There is a single question that drives the fundamental investment thought process perhaps more than any other. Over the long term what allows one business to create significantly more value for shareholders than another, ostensibly similar business? Arguably, there is no definitive answer. History has shown that companies can achieve success in any and every manner conceivable. There is however, one feature so pervasive among those truly outstanding companies as to become a central tenet of value investing and one of the foundational pillars of Clime’s investment process.
It is the ability to generate, retain and reinvest capital at incrementally accretive rates of return. The holy trinity of value creation. The challenge is identifying such companies, preferably early, before their truly outstanding attributes are widely recognised by investors. This is easier said than done but I hope to provide you with some identifiable flags that may make identifying such companies a little easier.
Figure 1. The generate, retain, reinvest cycle
Source. Clime Group
1. Generating Capital
Let’s look at the first characteristic, the ability to generate capital. This tends to be found in companies with sustainable competitive advantages, or what Buffett refers to as economic moats. Such moats are typically a function of operational and reputational superiority, leading to higher market share which sustains pricing power and barriers to entry. These are necessary conditions not only for revenue growth but also for superior levels of profitability; both of which result in greater capital generation. Identifying this characteristic in isolation is not difficult. The ASX has numerous large cap stocks with strong economic moats and dominant market positions.
2. Retaining Capital
Finding those companies that can effectively retain high levels of capital is also reasonably straightforward. This characteristic is defined by high operating margins, low fixed capital commitments and more generally, low capital intensity. This typically translates to high free cash flow generation which we believe is one of the defining features of strong long term investments. Given many market participants value companies as a function of their cash flows or return on investment, again these are not ground breaking concepts.
3. Reinvesting Capital
The real challenge comes down to finding companies with that third characteristic – the ability to reinvest capital at incrementally accretive rates of return. First and foremost, this requires that a large portion of the firm’s free cash flows are reinvested and not distributed. This might be a scary prospect in today’s yield obsessed market environment. Some might even argue it has been made redundant by the incredibly low cost of debt firms currently enjoy. Reinvestment also carries much greater risk than distribution – new projects or expansions may fail and destroy shareholder wealth in the process.
Herein lies the hard part – finding a company that not only has capital to reinvest but also the opportunities to deploy incremental capital into high-return investments. Most large, mature companies, the kind which enjoy the aforementioned economic moats, simply do not have compelling opportunities to deploy capital at incrementally accretive rates of return. And that is why most high ROE companies are unable to sustain elevated levels of profitability over the long term. It also explains the tendency for large caps to maintain high payout ratios, particularly in Australia. This represents a capitulation of sorts, an acknowledgement that the firm cannot generate incrementally accretive returns on investment. For many investors, that is more than fair. High yielding cash cows with disciplined capital distribution policies are some of the most attractive investments in the world. But for those seeking truly outstanding investments, those capable of compounding value by achieving consistently high returns on incremental capital, we believe there must be meaningful reinvestment.
One thing we have found that allows such companies to exist, essentially outside the norms of economic logic is the virtuous cycle. The self-reinforcing network effect that actually increases pricing power, switching costs and barriers to entry the larger the company becomes. We view REA Group, Seek, and Carsales are examples of these types of businesses. Each has accumulated a dominant market share because as they have grown larger, their network effects have grown stronger. Take Carsales for example. The larger the inventory of cars on the site, the stronger the impetus for car sellers and buyers to use it – a self-reinforcing network effect. The same applies for Seek, whereby the scale of the network alone ensures that most job seekers feel obliged to use the platform and hence most employers feel obliged to post their job ads there. These companies hide in plain sight because they trade at significant premiums to the market and can be difficult to justify with traditional fundamental modelling techniques. The challenge for these three going forward is successfully extending their dominant business models beyond the local market. We view Seek as currently being best placed to do this and as such hold it across our portfolios.
Figure 2. SEEK’s virtuous cycle
Sources. Seek; Clime Group
Ultimately, our job as investors is to discern the extent to which the generate, retain, reinvest cycle can persist relative to investor expectations. Where opportunities often lie is when the market has not fully captured the value of compounding, which over time, massively increases the incremental returns on reinvested capital. Opportunities like that are what value investors dream of and ideally, have a meaningful portfolio exposure in, preferably before their outstanding attributes are widely recognised by investors. To leave you with something to think about, this illustration from Connor Leonard of IMC illustrates just how much of a value premium compounding marginal reinvestment can justify if deployed effectively.
*Assumes all earnings not reinvested are distributed as dividends
Figure 3. The power of returns on incremental reinvestment
Source: Connor Leonard (posted on Base Hit Investing)
If you would like to learn more about Seek, REA or Carsales, register for a trial at StocksInValue to read our recent articles.
Written by Damen Kloeckner, Associate Analyst.
Disclosure: Clime Asset Management owns shares in SEK.AX.