An Investment Story - Geneva/Turners/Heartland

[Baa_Baa]

Is that formulae a quote? It has some yukky and redundant {} in it.

[Snoopy]

Is that formulae a quote? It has some yukky and redundant {} in it.

I suppose I could have written Winner's formula (as I understand it) as below:

ROIC =D[A+B+C]/[(EE+ES)/2 +(DE+DS)/2]

Or maybe you prefer to read it this way:

ROIC = (1-'company tax rate')[ NPAT + Tax Paid + Interest Expense] / ['Average Equity Employed' + 'Average Borrowings Employed']

SNOOPY

[Snoopy]

There is no one statistic that is 'best' for analysing business efficiency. But sometimes comparing and contrasting different approaches can provide a deeper insight into the relative usefulness of two: in this case 'Return on Shareholder Equity' (ROE) and 'Return on Investor Capital' ROIC.

A company with a high ROE could indicate that it is undercapitalised, relying too much on external debt to keep the business going. A countercheck on this possibility is to look at ROIC, because this statistic looks at the return on the sum of shareholder equity AND borrowed money. Put simply, if ROE is high but ROIC is low, this could be a warning sign not to invest. However having a high ROE and a lower ROIC is not necessarily a bad thing. It could also be an indicator that the company has optimised their capital structure to maximise their returns to equity holders. Companies that operate in stable markets and have significant market share can be, by design, set up this way. Yet generally those businesses in second tier finance (Heartland), third tier finance (Turners) or fourth tier finance (Geneva) would not fall into this category. This doesn't mean these businesses are necessarily unsound. But it does mean they are likely to come under pressure over high stress periods within the business cycle.

Of the two indicators, I prefer to use ROE because:

1/ ROE is a little bit easier to calculate (and if a simpler calculation does a satisfactory job measuring 'business efficiency', then you should think twice about doing something more complex to provide a similar indication).

2/ ROE measures something that shareholders 'own' (the company equity). ROIC OTOH also measures company debt. Shareholders have ultimate responsibility for company debt repayment. But the debt is almost always owned by some-one else. So IMO, ROIC is an inferior indicator of shareholder returns.

As a long term shareholder (5 to 10 year horizon) I am interested in sustainable returns. This is why I have taken out what I consider 'one offs' and have used normalised profits to calculate ROE. By contrast other stakeholders that hold the debt -like banks or debenture holders- generally want their money back, or at least want to renegotiate terms before then. And banks just want to be paid back, and are unconcerned whether a company they lend to does this by using underlying earnings or one off sales of parts of the business or other windfall profits. So for my ROIC calculations I use headline profits. I am not claiming this is the 'right' way to do things. I am just explaining why I have done it this way.
(Edit: I have changed my mind and now use normalised profits for both, as this better facilitates a comparison).

I have tended to think of 'equity' and 'debt' as distinct and separate 'drawers' of, -to use a furniture analogy- a 'funding chest of drawers'. However, those of you who have ever used such a piece of furniture have probably noticed that if you go on a credit card spending spree and fill the top drawer with new clothes, while the bottom drawer (representing equity) remains empty, then the whole chest of drawers can become unstable. And fiddling with the top drawer alone can cause the whole chest to fall over. What I am hinting at here is that there needs to be a balance between equity and debt to keep a business on an even keel.

To use Turners as an example (they have the weakest ROIC of the three from an FY2018 perspective), we know they can borrow at 4.5% to 5.5% (FY2018 perspective) and ROIC was 6.1% for FY2018. So therefore any borrowing that Turners has is 'adding value'. However, this logic is akin to the person who has a two story 'financial chest of drawers' and is only concerned with pulling things in and out of the top drawer, while completely ignoring what is in the bottom drawer. So how do we bring what is in the bottom drawer into the equation to make sure that the company 'financial chest of drawers' remains balanced?

One way to do this is to assume that company equity is not 'free', but there is a cost for the shareholders to hold it. The cost most shareholders fear is that the market share price will go down and they will lose money. If you have a stable industry, then simply being a major player (top three in that market) is a good indicator that you are in a stronger position than those lesser market players. Such a company is liable to be less 'downside volatile' than the market in general. By contrast 'upward volatility', where a company makes a breakthrough (and major market players are the more likely to make short term breakthroughs) is a good kind of volatility risk that we shareholders want. Yet, the longer the term you wish to hold a particular share, the less important share price volatility, on a daily basis, becomes.

One mathematical technique for assessing the total cost of capital (a weighted sum cost of debt capital and equity capital) is called the CAPM or 'Capital Asset Pricing Model'. However, the equity weighting component in this model does not differentiate between 'negative volatility' (we investors do not want to see our share price plunge) and 'positive volatility' (we investors do want to see our share price soar). It also uses past share price volatility (that might have occurred while a business was restructuring for example) as an indicator of future share price volatility which -after any restructuring is completed- is likely to be lower.

By

1/ Discounting for a risk that is positive and desired by shareholders AND
2/ Likely Mis-estimating future share price volatility,

the CAPM ,in my opinion, gives an inaccurate assessment of future share capital cost - an estimate that is generally too high. For these reasons I prefer to use my own industry estimates to assess equity capital costs, and break away from the implicit CAPM assumption that 'volatility' is a proxy for 'risk', when in fact they are (day traders excepted) entirely different things.

Readers may at this point accuse me of rambling off topic. So I want to bring things back to the ROE vs ROIC debate so that you can see why the above couple of paragraphs were not off topic rambles.

ROE does not consider the 'cost of equity capital', as such. Equity capital is looked upon as a simple resource. And NPAT is a measurable return on that resource. So ROE is in reality a simple ratio that can be used to measure how well a business is doing relative to other businesses. There is no particular 'stake in the ground' that the market puts on businesses that determines what the ROE of any particular business should be. ROE is dependent on 'business inputs'.

In the case of ROIC, the return on the 'debt' part of that invested capital is tied to the market, because the source of that capital must come from the market (not as a rule, from you as a shareholder). So now we need a tool, a measuring stick if you like, to make sure the business proposition put up is worth funding by 'the market'. One tool to make this assessment is the Capital Asset Pricing Model. This is a tool that is well accepted in the market as one way (some think it is the only way) to assess how high the 'funding hurdle' should be, and so assess how viable funding a particular enterprise is. ROIC is dependent on 'business inputs' and 'wholesale market inputs'. The problem with ROIC that I have is that 'wholesale market inputs' are not within the control of the business. For me this weakens ROIC as an indicator of preference.

SNOOPY