Terry Smith on Opportunity Cost

It is not a bad starting point when trying to estimate a cost of equity capital to look at the long-term return on equities as it is in effect an opportunity cost: what return should an investor expect from equity investment over the long term? That is what they should demand as a cost of supplying equity by owning shares — the cost of equity capital. US equities have averaged a return of about 9% p.a. over the past century. It certainly isn’t 2%. If companies or investors start making decisions which deviate much from that assumption based upon soaring share valuations the outcome will be disastrous. In 2000 Vodafone, the UK based mobile phone operator which was one of the leaders in the Dotcom boom, bid for Mannesmann, the German mobile operator. At the time Vodafone was on a PE of 54 and Mannesmann was on a PE of 56. That points to another fallacy — managements often justify what they are paying for assets in booms and bubbles by the fact that they are paying by issuing over-valued or highly-valued shares. Hang on a minute, what does that imply for investors? We can see the results insofar as Vodafone’s shares peaked at a value of 570p in 2000 when it bid for Mannesmann and they are now trading at 99p. When value is destroyed by bad capital investment decisions there is always a reckoning.

However, the industry often results in what was once virgin rainforest being converted into biologically uniform palm oil plantations. The complexity of the issues surrounding the industry was shown when 2,000 palm oil plantation workers gathered in Malaysia’s capital, Kuala Lumpur, to protest against the EU’s plan to remove palm oil from its list of designated renewable fuels because of the impact it has on deforestation and the draining of wetlands. The farmers in Malaysia argued this wasn’t the case and that the only motive was to put Malaysian small holders back into poverty. The problem for FMCG companies is that substituting palm oil in their products will have a larger negative impact on the environment than continuing to use it. This is because palm oil yields around 5 tonnes of oil per hectare per year, which is almost 5x as much as rapeseed oil, the next best alternative with similar characteristics. Palm oil production also requires less fertilizer and fewer pesticides.at