Investing, Business Performance, Return: Analyzing for Results
This has been the more than a "Lost Decade" and all the prognostications are that the 10s will be the same. Certainly all the evidence we've presented on the state of the economy, the long-term outlook, the linkages between profits and markets, valuations (which we remind you are over-valued something like 20-25% right now a long-term basis) and the multiple discussions of business performance all point that way. So what do do? Ah, that IS the question. Alas poor Return, we know you well.
Well...this is going to be a stock-picker's paradise as well as needing to rethink investment strategies in light of ongoing major structural shifts. Neither the top-down macroperspective nor the bottom-up value perspective can be entirely neglected but must be integrated. A lot of that machinery has been laid out here. The remaining key question is how do you actually go about linking the headlines to readily available financial data to business performance analysis. But before we dive into our central focus let's revisit the case for active value investing with a hattip to Barry Ritholz. It seems Vanguard, one of the better outfits around period, made it's case for a Buy-N-Hold strategy with an interactive tool that showed the market outperforming an active investor following simple mechanical rules. Unfortunately for them Barry and Paul Kedrowsky proceeded to demonstrate that if you tuned the parameters slightly it went the other way. We spent some more time playing with and got the results collected in this composite graphic. Barry's post and charts are excerpted in the readings while our multiple fiddlings are here, and if you click on the chart you'll go to the Vanguard's tool to play with yourself.
What you see at top is two alternative rules that do better than simple buy-n-hold, in case with less risk and the other with slightly better returns. In some ways case closed.But if there's any economy - markets - investing link we've been pounding on it's that economic turning points are visible a long way away and that economic performance drives markets in the long-run. So in addition to sensible asset allocation plus active value investing plus excellent company performance analysis it seems to us that the first, fundamental key is playing the turning points. Which we sorta mimicked by breaking up the time periods. Within the limits of Vanguard's tool, not designed for this purpose, we're in effective suggesting that you make the big turning point In/Out decision and then adapt/adopt an appropriate rule appropriate to the macro regime. Right now and for the rest of the 10's we think that regime is a rangebound trading market, just to remind you.
Business Performance, ROIC and Investment
Of course some of the other recent investment news is the annual Berkshire meeting which produced a flurry of stories and articles. Some of which are excerpted below along with our selections from Warren's annual letter, as usual a great must-read. One of the more interesting is the Marketwatch story pointing out that BRK beat all mutual funds for the last 45 years. By this time we basically know roughly how he does it (NB: the recent stories on how and why he took a pass on LEH reinforce it - a day with the 10K, some hours interviewing Dick Fuld, a complete lack of confidence in management and voila!) which is to pick good companies with aggressively defensible market positions and value-creating products run by management he trusts. Now we've spent a lot of time digging thru a bunch of different companies here to break that down in much more detail but we want to point to a way to screen and analyze companies for deeper analysis.
One key way to do it, with a number not commonly looked at but rather widely available, is ROIC, or Return On Invested Capital (sometimes ROC). And the guy who surfaced it and was cited by a bunch of major bloggers was our old buddy Jim Jubak in this column: The one must-have number for successful long-term investing. It strikes a theme and approach he's been using in several by-the-way. But basically ROIC tells you how a company is doing with the resources it has available. We'll note in passing that our recent dive into Home Depot that they link business and operational strategy to key performance metrics to ROIC and capital discipline in a closed-loop management process that is a beauty to behold.
We put together this sampling of some key bellweather companies, headline names and/or ones we've written about and make good comparisons, using the stats readily available on MSN Money's stock profile pages.One of the things we like is that it shows you ROE, ROA and ROC all side-by-side. ROE is the one most commonly followed but that's dangerous since it's simply ROA leveraged up, and subject as to management folly and accounting whimsies.
