwriter will defer all or part of their IPO fees (usually 6% of market cap) and wait till an acquisition/merger is sealed before collecting. This is likely to also put pressure, or incentivize (depending on your perspective), management to bag a deal - it's hard to imagine iBankers doing a deal if they didn't think there would be some fee payoff.
In addition to funds raised via the IPO of units, management typically buys 20% of equity in a private placement, which may or may not be in the form of common stock or warrants, and normally sold at way below the public offering price of the units. Yes, they benefit a disproportional amount if a deal pulls off, but then they have to go scour for the deal plus warrants cannot be exercised until a deal has been completed. Management's warrants sometime come with a 2-3 year lock-up. Basically, this prevents them from off-loading and doing a runner if they get bored.
In some cases, management must buy warrants at a set price on the open market, supporting warrant prices for investors, and ensuring management has more of their money on the line. Management thus has some “skin in the game” whatever the flotation's intricacies.
Spacs are working against a ticking clock, they must seal a deal in 18 months with a 6-month extension if a deal has been announced but not completed within the initial 18 months.
Also it is normal for at least 85% of proceeds from the IPO to be kept in trust, so management can't cane the money on margaritas and lap dancers in Cancun. So while management are hunting for a target the cash accumulates interest, although not always at full money market rates – you need to check the interest payments in the financials to gauge what the trust acct pays.
Theoretically, the money in trust is safe… but it has been pointed out those funds may not be immune to third party claims and shareholders claims may be secondary to other claimants. That having said, I haven’t heard of a case where a Spac has been successfully sued over funds in trust and if the Spac is purely equity-financed its hard to see who else is likely to be above the shareholders in terms of claimants. (If you know of any incidents where shareholders claims have been made secondary to another party, or the funds in trust have been subject to third party claims PLEASE LET ME KNOW).
Once a deal is announced management needs 80% (exceptions exist though) of shareholders backing. The Spac must also use up 80% of cash in their trust for the deal. If a proposal is rejected the Spac shareholders can also force the vehicle to liquidate.
While it is rare, investors have shot down deals before. In December 2006 investors at TAC Acquisition Corp (TACAU) gave the thumbs down for an acquisition of Aviel Systems. In February shareholders approved a dissolution of the company. Obviously, the warrants went up in smoke as they were contingent on a deal being sealed, but the common stk got reimbursed. Holders of common stock received $5.6941 in cash per share; units had originally gone for $6.
Nonetheless, even if YOU don't like the deal and it still gets an 80% thumbs up from other investors you can still cash out (assuming you hold common stock in the Spac) and receive cash in proportion to your slice of funds in the trust. There may be some charges however if the deal receives shareholders' blessing but you decide to liquidate.
One issue which I'm not entirely sure on and would be interesting to check is if you decide to liquidate in the event a deal goes through and you are still holding the original units, presumably your common stock is dissolved but do you still get to hold onto your warrants? Does anyone know?
Anyway, that's the basic lowdown on Spac structure. If you're interested in a much more detailed breakdown of Spacs then check out this link.
In the next post I'll look at why value investors may be interested in these vehicles.
Spacs are sold in “units”, which are composed normally of one common stock and one or two in-the-money warrants. Check in what kind area the Spac is looking to make a deal in, what the composition of the units are, and how many are being sold to the public. You also want a solid management team; that’s who you are betting on to go get an acquisition together.
You can find what Spacs are coming to market by going to the SEC website and doing an Advanced Search under S-1 filings in Form Type. In “Search for Text” type “blank check company”.
Sometimes, the underwriter will defer all or part of their IPO fees (usually 6% of market cap) and wait till an acquisition/merger is sealed before collecting. This is likely to also put pressure, or incentivize (depending on your perspective), management to bag a deal - it's hard to imagine iBankers doing a deal if they didn't think there would be some fee payoff.
In addition to funds raised via the IPO of units, management typically buys 20% of equity in a private placement, which may or may not be in the form of common stock or warrants, and normally sold at way below the public offering price of the units. Yes, they benefit a disproportional amount if a deal pulls off, but then they have to go scour for the deal plus warrants cannot be exercised until a deal has been completed. Management's warrants sometime come with a 2-3 year lock-up. Basically, this prevents them from off-loading and doing a runner if they get bored.
In some cases, management must buy warrants at a set price on the open market, supporting warrant prices for investors, and ensuring management has more of their money on the line. Management thus has some “skin in the game” whatever the flotation's intricacies.
Spacs are working against a ticking clock, they must seal a deal in 18 months with a 6-month extension if a deal has been announced but not completed within the initial 18 months.
Also it is normal for at least 85% of proceeds from the IPO to be kept in trust, so management can't cane the money on margaritas and lap dancers in Cancun. So while management are hunting for a target the cash accumulates interest, although not always at full money market rates – you need to check the interest payments in the financials to gauge what the trust acct pays.
Theoretically, the money in trust is safe… but it has been pointed out those funds may not be immune to third party claims and shareholders claims may be secondary to other claimants. That having said, I haven’t heard of a case where a Spac has been successfully sued over funds in trust and if the Spac is purely equity-financed its hard to see who else is likely to be above the shareholders in terms of claimants. (If you know of any incidents where shareholders claims have been made secondary to another party, or the funds in trust have been subject to third party claims PLEASE LET ME KNOW).
Once a deal is announced management needs 80% (exceptions exist though) of shareholders backing. The Spac must also use up 80% of cash in their trust for the deal. If a proposal is rejected the Spac shareholders can also force the vehicle to liquidate.
While it is rare, investors have shot down deals before. In December 2006 investors at TAC Acquisition Corp (TACAU) gave the thumbs down for an acquisition of Aviel Systems. In February shareholders approved a dissolution of the company. Obviously, the warrants went up in smoke as they were contingent on a deal being sealed, but the common stk got reimbursed. Holders of common stock received $5.6941 in cash per share; units had originally gone for $6.
Nonetheless, even if YOU don't like the deal and it still gets an 80% thumbs up from other investors you can still cash out (assuming you hold common stock in the Spac) and receive cash in proportion to your slice of funds in the trust. There may be some charges however if the deal receives shareholders' blessing but you decide to liquidate.
One issue which I'm not entirely sure on and would be interesting to check is if you decide to liquidate in the event a deal goes through and you are still holding the original units, presumably your common stock is dissolved but do you still get to hold onto your warrants? Does anyone know?
Anyway, that's the basic lowdown on Spac structure. If you're interested in a much more detailed breakdown of Spacs then check out this link.
In the next post I'll look at why value investors may be interested in these vehicles.
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