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!

Friday, October 16, 2015

Pay Up for High ROIC! (Part 1)

Part 2 is out!

In financial math, high ROIC or return on invested capital can justify almost any PE to buy. This is what this post strives to illustrate. Do read on, it's really important! Promise you won't waste your time. Invested capital simply accounts for all the capital that businesses need: equity and debt. ROE which stands for return on equity, does not take into account of debt. In the financial world, most people talk about ROE but essentially both ROIC and ROE are about how much we can get back by putting in $100.

The genesis of this post comes from:

Some businesses are inherently very strong and generates huge cashflows. For every $100 that we put into the business, we could be making $20. That's ROIC of 20%. One example could be the potato chips business. Raw materials are essentially potatoes and packaging materials which cost next to nothing and what matters is the ability to put it into shelves around the world, in the 7-11s, the Tescos and the mom-and-pop stores all across the planet. Well, this, my friends, is the business moat: global distribution networks that takes years, if not decades to build. The world's biggest potato chips maker had shown that ROIC of this business is pretty high. That's Frito Lay or Pepsico, the listed parent entity.

Don't we all love Frito Lay?

For simplicity let's assume that the potato chips firm can generate 20% ROIC (Pepsico does around 15%). We further assume that in Year 1, its earnings per share or EPS is $1. Because of it's ability to return 20%, this $1 will make $0.2 in Year 2 and together with the original ability to make $1, EPS in Year 2 is $1.2. As we can see, this is compounding at work, So Year 3 will be $1.44 and Year 10 EPS is a whopping $6.2. Assuming that we paid $20 for the EPS $1 in Year 1, ie paying up 20x PE, what is our return after 10 years? It's phenomenal! (All this math is in Table 1 below)

The original capital of $20 now generates $6.2 i.e. over 30% return, over the next decade, it will generate more than the original capital in one single year (Year 17 to be exact). If we assume that it trades at 10x PE at Year 10 (which is ridiculously cheap, remember we bought it at 20x PE), the stock will be worth $62 (ie more than double our original purchase price or around 7%pa using our rule of 72. In Year 17, when EPS is $22.2, more than two dollars higher than our purchase price, the same stock should be worth around $222 dollars at 10x PE. So, in a nutshell, what we bought at 20x PE became a ten bagger. Thanks to its ROIC!

Table 1

In Year 20, using the same methodology, the same stock will be worth $383 while generating almost twice the our original capital ($20) in  EPS (of $38) in a single year. This is why we pay up for high ROIC!