The top row is all Tech firms, the middle row exemplars of sorts we've discussed and the bottom row some representative samples. For example MickeyD's (MCD) vs. Burger King (BKC) - both are showing decent ROC, more importantly it's improving compared to the 5 year and tells us there may be a couple of winners. Since we used MCD as our working case for long-term valuation that's good to know. Exxon - the best run by far of the oil major- is interesting since current ROC is so much lower than historical. We know that's not for internal performance reasons but we also know that the world energy ecology is under-going a major structural shift that severely limits the long-term profitability of the Majors. The HD vs. WMT numbers are interesting - HD clearly has a ways to go. Also really interesting are the trends apparent in the Tech row. Dell for example has a decent current ROC but has fallen a long way, Apple seems to be maintaining its exemplary performance and Intel and Cisco are getting good returns with slight drops below historical performance yet, as we've discussed, are going thru major transformations. In other words we may be seeing Red Queen Syndrome in a relatively mature industry where only Apple has found a new value proposition, CSCO/INTC are extremely well run but aren't delivering breakthrus and Dell is struggling. IBM on the other hand is a different story.
ROC, ROA and the DuPont Method
A related number that's often easier to get, understand and analyze is Return on Assets. Especially since breaking it down and linking it to details of company performance has a long...long history having been invented by Pierre du Pont to help run DuPont rationally in the early 1900s but being more fully developed in his takeover, salvation and transformation of GM. (Strategy and Structure: Chapters in the History of the American Industrial Enterprise by Alfred Dupont Chandler). In the readings there are pointers to more educational resources on Dupont Analysis, somewhat related Enterprise Value/FCF and ROC or ROIC. Let's take a look at the relationships in DuPont's framework and what it says about business performance. A couple of notes - ROI here is also ROA, DuPont's critical metric. ROE is related to ROA by ROE = ROA* Equity Multiplier, where the EM is a measure of leverage and is given by (1+Debt/Equity). You can and should break down ROA into its major components.
Operating Efficiency = Profit Margin = Net Profit/Sales tells us how efficiently a company is running today within existing resources. The trends over time and the value of various tactical and strategic initiatives, when analyzed thru the filter of their impacts on Revenue, Profit and operating costs, tells us where it's been and where it's going.
Capital Asset Effectiveness = Asset Turnover = Sales/Assets tells us how effectively a company has been and is being run. And, again, what the future holds by working the initiatives you read in the press and in the analyst and annual reports thru these filters, how it's likely to do in the future.
Capital Structure = Leverage Multiplier = Assets/Equity tells us whether or not the sources of performance are operational, business or financial engineering. Over the last couple of decades too much attention has been paid to short-term ROE which means too much credence has been given to financial engineering and leverage and not enough to business fundamentals.
Return vs. Performance: the final implicit equation is ROE = ROA X Leverage = Profit Margin X Asset Turnover X Leverage. It's the first two you want to know are improving and are likely to keep improving, or not. 
Business Think vs Financial Think
All too often the press and analysts get numbers confused with running the business when actually it's the other way around. The numbers should result from business decisions, not drive them. But in a quarter-to-quarter world where headline earnings are all that matters for compensation plans just the opposite happens. Let us try and illustrate some ways of thinking the way a business person thinks, or tries to, or should (if they're not Dick Fuld and the management of Lehman).
Suppose a medium-sized manufacturer is facing an over-capacity market with lots of competitors and no clear differentiation. And they decide that the way to create a major value engine is to improve total operational service from ordering to delivery and installation to after-market and life-time service. As we know from our whole enterprise investigations that's not just beating up the troops to smile on the phone but involves deep operational changes in order process, fulfillment and distribution, perhaps the creation of a whole new service support organization with its own capabilities plus tight linkages to manufacturing and product development. Over time, say in a phased approach, you're likely to see the impacts on the P&L and the Balance Sheet work themselves out something like we've illustrated.
Beyond that "simple" change that creates a sustainable and appreciating advantage lies a whole host of other possibilities one could envision. Changes in fulfillment and speeding up the order-to-delivery and order-to-cash cycle might lead to and fund major changes in manufacturing operations, say to a leaner operation. With a more cell based operation and less emphasis on long production runs. That kind of flexability means the company could go after smaller markets more profitably, be more responsive to customers and have a broader product line. Which then would support a whole new approach to Product Development and Marketing and so forth...one thing leads to another.
We've covered a lot of ground and tried to do it at some depth, from alternative approaches to Investment Strategy to deep value screening and analysis of companies to deeper methods of business analysis linked to business performance. If there's a final argument to be made here it's that in this market and with this economic outlook the companies doing and demonstrating this kind of thinking are the ones you need to be looking into. Otherwise you'll be lucky to get your 4% return over the next decade.
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