Accessing the power of value creation
Value creation has been a topic of much discussion among investors for decades – yet, for some it is still considered a ‘niche’ concept. Our white paper, The Power of Value Creation, sets out why we believe adopting a mindset focused on a business’ return on invested capital (ROIC) can identify companies which consistently create value that ultimately translates into improved shareholder returns.
29 January 2018
Measuring a company’s true value
While ‘quality’ as an investment style is highly subjective and notoriously difficult to pin down, its subset, value creation, takes us closer to the idea of true quality. In essence, if a company can continue to create consistent returns on investment over and above its cost of capital, the share price will take care of itself.
While multiples such as price-to-earnings are intuitive and allow quick comparison across a range of sectors and regions, they are blunt instruments which overlook capital intensity (the level of capital required to generate a unit of cash) and capital allocation (how any excess cash is put to work by management). Measuring a company’s value creation via ROIC is a more robust way of gauging a company’s potential for sustainable growth and a better indication of its underlying quality than other metrics.
Value creation is a virtuous circle
Cash-generative companies with sustainable capital allocation strategies create a positive feedback loop, enabling them to promote consistent growth over the long-term.
Building a portfolio of these companies with a high and sustainable ROIC gives investors a superior pool of stocks which demonstrate persistent value creation over time.
ANALYSING THE RETURNS OF THE VALUE CREATORS
In this simplified example, we can demonstrate how two theoretically identical companies, operating in the same sector and
with the same business prospects at the outset, can have vastly different outcomes, based on their approach to capital
Company X generates free cash flow (FCF) equivalent
to 10% of its annual sales, with a FCF margin of 10%,
is growing sales at 2% per annum but is operating at
near-full capacity. Its management runs the business for
income, therefore 100% of FCF is allocated to rewarding
shareholders through dividend payments. Nothing is
allocated to expansionary capex. In our example, over
five years, due to serious capacity constraints, the
company’s growth rate declines by 2 percentage points (pp)
every year. In that time, its generous dividend policy means
shareholders gain US$100 per annum. However, this dividend
is not sustainable and by year 10 declines to US$90 in line
with sales. Despite its sector growing at 2% per annum,
Company X experiences falling sales. Shareholders –
initially attracted by generous dividends – are faced with
a declining (and ultimately unsustainable) income stream,
falling to only US$54 per annum in year 20.
Company Y, by contrast, has an identical FCF margin
but reinvests heavily in the business, allocating 90%
of capital to expansionary capex, paying out the
remaining 10% of annual FCF in dividends. Company
Y’s expanding capacity enables it to take market
share away from Company X. As a result, sales growth
accelerates by 2pp per year. In Year 5, shareholders
receive a dividend of US$24, but it is sustainable and
growing, so that by Year 20 Company Y’s dividend is
greater than Company X’s and it has an expanding,
Source: Martin Currie.
The data supplied is used for illustrative purposes only.
These examples are representative and do not reflect existing companies.
Markets misprice true value in companies
Looking at the MSCI ACWI over a 10-year period, of the firms with a high ROIC (greater than 20%) in 2007, around half remained at this level in 2016. It is this persistence of high returns that mean-reversion mindsets fail to recognise*. The short-term outlook of markets means there is a strong potential for high-ROIC stocks to be mispriced, creating opportunities for long-term investors.
By adopting the mentality of stakeholder/owner – rather than shareholder – we believe investors are able to access the benefits, not just of the accumulative power of compounding over an extended holding period, but also of avoiding the destructive erosion of capital from transaction costs.
Source: Martin Currie and FactSet as at 31 December 2016. Data calculated on 28 November 2017. Banks, insurance and companies with negative invested capital excluded.
The challenge: finding the true value creators
However, no two ‘value creators’ are alike. Screening for stocks with a long track record of value creation gives an advantaged starting point, but building conviction requires an active approach, consisting of in-depth research, extensive company engagement and a firm understanding of ESG. In this way we can identify the companies planning for the future – not just the next quarter.
There are three key strands to our approach:
- Good capital allocation – a company’s ability to reinvest in its business.
- Long-term strategy (not short-term tactics) – evidence a company is guided by a genuine focus on long-term sustainability.
- Appropriate management incentives – remuneration structures sufficiently balanced between long-term capital allocation and short-term performance.
At the heart of this is a detailed analysis of financial statements, in order to assess the quality of a company’s earnings and the true health of its balance sheet – our proprietary accounting diagnostic review (ADR) is an essential tool in drawing out issues that may not be immediately obvious. Equally important is our significant emphasis on stewardship, which provides us with a better understanding of the mechanisms of a company’s decision-making process.
Download the full white paper
* Source: Martin Currie and FactSet as at 31 December 2016. Data calculated on 28 November 2017. Banks, insurance and companies with negative invested
Past performance is not a guide for future returns
Investors should also be aware of the following risk
factors which may be applicable to the strategy.
Investing in foreign markets introduces a risk where
adverse movements in currency exchange rates could
result in a decrease in the value of your investment.
Emerging markets or less developed countries may
face more political, economic or structural challenges
than developed countries. Accordingly, investment in
emerging markets is generally characterised by higher
levels of risk than investment in fully developed markets.
For Investors in the USA, the information contained
within this document is for Institutional Investors only
who meet the definition of Accredited Investor as
defined in Rule 501 of the United States Securities Act
of 1933, as amended (‘The 1933 Act’) and the definition
of Qualified Purchasers as defined in section 2 (a) (51)
(A) of the United States Investment Company Act of
1940, as amended (‘the 1940 Act’). It is not for intended
for use by members of the general public.
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Currie Australia (‘MCA’). Martin Currie Australia is a
division of Legg Mason Asset Management Australia
Limited (ABN 76 004 835 849). Legg Mason Asset
Management Australia Limited holds an Australian
Financial Services Licence (AFSL No. AFSL240827)
issued pursuant to the Corporations Act 2001.
This information is issued and approved by Martin
Currie Investment Management Limited (‘MCIM’). It
does not constitute investment advice.
Market and currency movements may cause the capital
value of shares, and the income from them, to fall as well
as rise and you may get back less than you invested.
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of the named manager(s). They may not necessarily
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