Friday, October 23, 2015

Pay Up for High ROIC! (Part 2)

Do read from the first post.

So does it make sense to pay 20x for 20% ROIC? The answer is YES! In fact, as a rule of thumb in Singapore's investment circle, we should pay one multiple point for 1% of ROIC. So if it's 20% ROIC, we can pay up to 20x and still get a good return. If it's 30% ROIC, then it's 30x. Here's the same table from the previous post showing a 15% ROIC business, let's call it Table 2.

Table 2

So as we can see, at Year 8, even if we value the business at just 10x its earnings per share or EPS, it is worth $30.6, which is more than twice the original price of $15 if we paid 15x for this 15% ROIC business. Now eight years might be a tad too long for most people on this planet, particularly finance people working on Wall Street, or for those of us who can't wait for 2 years for a new iPhone and go for the minor upgrade S version and be disappointed but for true blue value investors, this is the time horizon we are talking about. 

To test the rule of thumb, here's another table (below) showing how long it takes before we double our money using the same assumptions in Table 2. As we can see in the Table 3, testing the original rule of thumb of paying one multiple point for 1% of ROIC, it takes 6 to 8 years to double our money. In fact, if a business can generate sustainable ROIC of 50%, even paying 50x PE, it would only take 5 plus years to double our money. 

Table 3

But how do we know that this 50% ROIC is sustainable? Well, we don't. We can only base in on track record of both the business and its managers. As we discussed before, there are inherently good businesses: consumer related brands, razor-and-blade models, asset light and recurring revenue operations but as businesses grow, incremental return would diminish. For those of us who had scoured businesses across the globe for years, well ROIC of 50% doesn't sustain for too long. 

Hence while in theory it works, in reality, even if we see one or two years of 50% ROIC, it should be safe to assume that ROIC would normalize at some point. Alibaba illustrated this point well. It went public with ROIC at 50-100% which allowed its promoters to justify paying 50-100x for this world's #1 internet stock. ROIC then went on to normalize to around 10-20% today and we saw its share price fell from $100 to a low of $50 before rebounding to $72 today.

Alibaba's ROIC from Gurufocus

More importantly, business managers must stay really focused to reinvest all those earnings for us at higher than normal ROIC (normal means only 8-10% ROIC). Most business managers aren't able to do that. They would see all these cash being churned out and be tempted to use them to buy up low ROIC businesses. It's just too hard to sit there and see the cash pile up for most corporate CEOs. This is why it is way more difficult to find strong capital allocators. Especially so in today's world of short-termism. Even if the CEO did resist doing silly investments, he would be bombarded daily by hedge funds and bankers asking him to spend the money. It would take a zen master to be able to resist the Wall Street vortex of financial sorcery.

Hence, based on experience it is really difficult to find businesses with sustainable ROIC of more than 25%. If that is the case, we have to assume that most businesses would only be able to generate at best high teens ROIC over time. Then going by the rule of thumb, we should then be paying just high teens PE. In the past, I have advocated not buying anything at more than 20x PE. This is one of the criteria of an all-important checklist.

So pay up for high ROIC, but only to a limit - 20x!

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