Tuesday, October 30, 2012

Maximizing Per-Share Value

From this Barron's interview of Bill Nygren, co-manager of the Oakmark Fund:

"...something gets missed when people are talking about expectations of lower corporate profit growth and lower gross domestic product. What they are missing is how much excess cash companies have today and will continue to produce if the real-world economy isn't growing much."

These days, a much lower proportion of earnings are paid as dividends compared to historical norms. Since 1900, companies have, on average paid out something like half of earnings in dividends.* By comparision, the dividend-payout ratio in recent years has been more like 1/4 to 1/3 of profits. Nygren also added:

"There aren't many opportunities to invest in expanding capital expenditures, because there isn't growth there to be had."

For a variety of reasons, there is just fewer opportunities to intelligently deploy all the cash being generated in the current environment. Combine the current reduced capital needs with historically low dividend payout ratios and the net result is cash piling up on corporate balance sheets. This all makes for an environment where many businesses can easily afford to increase dividends and/or buyback shares.

Nygren points out that a company with a P/E of 14 and pays out as dividends one-third of its earnings has sufficient capital to buyback close to five percent of its stock every year. He goes on build on the assumption that ("the bears on the economy are right") there continues to be a subpar macro environment, maybe something like 1% real GDP growth (well below the historic norm) and 2% inflation:

"...that gets you to about 3% nominal GDP growth, which is a pretty good proxy for corporate profit growth. But that's on a share base that's shrinking 5% a year. Companies can still deliver upper-single-digit— if not double-digit—earnings-per-share growth rates, given how strong balance sheets are and how strong free-cash-flow generation is. So it is more important than ever for investors to align themselves with managers who think about not just maximizing value, but maximizing per-share value."

The next time someone tries to equate underwhelming GDP growth with subpar returns on marketable common stocks keep this in mind.

For good businesses, reduced economic growth likely means less capital (capital expenditures, other long-term investments) is necessary. Reduced capital requirements allows management more flexibility over what to do with the excess cash available.

"...the companies we are most interested in are the ones that are just as happy to use that capital to reduce their share base as they are to build a new plant or go make an acquisition."

For investors, it's not just key to buy cheap shares of companies with modest incremental capital requirements.

It's key to own small pieces of a business that can comfortably maintain (or ideally expand) its long-term competitive advantages when deploying only modest incremental capital.

The better businesses can do this but corporate managers need to be interested in "maximizing per-share value" instead of "expanding the empire" with per-share value creation a secondary consideration (or worse). Some are very clever about selling the idea that they're doing the former when it's actually more about the latter.

A weaker business, no matter what the macro environment happens to be, needs lots of incremental capital just to maintain competitiveness.** Even when the business has had enough ongoing investment to remain competitive, the returns on the capital that gets put to work isn't great. So these necessary capital expenditures, at best, produce just decent return on capital and, for the worst businesses, downright unattractive returns. Management has the option to underinvest (neglect necessary capital expenditures), allow competitiveness to suffer in the core business, while deploying the proceeds to some opportunities that generates better returns. The hope being that the new investments will pay off before the original business suffers too much (and shrinks in relative importance over time) and eventually leads to more attractive overall shareholder returns. This requires skilled management and is hardly easy to execute. At a minimum, figuring out how a situation like that will play out in advance is usually a pretty tough call.

Good businesses are the opposite. They need little capital to maintain competitiveness (and maintain attractive return on capital) but, when the opportunity to put additional capital to work arises, the incremental returns are attractive. In other words, the returns for shareholders end up being attractive whether there is impressive growth prospects or not.

This gets at the core of why exciting growth isn't necessary to achieve rather attractive long-term results. It's more important for a business to have durable competitive advantages than astonishing growth prospects. Those advantages allow shareholder to do well even if growth prospects remain fairly modest. Growth can, of course, be a good thing. Yet some assume it is always a good thing.
(The prior related posts below are meant to, at least, challenge that sometimes mistaken assumption.)

"Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive." - Warren Buffett in his 1992 Letter

The real question, at least for common shareholders, is whether the growth has a favorable impact on the per-share value created over a very long time. Sometimes it does. Sometimes it does not.

Growth, of course, will often have a favorable impact on value. 

It just happens to be a mistake to think that it always has a favorable impact. 

In fact, growth can actually reduce value if it requires capital inputs in excess of the discounted value of the cash that will be generated over time. Sometimes, the highest growth opportunities attract lost of capable competition and capital that ruins the long run economics. Sometimes, high growth requires expensive but necessary capital raising that dilutes existing shareholders and reduces per share returns.

Finally, even if growth that materializes does have favorable economics, some investors tend to pay a large premium upfront for those growth prospects. That hefty price paid may turn attractive long-term business results into not so attractive investment results.

Check out the full Barron's interview.

Adam

Related posts:
Death of Equities Greatly Exaggerated - Aug 2012
Stock Returns & GDP Growth - Jul 2012
Why Growth May Matter Less Than Investors Think - Jul 2012
Ben Graham: Better Than Average Expected Growth - Mar 2012
Buffett: Why Growth Is Not Necessarily A Good Thing - Oct 2011
Grantham: High Growth Doesn't Equal High Returns - Nov 2010
Growth & Investor Returns - Jun 2010
Buffett on "The Prototype Of A Dream Business" - Sep 2009
High Growth Doesn't Equal High Investor Returns - Jul 2009
The Growth Myth Revisited - Jul 2009
The Growth Myth - Jun 2009

* The real issue is whether the payout ratio allows the business to maintain competitiveness or, when applicable, expand the business in a high return manner for shareholders. For some businesses, a high payout ratio makes a lot of sense. For others, it certainly does not.
** The Berkshire Hathaway textile business comes to mind. If Buffett had just continued investing in the textile business instead of allocating capital elsewhere, Berkshire Hathaway would be a shadow of itself today. Check out the 1985 Berkshire Hathaway (BRKaShareholder Letter for more background.
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