Exec Comp & ROIC Model Portfolio: Recap from October’s Picks
Our Exec Comp Aligned With ROIC Model Portfolio (+4.0%) outperformed the S&P 500 (+1.5%) last month. The best performing stock in the portfolio was Harley-Davidson (HOG), which was up 19%. Overall, 10 out of the 15 Exec Comp Aligned With ROIC Stocks outperformed the S&P in October.
The success of the Exec Comp Aligned With ROIC Model Portfolio highlights the value of our forensic accounting (featured in Barron’s). Return on invested capital (ROIC) is the primary driver of shareholder value creation. By analyzing footnotes in SEC filings, we are able to calculate an accurate and comparable ROIC for 3000+ companies under coverage.
This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating and align executive compensation with improving ROIC. We think this combination provides a uniquely well-screened list of long ideas.
New Stock Feature for November Cooper Tire & Rubber Company (CTB: $37/share)
Cooper Tire & Rubber Company (CTB), automobile tire manufacturer, is one of the additions to our Exec Comp Aligned With ROIC Model Portfolio in November.
Since 2013, Cooper Tire has grown after-tax profit (NOPAT) by 5% compounded annually to $211 million in 2015 and $248 million over the last twelve months (TTM), per Figure 1. Over the long-term, CTB has grown NOPAT by 13% compounded annually over the past decade. Additionally, CTB has improved its NOPAT margin from 5.5% in 2013 to 8.5% TTM and generated a cumulative $1.1 billion in free cash flow over the past five years.
Figure 1: NOPAT Growth Since 2013
Sources: New Constructs, LLC and company filings
Executive Compensation Aligned With ROIC Creates Shareholder Value
Cooper Tire added ROIC to its executive compensation plan in 2000 and the compensation committee determined the company’s ROIC correlates to changes in shareholder value, a finding we’ve discussed in detail here. Since 2013, CTB’s ROIC has improved form 7% to 10% TTM, per Figure 2. Long-term, Cooper Tire’s ROIC has improved from 3% in 2005 to 10% TTM.
Figure 2: ROIC Improvement Tied To Shareholder Value Creation
Sources: New Constructs, LLC and company filings
In 2015, ROIC was weighted at 20% of long-term incentive compensation, which includes restricted stock units, performance based stock units, and performance based cash. Net income is the other metric used to determine long-term incentive awards. Investors should see less risk and more upside in stocks where management incentivizes focus on ROIC and avoids questionable non-GAAP metrics.
Despite Price Increase, CTB Remains Undervalued
Despite Cooper Tire’s share price increasing 21% over the past six months, shares remain significantly undervalued. At its current price of $37/share, CTB has a price-to-economic book value (PEBV) ratio of 0.7. This ratio means the market expects CTB’s NOPAT to permanently decline by 30%. Such low expectations seem pessimistic given CTB’s ability to grow NOPAT over the past decade.
If Cooper Tire can achieve 6% NOPAT margins (5 year average, but below 9% TTM) and grow NOPAT by just 3% compounded annually for the next decade, the stock is worth $46/share today – a 24% upside. This scenario assumes Cooper Tire’s spending on working capital and fixed assets will be 2% of revenue, which is the average change in invested capital as a percent of revenue over the past decade. Coupled with CTB’s 1% dividend yield, this stock provides a great low risk/ high reward opportunity.
Impacts of Footnotes Adjustments and Forensic Accounting
In order to derive the true recurring cash flows, an accurate invested capital, and a real shareholder value, we made the following adjustments to Cooper Tire’s 2015 10-K:
Income Statement: we made $290 million of adjustments with a net effect of removing $2 million in non-operating income (<1% of revenue). We removed $144 million related to non-operating expenses and $146 million related to non-operating income. See all adjustments made to CTB’s income statement here.
Balance Sheet: we made $1.4 billion of adjustments to calculate invested capital with a net increase of $419 million. The most notable adjustment was $517 million (26% of reported net assets) related to other comprehensive income. See all adjustments to CTB’s balance sheet here.
Valuation: we made $1.3 billion of adjustments with a net effect of decreasing shareholder value by $693 million. The most notable adjustment to shareholder value was the removal of $571 million due to pension-funded status. This adjustment represents 29% of Cooper Tire’s market value. Despite the net decrease in shareholder value, CTB remains undervalued.
This article originally published here on November 21, 2016.
Disclosure: David Trainer, Kyle Guske II, and Kyle Martone receive no compensation to write about any specific stock, style, or theme.
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Article by Kyle Guske II, New Constructs