One of the most important tasks facing a company’s management team is the allocation of capital. How well this is done has considerable influence over its share price. Get it right, and management can expect to see the company’s share price appreciate over time. Get it wrong, and the market can mete out punishment in the form of a declining share price. Good capital allocation drives capital appreciation, while poor capital allocation often drives ‘capital punishment’!
How do we identify those companies that allocate capital well? What are the signs that we look for?
With this in mind, there are a few important considerations: how do we identify those companies that allocate capital well? What are the signs that we look for? What other aspects do we consider in deciding whether or not to purchase a company’s shares for our clients? In order to answer these questions, we need to define a few terms: ‘capital’ (or ‘invested capital’), ‘return on capital’, and ‘cost of capital’.
By capital or invested capital (we use these terms interchangeably), we mean the capital that a company’s management has chosen to invest in the productive capacity of the business. We call these investments in productive capacity ‘capital investments’, or simply ‘projects’. For example, if a company’s management decides to build a factory, we count the cost of building the factory as a capital investment.
Similarly, if a company’s management decides to buy another company, we count the full cost of buying the company as a capital investment. Where a company utilises intellectual instead of physical capital, we count the cost of research and development spending as capital investment, as this spending builds the future productive capacity of the business.
The return that a company makes on its capital is crucial. We define return on capital as the cash profits that a company makes from utilising its productive capacity, divided by the total cash amount invested in the business (Invested Capital). Imagine for a moment that you are considering two different investment options: the first, buying a coffee shop for £100,000, the second buying a jewellery business for £100,000. In the first example, if the coffee shop produces profits of £10,000 per year, then the return on capital is 10% (£10,000/£100,000 = 10%). If the jewellery business, however, produces profits of only £1,000 per year, then the return on capital is just 1%. Other things being equal, we would clearly prefer to invest in the coffee shop instead of the jewellery business, because the coffee shop generates a higher return on capital.
In determining whether a company creates value from allocating its capital, it is also important to consider the cost of that capital. This is simply the cost of funding the company’s total investment in its productive capacity. When choosing funding, companies can use debt (borrowing money) or equity (selling shares in the business) or a combination.
Both sources of capital have a cost. For debt, it is the interest cost. For equity, it is the opportunity cost of the equity capital. This is best thought of as the rate of return the investor could have made, had s/he invested their capital in an alternative project. Another way of thinking of it is as the required rate of return; that which adequately compensates the investor for risking their capital in this particular venture.
A company creates value when it invests in projects that generate a return on capital greater than the cost of capital. In our coffee shop/ jewellery example, let us assume that the cost of capital in both cases is 7.5%. For the coffee shop, given the return on capital of 10% is greater than the cost of capital of 7.5%, investing in this venture is ‘value creating.’ In contrast, the jewellery business only generates a return of 1% versus a cost of 7.5%. An investment in the jewellery business would be ‘value destroying,’ because the investment generates returns on capital, which are lower than the cost of capital.
The idea of value creation vs value destruction is perhaps most easily understood in the case of a wholly debt-funded business. If it generates a profit of £1,000 but the interest costs £7,500 (7.5% of the jewellery business investment) then it is pretty clear it will end badly. The principle is exactly the same for equity or mixed funding.
At Investec Wealth & Investment, we employ exactly the same techniques to gauge how well a company invests its capital. We calculate the total return the company makes on all of its invested capital (which we call CFROIC or Cash Flow Return on Invested Capital) and compare this to our assessment of the cost of capital. We prefer companies that consistently generate returns on capital that exceed its cost. Some companies are able to do this, while others are not.
Can we expect to outperform the market if we only invest in companies that allocate capital well?
There is one more piece to the puzzle, however. Can we expect to outperform the market if we only invest in companies that allocate capital well? Phrased differently, is a company which generates high and stable returns on its capital a good investment? The answer to this question is ‘not necessarily’. It depends on the degree to which the company’s share price over or under-reflects the returns on capital it will generate in the future.
The key aspect to consider here is how returns on capital change, or fade over time. Some companies will see their returns on capital decline over time as competition erodes their profitability. Conversely, some companies will see their returns on capital increase, as they use their competitive advantage to invest in value-creating projects. Then there are those who will see their returns on capital remain the same.
We focus our attention on judging a company’s future returns on capital, and whether this particular view is reflected in the current share price. Companies with return-generating capacity not sufficiently reflected in the share price represent ripe investment opportunities for us, and therefore our clients.
Future returns on invested capital are crucial in determining share price performance. At IW&I, we focus on building an informed judgement of what these future returns will be. We believe this focus will allow us to identify the best investments for our clients.