Terry Smith on Capital Allocation

Quantitative Easing (‘QE’), so-called ‘printing money’ in which central banks created money to purchase assets, starting with government debt but eventually ranging into corporate debt and equities. As an aside, quite how it aided the economy of either Japan or Switzerland for their central banks to buy international equities is beyond my grasp. This was combined with low, no (Zero Interest Rate Policy — ZIRP) or even negative interest rates (NIRP). These measures I have collectively christened with the generic term ‘easy money’. Attempts to suppress volatility will only exacerbate it in the long term. If you count the current events, we have now had three economic and financial crises this century and it is still in its first quarter. This would seem to illustrate that attempts to expunge volatility from the financial system are actually producing the opposite of the desired effect. They breach the rule for what you should do if you find yourself in a hole. This is hardly surprising given that the central banks were aiming at the wrong targets. Central banks were attempting to maintain a benign level of consumer price inflation but ignored asset price inflation caused by their actions. Some also adopted employment targets that were not or should not be part of their remit. One of the problems of easy money is that it leads to bad capital allocation or investment decisions which are exposed as the tide goes out.

If we apply this concept to the case of Intuit, it would imply that the company is not in fact trading at a trailing twelve-month free cash flow yield of 3.5% as it seems. Removing $1.5bn of share-based compensation from the $4.1bn of operating cash flow reported in the cash flow statement would leave Intuit’s free cash flow yield much lower, at 2.2%. This example gives a sense of the magnitude of distortion that the accounting for share-based compensation could inflict on free cash flow yields. However, I suspect the most pernicious effect of adjusting profits to exclude the cost of share-based compensation occurs when the management start to believe their own shtick and mis-allocate capital based upon it. Too often management fail to mention expected returns on capital deployed when they make acquisitions and instead rely on statements about earnings dilution or accretion. We have just been living through an era where interest rates were close to zero. Statements about earnings dilution or accretion from an acquisition versus the alternative of interest income forgone on the cash do not reflect anything useful. In a period of such low rates the only acquisitions which could be dilutive are those where the money was literally shredded. Amazingly there are some of those too.

Microsoft and Visa both appeared in this list last year and have been consistently amongst the best performing stocks since inception of the strategy. Someone once said that no one ever got poor by taking profits. This may be true but I doubt they got very rich by this approach either. The bottom five were: Church & Dwight -0.7% 3M -0.3% Colgate-Palmolive 0.0% Clorox 0.0% Reckitt Benckiser +0.3% We switched the holding in Church & Dwight into another American consumer products company – Clorox – which produces a higher return on capital. We sold our stakes in 3M and Colgate Palmolive during the year. With 3M we were acting on growing doubts about the current management’s capital allocation decisions, and in the case of Colgate Palmolive we grew tired of waiting for an effective growth strategy to emerge. This year we have included the Sharpe and Sortino ratios for our Fund and the Index in the performance table on p.1. I realise that for those of you who are not investment professionals what I say next may well seem to be gobbledegook. However, whilst the returns which our Fund provides are very important so is the amount of risk assumed in producing those returns. These ratios attempt to measure that.

The biggest flaw in value investing is that is does not seek to take advantage of a unique characteristic of equities. Equities are the only asset in which a portion of your return is automatically reinvested for you. The retained earnings (or free cash flow if you prefer that measure, as we do) after payment of the dividend are reinvested in the business. This does not happen with real estate — you receive rent not a further investment in buildings, or with bonds — you get paid interest but no more bonds. This retention of earnings which are reinvested in the business can be a powerful mechanism for compounding gains. Some 80% of the gains in the S&P 500 over the 20th century came not from changes in valuation but from the companies’ earnings and reinvestment of retained capital. If you were a great (and long-lived) value investor who bought the S&P 500 at its low in valuation terms, which was in 1917 when America entered world war one and it was on a P/E of 5.3x, and sold it at its high in valuation terms in 1999 when it was on a P/E of 34x, your annual return during that period would have been 11.6% with dividends reinvested, but only 2.3% p.a. came from the massive increase in P/E and 9.3% (80% of 11.6%) came from the companies’ earnings and reinvesting their retained earnings. The S&P example is for 500 average large companies.

