Amid volatile global equity markets, long-term investors can find long-term stable returns. Clyde Roussow and Simon Brazier, Co-Heads of Quality at Investec Asset Management, argue that by focusing on finding companies with strong business models, brands and astute management, investors can benefit from long-term capital appreciation and ongoing dividend income.
Profiting from long-term value creation in the equity marketsClyde Rossouw and Simon Brazier, Co-Heads of Quality, Investec Asset Management
In 2015 many of the world’s stock markets became volatile, causing many institutional investors to either allocate away from equities into bonds to assuage losses or to adopt risk-reducing passive strategies. However, these may not necessarily be the best options for long-term investors? By identifying companies with strong business models, brands and astute management that make good investment decisions, Clyde and Simon discuss how stock pickers can develop strategies that harness the compounding effects of long-term value creation, while dampening the portfolio’s volatility.
“Nirvana for shareholders is a company with high return on invested capital, a strong balance sheet and the ability to expand rapidly.”
Finding companies with long-term returns
According to modern financial theory, an investor should only invest in a company if its management can generate returns above the cost of its capital. If the management team have consistently pursued strategies that have achieved this aim then shareholder value will grow as the company expands.
A company’s return on invested capital (ROIC) measures how effectively successive management teams have historically deployed cash into the business. A company with a consistently high ROIC can invest in products and services that enable future growth while also creating barriers to entry to new competitors.
Nirvana for shareholders is a company with a high ROIC, a strong balance sheet and the ability to expand rapidly. These characteristics mean that the company needs to invest proportionally less compared to a low-return business for the same level of growth. Consequently, the company can return more cash to shareholders, in the form of dividends and share repurchases, without negative knock-on effects to future growth.
Of course high returns should start to attract competition into the industry: as new competitors seek to gain market share it is likely they will begin to challenge the returns of the incumbent, causing those returns to decay or mean revert closer to the company’s cost of capital. High returns are in effect ‘supernormal’, therefore, and end up being competed away.
Yet, the fact that certain companies have sustained a high ROIC over the long term suggests that they are likely to possess one or more competitive advantages that are hard to replicate and can help them fend off would-be competition. These enduring competitive advantages are often intangible assets, such as brands, patents, distribution networks, entrenched customers and other forms of unique content or networks of users.
We believe that – all else being equal – a company generating a high ROIC deserves a higher relative valuation than a company generating a lower ROIC. However, the performance of high- and low-returning companies essentially depends upon the market’s implicit assumption as to how quickly mean reversion will take place. As a result, the market tends to assign too low an intrinsic value to certain quality companies with high ROICs that can sustain high returns via their competitive advantages. The share price of these types of businesses should, therefore, outperform over the long term.
We have tested this hypothesis by examining the ROIC progression, and resulting relative performance, of companies within the MSCI All Countries World Index between 1988 and December 2014, using five years of data at each annual increment. We found that mean reversion does occur over a five-year period, but that certain companies in certain sectors have proven more resilient. They have been able not only to generate a high ROIC but also to defy mean reversion and sustain that high ROIC over time. In fact, as illustrated in Figure 1, nearly three-quarters of companies that start with an above average ROIC have been able to sustain that over a rolling five-year period, and those companies that have achieved that, have outperformed the wider market by 4.5% on average.
These quality companies have used intangible assets such as brands, patents and distribution networks to create significant and enduring competitive advantages for themselves that in turn have created barriers to entry. This has provided them with an economic moat around their businesses that protects them from competitive threats. With strong and established market positions, they are extremely difficult to unseat. Compelling business models, disciplined management teams and typically low levels of financial leverage have enabled quality companies to sustain a high ROIC and grow their profits through the cycle.
Generating consistent returns
As high-quality companies tend to be capital light and require minimal capital expenditure to maintain existing business activity, these profits convert almost entirely into cash. Cash is a vital determinant of the sustainability of a company’s expansion, providing management teams with significant optionality. They can simultaneously reinvest cash to generate organic growth or acquire new businesses to maximise their future growth potential, whilst being able to return excess revenue back to shareholders through a growing dividend.
“A progressive dividend policy is important as it can be beneficial to a company’s strategy as a way of demonstrating capital discipline.”
A progressive dividend policy is important as it can be beneficial to a company’s strategy as a way of demonstrating capital discipline. This approach is also a signal of business model strength and confidence in the outlook for the company. Dividends represent an ongoing commitment to shareholders that requires a long-term focus from company management on the efficient use of capital. It is also critically important to the growth and sustainability of that dividend that it is paid out of the ongoing free cash flow of the business, not from the balance sheet through either increasing debt or disposals.
With these dividends typically backed by recurring revenues from diversified, defensive and repeat business, high-quality companies have proven more likely to sustain dividends in difficult market conditions, as well as grow dividends in healthier markets. Strong balance sheets driven by low levels of financial leverage and low capital intensity mean there are minimal claims on a quality company’s cash, either through interest payments on debt or capital expenditure to maintain and replenish ageing plant and equipment. Instead cash can be used to support a growing dividend and help deliver future growth.
As quality investors we value consistent, long-term returns. We believe that volatile or financially geared businesses generally indicate a riskier, or flawed, business model. Quality stocks are not generally volatile as they combine defensive recurring revenue streams from the sale of large volumes of low-ticket items, established industry positions, low sensitivity to the economic and market cycle, geographic diversification, and low operational and financial leverage. The lack of volatility is further enhanced by the fact that quality companies are predominantly headquartered in developed markets where they trade on large, open, liquid and regulated exchanges with high standards of corporate governance, disclosure and transparency.
The importance of valuation
Valuation also plays an important role in an analysis of a quality company. We prefer to use free cash flow yield as our valuation metric as it captures the cash-generating power of the business. The free cash flow yield also better reflects the available cash that can be reinvested into a business for future growth, or returned to investors. We believe investing in high-quality companies only makes economic sense if free cash flow yields are superior to long-term bond yields. This comparison comes from the stable and consistent cash flow generation of these companies, many of which have bond-like characteristics. It is also important to look at valuation in the context of a company’s quality and growth characteristics.
Quality stocks may have re-rated in recent years, alongside the market, but their ability to deliver consistent levels of growth and capital return to shareholders during times of economic uncertainty and record-low bond yields means that these stocks still provide compelling value in our view. We are not seeking a further re-rating in the value of quality stocks – we believe it is the continued compounding effect of free cash flow generation and the reinvestment of that cash for growth that will be the key performance driver of quality stocks over the long term.
Investing across market cycles
Very few companies possess the rare and exceptional qualities required to create enduring competitive advantages that can sustain high long-term returns. These quality companies have combined a sustainably high ROIC and a high conversion ratio of profits into cash, with a strong balance sheet and minimal capital requirements.
Normal cycles produce an abundance of economic growth, which create opportunities for higher earnings for all companies, and operational and financial leverage can improve returns materially. This cycle is far from normal, however. The compounding effect of the tax-efficient reinvestment of cash flows is even more important now in a world of low interest rates, anaemic economic growth and fair-to-high valuations. Quality businesses are more expensive than they have been in the recent past, but ironically far more valuable in today’s market environment where growth is scarce and priced at a premium. They have proven to be more resilient and less sensitive to the economic and market cycle, and still able to generate cash and reinvest that cash for growth, even in more challenging market conditions.
In this uncertain market environment, therefore, we believe quality companies continue to be well placed to compound long-term shareholder wealth and deliver attractive long-term total returns to institutional investors with a more durable and faster growing dividend and below average volatility.