What makes a stock go up? I mean, what makes it really go up. Not just for a few months or a year, but over a period of a decade or more? We know the answer. But it seems not widely known (if you read financial journalists, who appear completely unaware of it). And it leads to counterintuitive conclusions for most people (especially non-investors).
I’ve been reading the 7th edition of Valuation, which just arrived last week and deals with this central question. (I took the title above from the heading of Chapter 5). Some have asked me to do a review comparing it to the previous edition. Well, the only previous edition I read was the second, when it came out way back in 1994. The Dow was only ~3,700 back then. And Jeff Bezos had just left DE Shaw to start Amazon in his garage. It was a different world. And that book was an entirely different book.
Anyway, what I like about the new edition -- I’m only about 100 pages in so far -- are the anecdotes that salt its pages.
For example, consider the case of Costco versus Brown-Forman. Costco is the fourth-largest retailer in the US. Sales topped $126 billion in 2017. Brown-Forman makes Jack Daniels and other boozy beverages. Sales were $4 billion in the same year.
From 1996 to 2017, Costco’s profits increased at an 11% clip. It was one of the fastest growing companies in the US during this time. Brown-Forman, by contrast, grew profits at a 7% clip. This enormous gap means that at the end of 2017, Costco’s profits were 9x larger than they were in 1996. Profits at Brown-Forman were only 4x as large.
And yet, shareholders in both companies earned returns of about 15% annually. How so? The authors write:
“The reason Brown-Forman could create the same value as Costco, despite much slower growth, was that Brown-Forman earned a 29% ROIC (excluding the impact of acquisitions), while Costco’s ROIC was 13%.” (In other words, BF created more profits with much less capital relative to Costco.)
I love mini-case studies like this. They are like bite-sized chocolates. This particular example illustrates the fundamental framework of the book, summed up by the authors thusly:
“The amount of value a company creates is governed ultimately by its ROIC, revenue growth and ability to sustain both over time.”
Sound familiar? It’s the formula for 100-baggers, too. It’s a more precise formulation of my lazier “find a company with a high return on capital than can reinvest and earn that high return on capital over and over again.”
These concepts - ROIC and growth - are mathematically linked and the authors break it down for you in great detail. (I won’t do it here). But suffice to say in the Costco-BF example, high ROIC was the equalizer for BF against Costco’s superior growth.
Another dramatic example is Rockwell Automation. From 1995 to 2018, revenues for Rockwell fell from $13 billion to $7 billion as it divested its aviation and power systems businesses. Despite this massive shrinkage, shareholders enjoyed returns of 19% annually.
How so? You probably guessed it. The authors tell us ROIC went from 12% to “about 35% (including goodwill).”
But investing is not this simple. If it were, we could all just screen for high ROICs, buy those stocks and go to sleep. In the real world, it is not so easy to identify companies that will maintain or raise their ROIC over 10-15 years. (Not to mention that stock price volatility, bad news, quirks of human psychology, etc. make it hard to hold on to anything).
My choice of “10-15” years is deliberate. The authors maintain that share prices align with the performance of a company “over long periods -- at a minimum, 10 to 15 years.” Which is kind of distressing. It means you might have to wait a very long time while your unthinking friends clean up on stocks like Nio and Lemonade. (Paging Tom Russo and his “capacity to suffer…”)
This seeming eternity of 10-15 years also introduces a second complication: value creation and share prices can diverge. Share prices can get way ahead of value creation, such that continued great performance from the company doesn’t translate into exceptional stock price performance. The authors call this the “expectations treadmill.”
The Expectations Treadmill
Here is another one of those bite-sized chocolates: Tyson Foods versus J&J Snack Foods. Both are US branded-food processors. Tyson had $40 billion in sales in 2017 with brands such as Hillshire Farm and Sara Lee. J&J had just over $1 billion sales that year with brands such as Icee and Auntie Anne’s.
J&J was a better business by the relevant metrics. From 2013-2017, it grew sales faster, 6% to 3%. And it enjoyed a higher average ROIC of that period, 24% to 19%. But… shareholders wound up with a return of 27% annually with Tyson, almost 2x the 14% shareholders got with J&J.
How so? Valuation.
Everybody knew J&J was a better business. And the market priced it accordingly. J&J traded for 23x EV/NOPAT at the start, versus 13x for Tyson. (EV is enterprise value. NOPAT is net operating profit after tax.)
Another reason for the difference in return was the change in ROIC. Tyson’s margins increased. ROIC went from 12% to 22%. It got better. Investors who could peek around the corner got their just reward.
In this case, J&J as a business outperformed Tyson. Yet Tyson shareholders did way better. Valuation still matters. As the authors put it:
“The return on capital that a company earns is not the same as the return earned by every shareholder… All investors, collectively will earn, on a time-weighted average, the same return as the company. But individual groups of investors will earn very different returns, because they pay different prices for the shares, based on their expectations of future performance.”
Another stark example of the treadmill at work is the case of Home Depot, c. 1999. The authors point out that the market cap was $132 billion. The stock traded for 47x earnings. They say, using a discounted cash flow model, holding margins and ROIC constant, that HD would have had to increase sales at a 26% clip for the next 15 years to justify that price. Of course, it didn’t. Sales grew 13% annually, still an impressive rate. But shares lagged the S&P 500 by 8% per year.
How many stocks are in this position today? That is a tough spot to be in if you’re a CEO. What do you do? It’s not HD’s fault the market went nuts. The authors conclude this mini-case study with the following:
“Finally, be careful what you wish for. All executives and investors like to see their company’s share price increase. But once your share price rises, it’s hard to keep it rising faster than the market average. The expectations treadmill is virtually impossible to escape, and we don’t know any easy way to manage expectations down.”
Beyond the anecdotes (and logic), there is considerable empirical evidence supporting the ROIC framework -- which the authors cover. However, I’m going to stop my notes right here. As I say, I’m only about 100 pages in. Maybe, if you’d like, I’ll follow up with a “part 2” set of notes next week (assuming I made decent headway in this 800+ page behemoth).
As for the book itself: this isn’t’ beach reading. It’s a textbook with - gasp! - lots of math. If you already think about stocks in terms of ROIC, etc., this book will be a review of core principles. But I find refreshers helpful -- and as I say, I enjoy all those little mini-case studies peppered throughout the book.
Thanks for reading.
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Published July 7, 2020
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P.S. My family and I went for a short vacation in Castleton, Va. My parents rented a big house in the country to celebrate their 50th wedding anniversary. It was a peaceful setting. I loved sitting under a small tree near a pond in the backyard to read and think:
We also hiked in the nearby Shenandoah, which is full of beautiful spots like this:
And here is a shot of me with my Dad back at the house, enjoying the tranquility along with cigars and wine:
Pandemic or not, it was good to get away for a few days. I suspect there will be many driving vacations this summer!