Quality Control by Marathon Asset Management, dated May 2014. This is discussed in their new book Capital Returns: Investing Through the Capital Cycle: A Money Manager’s Reports 2002-15 we think – anyway read it below.
Capital Cycle analysis helps to identify investments with high and sustainable returns
The capital cycle approach to investing is often associated with stocks from the ‘value’ universe, where low and falling returns lead to capital flight, laying the foundations for an eventual recovery in profitability and valuations. It is perhaps less well understood how the capital cycle can also be applied to companies which have high and sustainable returns. This class of business has produced some of Marathon’s best performers over the last ten years – Coloplast, Intertek, Geberit, Gartner, Kao and Priceline to name a few. How do such investments fit in the capital cycle framework?
Pricing power has arguably been the most enduring determinant of high returns for these investments. It has come from two main sources. The first being a concentrated market structure, closely associated with effective management of capacity through the demand cycle which encourages a rational approach to pricing. The second being ‘intrinsic’ pricing power within the product or service itself. Intrinsic pricing power is created when price is not the most important factor in a customer’s purchase decision. Most often this property is generated by the existence of an intangible asset. There are several classes of intangible assets, examples of which can be found amongst Marathon’s holdings.
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An obvious one is consumer brands. In the toothpaste category, private label penetration is only 2 per cent, supporting Colgate’s excellent economics. An intangible asset can also derive from a long-term customer relationship, as in case of the agency business models (Legrand, Assa Abloy or Geberit) where the customer relies on intermediaries (electricians, architects and plumbers respectively.) The agent’s interest is safety, quality, reliability, availability and perhaps his own ability to earn a commission. Under such circumstances, price is a pass-through to the end customer, for whom product costs represent a small part of the total bill.
Sometimes a product is so embedded in a customer’s workflow that the risk of changing outweighs any potential cost savings – for instance in subscription-based services like computer systems (Oracle) or payroll processing (ADP, Paychex.) Networks, where the customer benefits from a company’s scale, as in the security business (Secom), industrial gases (Praxair, Air Liquide), car auctions (USS) or testing centres (Intertek) are another example. Finally, technological leadership (Intel, Linear Technology) can be another important intangible asset – although this is perhaps one of the less durable sources of pricing power, unless combined with others. The very best economics appear when some of the above characteristics combine in a situation in which the cost of the product or service is low relative to its importance. For example, the analog semiconductor chip which activates the car airbag, yet costs little more than a dollar.
The presence of intangible assets acts as a powerful barrier to entry. They are by nature durable, difficult to replicate and tending to economies of scale. Importantly, these barriers often strengthen over time as high returns on capital throw off abundant free cash flow which is in turn reinvested in the business. For example, over the last five years, P&G has spent over $40bn in advertising whilst Intel has invested over $40bn in R&D. This repels new entrants, short-circuiting the destructive side of the capital cycle – whereby excess profits normally attract competitors, which over time erodes profitability. Thus, the presence of intangible assets creates a virtuous cycle allowing intrinsic value to compound over sustained periods at above average rates, an extremely powerful combination for the long-term shareholder when allied with prudent use of free cash flow. (The importance of management in this process is paramount – high organic returns can be diluted quickly by poorly conceived investment decisions or badly timed buybacks.)
Critically, this higher rate of compounding comes at a lower level of risk as the economics of a high return business tend to be more resilient to adverse shocks. This is partly mathematical – a 1 per cent fall in margin has a greater impact on a 5 per cent margin business compared to one that earns 20 per cent. Equally though, the factors which create sustainably high returns – intangible assets, strong market position and rational management – also make a business more robust in the face of adverse changes in the business environment, whether of a macroeconomic or industry specific nature.
For investors with short-term horizons, the virtue of compounding at a higher rate can appear insignificant. Over short time periods, share prices are generally driven by other factors such as macroeconomic or stock specific news flow. Investing in a high quality company can seem dull and unrewarding in the near term. The lower risk which comes from investing in quality companies is only properly observed over the long-term. The fact that investors are often focused more on the short-term is partly a function of psychology – the human brain is simply not attuned to multiyear planning, being far better at responding to short-term threats and stimuli. This is seen in several behavioural heuristics – notably hyperbolic discounting1 and recency bias. Short-termism can be intensified in an institutional setting. Performance-related pay for money managers at most investment firms is weighted to annual performance, which discourages long-term thinking.
Finally, there is another more technical reason why the virtues of a high return business are not always fully appreciated by investors. This is the tendency of investors to focus on the income statement. This fosters a fixation on price earnings (P/E) valuation metrics and not price free cash flow (P/FCF). Thus all earnings growth is seen as equal, even though it is materially more value creative when return on capital and cash flow generation is higher. Faced with a choice between invest in two companies with the same earnings growth, we are prepared to pay materially more (in P/E terms) for the business with high returns on equity and superior cash flow generation.
In short, there are any number of good reasons to invest in businesses with durable high returns. Now appears an especially good time to do so. The rationale is simple – across nearly all sectors margins are close to peak levels. It is sensible, therefore, to consider whether current profitability is sustainable given the historical tendency of margins to mean revert. In addition, tail risks lurking in the background – namely elevated debt levels in the private and public sectors, and the uncertain consequences of the unprecedented degree of monetary stimulus – are likely to impact the profits of lower quality firms at some stage in the future. Current valuation levels do not require investors to pay a premium for this superior durability, hence the preponderance of higher return names in our global accounts.2