“Charlie and I for decades said that the best businesses don’t need capital and that’s still the case”

Warren Buffett

In my last article in i3investor in the link below,

https://klse.i3investor.com/blogs/kcchongnz/2020-02-04-story-h1483049632-Quality_Investing_kcchongnz.jsp

I mentioned that, “For most people, it is better to invest in quality companies for long-term. But that doesn’t mean one should pay any price for a quality company.”

This is particularly applied to young people who can leverage on time and the power of compounding, and those busy investors who have not much time to watch over the stock market but wish to build long-term wealth, steadily, safely but surely.

I have also discussed the qualitative attributes of qualities companies as summarized below,

1. makers of short-lived products with well-known brand names
2. providers of service/products that always must be/are purchased
3. companies whose products are sold at a distinct premium due to brand name, image, technology or quality
4. providers of products that are in demand due to external influences and regulations
5. businesses that have a high level of scalability, i.e. whose marginal cost is close to zero
6. providers of the cheapest product in the market

All the above qualitative attributes are important. However, they are subjective. In this article, we will use some objective and quantifiable measures to describe some of the attributes of a quality company.

In profitability of a business, most investors think a quality business must have high margins.  However, the profitability of a business can also be enhanced with higher sales, or high asset turnover, and appropriate use of financial leverage. In my opinion, the most important metric to identify a quality and profitable business is the return on capitals. That is a combination of the three factors just mentioned.

Return on capital allows investors to quickly see how much profit the company is driving from the money that’s been entrusted to it by either stock (equity) investors or a combination of stockholders and debt holders.

If capital is provided solely by the stockholders, the return of equity (ROE) is measured by,

ROE = Net Profit / Total equity = NP / E

Where E is the equity attributed to the common shareholders, or book value,

E = Total Asset – Total liabilities

If there is money provided by the debtholders such as bondholders or bank borrowings, the metric used is Return on Capital (ROC),

ROC (before tax) = Operating profit, or earnings before interest and tax (EBIT) / Capital

Or ROC (After tax) = Net operating profit after tax (NOPAT) / Capital = EBIT * (1-tax rate) / Capital

Capital = Total equity + total interest-bearing debt

Some investors like me prefer to use invested capital (IC), or Capital employed (CE)

IC = Total equity + Total debt – excess cash not needed in operation and other non-operating assets

Then return on invested capital, ROIC before tax = EBIT / IC

ROIC after-tax = EBIT *(1-tax rate) / IC

Note some people use ROC and ROIC the other way around. Some use different term. They all measure the same thing but differently.

Why Return on Capital Is Important?

A business that has a high return on capital is more likely to be one that can generate cash internally from its core operations, i.e. it does not have to borrow more money, which increases its bankruptcy risk or issue new shares which will dilute the shareholding of existing shareholders. It signifies that it has a competitive advantage, that it has a high margin, and/or able to sell more. For the most part, the higher a company's return on capital compared to its industry, the better. This should be obvious to even the less-than-astute investor. If you owned a business that had a capital of $100 million dollars and it made $15 million in profit, it would be earning 15%, which is better than one earning $5 million, or 5% on your capital.

What is a reasonably good ROC?

To evaluate whether a business is a quality one, we can look at the return it earns on invested capital and the cost of that capital. The difference between the two is a measure of the excess return that the firm makes and reflects its competitive advantages.

Excess return = Return on invested capital – Weighted Average Cost of capital

ER = ROIC - WACC

Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, equity and debt, widely known as the weighted average cost of capital, WACC. WACC, in other words, represents the investor's opportunity cost of taking on the risk of putting money into a company.

If a business has a 50% equity and debt structure, and the required return for equity shareholders is 12%, and required bank interest is 5%,

WACC = 0.5 * 12% + 0.5 * 5% * (1-25%) = 5.0% + 2.88 = 7.9%

As investors, we look at the return of the capitals utilized in the business and compare with this cost to determine if the company is doing the right thing in shareholder value enhancement. In other words, for shareholder value creation,

ROIC > WACC

In the above case, if the business returns a ROIC of 8% or more, it may be an investible business.

This is intuitive. Think about it, why would a company get into a business when the return of the capital is only 5%, while its cost is 8%? It would be a shareholder value destroyer. Unless it has huge amount of net quality assets selling at a huge discount.

Return on capital is particularly important because it can help you cut through the garbage spieled out by most CEO's in their quarterly and annual reports about achieving increased earnings, and those simplistic rules of improved quarterly earnings propagated in the internet space. Warren Buffett pointed out years ago that achieving higher earnings each year is an easy task. Why?

“Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report "record earnings" because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out as cash dividends. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management's fiscal adeptness than the annual earnings per share.”

ROC is my most important metric to identify a quality business. Look for companies with consistent high ROC for a long period such as 5 years, or even 10 years, as some companies’ earnings fluctuate wildly and too volatile to be investible.

Next, we will look at some other quantitative metrics for identifying a quality business.

For those who are interested in ways of identification of quality businesses to invest for long term, there are resources in the internet including many good books on learning about the fundamentals of investing. Here is one,

This book is on sale in the major bookshops such as MPH and Popular. You may also contact me to purchase a copy if you wish at the following email address.

ckc15training2@gmail.com

This may end up as your best investment.

KC Chong