A look at our investment process. Part three

In our previous segments we highlighted our first 2 steps in our investment process. First is asset value. This could be what it would cost for someone to replicate the assets of the business. This also could be simply be the liquidation or fair market value of the business assets. An appraisal if you will. In our example we highlighted the New York Knicks and NY Rangers sports franchises.

Our second step is Earnings power value or EPV. What is the cash flow stream and what would it be worth to an informed buyer.
We want to know what would be the sustainable net operating profit of the business in a normal business cycle. We discussed how a restoration of Dollar General’s margins would result in much higher cash flows and thus a much higher business value.

Both Asset Value and Earnings Power Value should then be compared to the value of the stock in the market. If done correctly a number of insights could be learned. For example if Asset value exceeds EPV the business is underearning. However the entity still could be a great value as in our MSGS example.

Conversely if EPV exceeds Asset Value then the business might have some sort of competitive advantage which enables it to earn more than the value of its assets. If it exceeds Asset value by a significant amount we might have a valuable Franchise.

For our usage FRANCHISE simply means a business that is capable of compounding over a period of time through reinvestment of its cash flows. Franchise stocks have high returns on equity (ROE) and tend to be capital efficient. For example ROE’s of 20%+ would be indicative of a franchise business. These are Warren Buffett stocks, buy and hold on and just let them compound over time. The business can reinvest its cash flows and get a rate of return greater than it’s cost of capital.

Cost of capital is a key concept in investing. In economics and accounting cost of capital is simply the cost of a company’s funds either through debt or equity.

In order for a company to grow profitably they must have a return on capital that is greater than it’s cost of capital.

In fact you hear all the time can this company grow? Well sometimes growth destroys value. If my cost of capital is greater than my return on capital then growth destroys value. For example GM’s return on capital is 3.0% while its cost of capital is 7%. So any pursuit of growth by management might be ill advised. Paying dividends to shareholders might be a better use of capital than growing in existing markets.

Long term compounders tend to have opposite dynamics. For example Paypal has returns on capital of 22% while their cost of capital is around 10%. Paypal can grow (within certain parameters and markets) and capture the 12% return in between. This is the magic of compounding. Taking existing cash flows and reinvesting in the business. “Gloriously tax efficient,” Charlie Munger would say.

The market uses the term growth generically and incorrectly. As if all growth is good. For example AI stocks have high growth rates attached to them. But it is too early to assess whether returns will exceed cost of capital. Many indeed are sucking up money at a high rate and in my view have a low probability of high near future returns. We label this type of investing as speculation and not in our purview.

In order for this concept to be true the company must have some source of competitive advantage or barrier to entry. If no competitive advantage exists or is fleeting, Asset value and Earnings Power value would be approximately equal as competitors come into the space and do exactly what the company is doing, thus capturing any excess profits that might have existed.

Competitive advantages could be network effects, economics of scale, high switching costs, patents, trademarks, and copyrights, and high barriers to entry. It is a subject of a course in and of itself. We will talk more about these later, but just remember high return stocks tend to have some source of competitive advantage. It is the investors or analysts job to assess how sustainable they are.

In other words Franchise Value stocks are unique and elusive. Their roster consists of companies like Visa, Microsoft, Alphabet, and the rest of the quite profitable Magnificent 7. But smaller niche stocks can also be Franchise stocks. Caseys General stores earns excess returns only in a certain region of the US. If all of a sudden they decided to operate in New York state where there are entrenched competitors and different regulatory environment they might get their lunch handed to them. Returns on capital would fall and the company could lose positive compounding effect.

With Franchise stocks how management allocates capital is very important. You want to monitor senior managements thinking and their strategic decisions. Are they investing and protecting their brands? What is their thinking about maintaining and maybe even expanding their competitive positions?

Our EPV example Dollar General qualifies as a franchise stock as it’s EPV is greater than its asset value. DG’s return on capital will widen as margins normalize and growth (to a certain point at least) will create value for shareholders. At some point DG’s cost of capital and returns on capital will be equal and then we must assess managements capital allocation decision making.

So in summation:

1) A Franchise stock or long term compounder has higher returns on capital than most company’s.
2) Growth is positive where Returns on capital exceed cost of capital.
3) Where cost of capital is the same or more than Returns on capital growth destroys value. Management should behave accordingly, but often don’t.
4) In order for compounding to exist there must be some competitive advantage present
5) Franchise stocks can be fantastic investments
6) We would love to purchase franchise stocks at a stock price below our perceived assessment of value.
7) We like to identify Franchise stocks early and wait until the market gives us an opportunity to buy one at a significant discount.

In other words be a learning machine and be patient. One day Mr. Market might give you an opportunity to buy a franchise stock at a discount to it’s intrinsic value. The more you know the easier it is to take a nice size position and then let the compounding work for you.

If this type of investing makes sense to you. You can contact me via email at steve@cshinvestments.com or call one of our offices at 217-824-4211 or 573-808-1959.

C Steve Henry