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 allocation:

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, well-invested business.

ANALYSING THE RETURNS OF THE VALUE CREATORS

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.

GLTU Destination of ROIC over a 10-year period

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 capital excluded.


Important information

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.
Any distribution of this material in Australia is by Martin 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. The document may not be distributed to third parties and is intended only for the recipient. The document does not form the basis of, nor should it be relied upon in connection with, any subsequent contract or agreement. It does not constitute, and may not be used for the purpose of, an offer or invitation to subscribe for or otherwise acquire shares in any of the products mentioned.
The information contained has been compiled with considerable care to ensure its accuracy. However, no representation or warranty, express or implied, is made to its accuracy or completeness. Martin Currie has procured any research or analysis contained in this document for its own use. It is provided to you only incidentally and any opinions expressed are subject to change without notice.
The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of the security transactions discussed here were or will prove to be profitable.
The opinions contained in this document are those of the named manager(s). They may not necessarily represent the views of other Martin Currie managers, strategies or funds.