This proportion of your return from the companies’ reinvestment activities is even more extreme when you invest in a good company with a high return on retained capital than in an average company. All of this was much more succinctly encapsulated by Warren Buffett when he said: ‘It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.’ He made the transition from being a traditional value investor based upon studying under Benjamin Graham (author of “The Intelligent Investor” and “Security Analysis”) into a quality investor looking for companies which could compound in value based upon the teachings of Philip Fisher (author of Common Stocks and Uncommon Profits) and the influence of Charlie Munger. Here’s how Buffett explained this change in his 1989 letter to Berkshire Hathaway shareholders: ‘The original 'bargain' price probably will not turn out to be such a steal after all. In a difficult business, no sooner is one problem solved than another surfaces — never is there just one cockroach in the kitchen. [Plus], any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.investment

The sort of stocks which trade on low enough valuations to attract value investors are unlikely to be those which we seek – businesses which can somewhat predictably produce a high return on capital employed, in cash, and can invest at least part of that cash back into the business to fund their growth and so compound in value. Unlike our strategy which is to seek such stocks and hold onto them, letting the returns which the company generates from this reinvestment produce good share price performance, value investing suffers from two handicaps. One is that whilst the value investor waits for the event(s) which will crystallise a rise in the share price to the intrinsic value that has been identified, the company is unlikely to be compounding in value in the same way as the stocks we seek. In fact, it is quite likely to be destroying value. Moreover, it is a much more active strategy.this

In Nestlé’s case this was followed by the announcement of new margin and share buyback targets and then a deal to purchase Starbucks supermarket coffee products, excluding the ‘Ready to Drink’ ones, for $7.15bn. In other words, bags of coffee. Presumably we can also look forward to being able to purchase Starbucks Nespresso pods. Virtually no mention was made of the royalty which Nestlé will continue to pay to Starbucks on sales of these products. We rely on the management of our companies to allocate capital in ways which create value for us as investors, and this deal did not seem to meet those criteria, although it certainly seemed to fit the activist imperative to do something and looked like a good deal for Starbucks. This year I thought I would use the opportunity afforded by this letter to talk about our engagement with companies. We are often asked by investors whether we meet company management and how we engage with them. The answer is that we meet them a lot. We visit companies we wish to research and meet them physically or virtually at results meetings and industry conferences.all

During the year we wrote to the management of those companies within our portfolio which have engaged in share buybacks to ask for some insight into their rationale. The responses ranged from prompt, personalized (by the CEO) and well reasoned to being completely ignored. We regard the greatest risk for our investors after the obvious potential for us to buy the wrong shares or pay too much for shares in the right companies, as being reinvestment risk: we seek to buy companies which deliver high returns on capital in cash. What the management then does with these cash returns is one of the major factors affecting future returns on the portfolio. Management faces three main options for deploying these cash returns: return cash to shareholders, invest to grow the business organically or make acquisitions.for

As our portfolio had an average return on operating assets of 50% this reinvestment of cash flows should produce compounding of value for us as shareholders. This FCF yield compares with a FCF yield on the S&P 500 of a bit less than 7%. The median (250thranked) FCF yield in the S&P is 6.6%. What we can say with a high degree of certainty is that our portfolio has a FCF yield higher than the average for the market. Yet it is inconceivable in our view that it is not of higher than average quality in terms of longevity, resilience, predictability, profit margins, return on operating capital and the conversion of profits into cash. Put simply this means that we own shares in businesses which are higher quality than the market on a valuation lower than the average for the market. Whilst that is not a total solution to successful investing, it strikes us as at least a good start. We regard an equity holding as a claim on a share of the cash flow produced by a business. In the Fund we seek to own companies which produce high cash returns on capital and distribute part of those returns as dividends and re-invest the remainder at similar rates of return. And we want to own those companies shares at prices which at best under-value their returns and at worst value them fairly.