Return On Capital Matters

Momentum in the markets is seductive. Most people (even seasoned investors) find it very difficult to argue with rapidly rising or rapidly falling prices.

Since at some level most people have been infected by the efficient market theory (EMT) virus, most people will justify any rapid change in price with fundamentals.

While fundamentals do change and the future is indeterminate, the most egregious fallacies can be observed in stocks of companies that are utility-like in their return (and risk) profiles.

Businesses like airports, power plants, pipelines, toll roads, LNG terminals, power transmission lines and many others that are capital or infrastructure intensive have long but stable (if well run) pay off profiles. The return on capital employed (RoCE) for the best of these companies does not exceed 15 - 16%. With large amounts of leverage, returns on equity (RoE) can potentially be increased to 18-20% with a significant increase in risk. In the current environment when nominal interest rates for avergae borrowers range from 14-16%, the leverage effect on RoEs is lost.

I will argue that most leveraged financial institutions are also utility like. Even the best run banking and non banking finance companies find it very hard to exceed RoEs of 18-20%. This despite carrying 10X leverage and significant risks of equity erosion due to non performing loans.

I find it fascinating that investors (and sophisticated ones) will pay 2, 3 and sometimes 4 times of book value to acquire interests in companies with such utility-like returns. I did an excel exercise and the results are below.

Book Value = 100. Holding period 25 years
100 200 300 400
16.00% 12.83% 11.01% 9.74%
4087 4087 4087 4087
100 200 300 400
14.00% 10.88% 9.10% 7.85%
2646 2646 2646 2646
Book Value = 100. Holding period 15 years
100 200 300 400
16.00% 10.76% 7.81% 5.76%
927 927 927 927
100 200 300 400
14.00% 8.85% 5.95% 3.94%
714 714 714 714

As can be seen, with a generous 25 year holding horizon, buying something that intrinsically yields 16% at just 2 times book value reduces investor returns to 12.83%. Reducing the holding horizon to 15 years reduces investor returns to 10.76%. Most private equity funds have mandates of only 10 years. And god forbid, if something doesn't workout as planned and instrinsic return falls to 14%, the return to investors at 2 times book value and a 15 years holding horizon falls to 8.85%.

However, just like rapidly rising prices of stocks are hard to resist, rapid earnings growth is very hard to resist for investors. Investors seldom see that most earnings growth in such utility-like business is fueled by increasing amounts of capital employed (equity or debt). In fact, companies with rapid increase in capital employed and earnings growth often see declines in returns on capital employed.

In euphoric times, rapid earnings growth fuels stock prices that enables companies to raise larger amounts of equity capital at inflated valuations in a ponzi-like fashion. The overvalued capital raises create no value and merely result in a transfer of wealth from new shareholders to existing shareholders.

It is therefore imperative to look at the intrinsic return on capital generated by a business and to be weary of excessive multiples to book value.