Donville Kent Asset Management on High ROE Stocks
The first half of 2014 has been kind to our investors. The Capital Ideas Fund was up 13.3%1 as of the end of June, and we feel optimistic about the markets for the balance of the year.
The month of July has been a busy one for me personally, as I was in Denver for close to ten days watching the World Lacrosse Championships. As a supporter of Team Canada, I had the joy of watching my oldest son living out one of his dreams and the thrill of watching underdog Canada score a stunning 8-5 victory over Team USA in the championship game. Wow…I am still tingling!
On high ROE stocks
Since my last newsletter I have had more than a few discussions with analysts and clients about why I focus on high ROE stocks. While I have written on this topic before, I thought I would share with you a few insights that will give you a better understanding of the methodological journey that I have been on since the early 1990’s, when I attended the University of Western Ontario Business School (now called the Richard Ivey School of Business).
I arrived at the University of Western Ontario in the summer of 1990, just a few months removed from the First Canadian Submarine Squadron. At that time, all I knew about myself was that I was ready for a career change and that I wanted to acquire the basic accounting, marketing, finance and operations knowledge that would allow me to be employable and successful in a business career.
At Western, I had the benefit of taking a number of wonderful courses that opened my eyes onto worlds I had never thought much about before. The one course I wanted to take but couldn’t due to scheduling issues was Professor David Shaw’s course on capital allocation, which leaned heavily on the work of the consulting firm Stern Stewart and valued based management. While I was not able to enrol in Shaw’s course, I did read the textbook and the key concepts that I took from the book formed the basis for how I looked at companies and investments. For me, the key concept from Stern Stewart was that capital has a cost, and the most valuable companies to own are those that can consistently earn a return on capital that is well in excess of their cost of capital. A second concept, which was almost as important, was the impact that management can have on the enterprise by getting the asset allocation function right. Companies make things, sell things, etc. but the role of allocating capital intelligently is in itself a sophisticated skill set, and many companies that are good at making and selling things can also be poor allocators of capital.
While I admit that the previous paragraph is a bit dry, when we look at specific companies, the importance of capital allocation that I learned from the likes of Stern Stewart hopefully become a bit more interesting. Readers of this newsletter know that I am a fan of technology companies, and two companies that we have looked at frequently over the years are Constellation Software Inc. (TSE:CSU) (Figure 1) and Descartes Systems Group Inc (NASDAQ:DSGX) (TSE:DSG) (Figure 2). Both companies are very successful software companies and thus they each get high marks in terms of making and selling things. But we have chosen to own Constellation Software over Descartes because we think the former is a much better allocator of capital. Constellation’s Return on Equity (as we measure it) is typically three times higher than that of Descartes, in part because Constellation runs with an appropriately lean capital structure while Descartes is perennially over-capitalised. Both companies have delivered strong returns to investors, but Constellation’s superior capital allocation strategy has made a significant difference in terms of its long-term share price performance.