Capital Discipline – There Is A Fourth Great Stock Market Anomaly by Andrew Hunt, Better Value Investing: A simple guide to improving your results as a value investor
Pretty much every investor is aware of the big three stock market anomalies. They are Value, Quality and Momentum. These three strategies have outperformed over the long term across most markets. Indeed, most investors define their styles by one of these approaches or a mixture of them.
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Yet there is a fourth great anomaly that is at least as powerful as the big three. It also has sound, long-term empirical backing and real world explanations. This fourth anomaly is Capital Discipline. I also call it the “Parsimony ‘n’ Payouts” anomaly, because strong Capital Discipline manifests itself in two broad ways: low spending and high payouts. In the table below I define the attributes of Capital Discipline versus its opposite, profligacy.
|Capital Discipline – good signs||Profligacy – bad signs|
Low or negative growth in operating expenditures
|Rapidly rising costs|
No or low M&A activity
|High M&A activity. Especially big deals, deals paid in stock or diversifying deals|
|Low or falling capital expenditures||High or rapidly growing capital expenditures|
|? 3 years since peak capex||Near peak capex|
|Low or negative total asset growth||Rapid total asset growth|
|Low or negative working capital growth||Ballooning working capital|
|Consistently negative cash from financing||Consistently positive cash from financing|
|A growing or initiated dividend||Little or no shareholder returns|
Flat or falling share count
Rising share count
|Issuance of exotic securities (convertible bonds, PIK notes etc.)|
|Falling debt, debt buybacks||Rising debt. New debt issuance|
Like the big three, Capital Discipline is measurable in various ways, and also overlaps with the other anomalies – especially Quality and Value. However, it tends to get significantly overlooked.
For example, when we think of quality investing, we normally define it in terms of stability (such as low earnings volatility or low beta), high profitability due to some form of sustainable competitive advantage, a strong financial position and reasonable growth prospects. Capital Discipline rarely tops that list.
No-one has done more to prove up the big three than Cliff Asness of the hedge fund AQR. Asness has run hundreds of back-tests across different markets, countries, sectors and time periods. His research is pretty rigorous, and as a result he has found that many recorded anomalies are nothing more than statistical quirks. Nevertheless, Asness has found robust evidence of consistent outperformance for basic Value, Quality and Momentum strategies.
Two of Asness’ recent big studies have been on quality investing[i] – an increasingly popular area. In these papers, Asness sought to define quality and then test for it. Sure enough, quality factors outperformed. But now look at his findings:
The most powerful Alpha factor here is Payout (which Asness defines as the aggregate of dividends, buybacks and debt pay-down less issuance and debt raising). Not only does Payout deliver greater alpha than any of the other quality factors, it delivers more alpha than all the factors combined (QMJ in the table above)! Strip out the Payout bit and the other factors behind the quality anomaly offer pretty slim pickings.
It’s not only Cliff Asness who has stumbled on the Capital Discipline Anomaly. Every Capital Discipline factor in the table above has been found to deliver positive alpha in a wide range of back-tests covering different time periods, different countries and different sectors. The Capital Discipline (aka The Parsimony ‘n’ Payouts) Anomaly appears to be universal.
Some examples of research supporting the findings include:
- The outperformance of parents and spin-offs after a spin-off (Rüdisüli, 2005).
- The accruals anomaly. Companies with low or negative accruals have outperformed those with high accruals (Richardson, Sloan, Soliman & Tuna, 2005). Accruals are the difference between reported earnings and reported free cash flows. Hence negative accrual companies have low capex and low working capital.
- Companies with the lowest growth in operating costs have been found to subsequently outperform (Huang, Jiang, Tu & Zhou, 2014).
- The value destruction of M&A and subsequent underperformance of acquirers has been widely reported, while those selling or divesting tend to do much better (e.g. Sirower, 1997; Loughran & Vijh, 1997)
- Out-performance of stocks with the lowest capex growth (Anderson & Garcia-Feijoo, 2007) and lowest total asset growth (Cooper, Gulen & Schill, 2006; Li & Sullivan 2015), and underperformance of those growing fastest.
- The widely recorded success of dividend strategies, such as the Dogs of the Dow (see this Tweedy, Browne paper for a helpful summary: http://www.tweedy.com/research/papers_speeches.php ). In particular, two studies have made the counter-intuitive finding that stocks with high dividend payouts actually experience faster future earnings growth than stocks with low dividend payouts! (Arnott & Asness, 2002; Zhou & Ruland 2006).
- A similar body of research exists on the outperformance of companies buying back shares, especially when they’re cheap (e.g. Bali, Demirtas & Hovakimian, 2010)
- More recently, research has emerged finding that yield or buyback strategies can be enhanced by using a total shareholder yield measure – the aggregate of buybacks, dividends and debt paydown less equity and debt issuance (Gray & Vogel, 2012; Bradshaw, Richardson & Sloan, 2006; Meb Faber, 2013).
From Meb Faber research: http://mebfaber.com/2012/10/09/a-50-tax-rate-on-dividends/
- However, by far the most comprehensive body of research on Capital Discipline has been compiled by Empirical Research Partners. They’ve written dozens of papers looking at all different aspects of Capital Discipline (changes in share count, dividend policies, asset growth, capex, M&A etc.) as far back as 1952.[ii] They’ve back-tested in the US and internationally, across different sectors, and over holding periods from one month to three years; yet their findings have been remarkably consistent. The most disciplined companies tend to outperform the most spendthrift by about ten percent a year. Further, a Capital Discipline filter is complimentary to value strategies, typically adding about 5% of outperformance a year.
Why is Capital Discipline so powerful?
I recently attended a wedding. The bride had a beautiful new dress, we had a picnic followed by a house-party with live music, and there were flowers and cake – everything that a great wedding needed. As the couple were trying to save, they did the whole thing on less than $500. By contrast, last week newspapers reported a Russian oligarch spent a cool billion dollars on his daughter’s wedding. In the end, both couples had a fabulous and memorable day surrounded by friends and family.
The point is, just as there is no limit to how much you could spend on a house, a meal, an outfit or a wedding, there is no limit to what companies can spend. You can get an office chair for $10 or $10,000, a headquarters can cost over a billion, and there really is no ceiling to how much you can pay staff, throw at M&A, or fritter away on management pet projects, private jets and even stationery. The whole capitalist system is designed to take money off you as fast as you can spend it.
For example, Facebook blew $21bn on an app which may already be becoming obsolete, and pays its mid-level programmers $4m a year. Google has just paid its CEO over $100m for his first year in the job! Since 2007, 90% of all M&A by mining companies (remember all those multi-billion dollar deals) has been entirely written off!
To illustrate just how bad companies generally are at spending money, James Montier looked at dividend growth rates and reinvestment rates since 1955.[iii] While the average company retains nearly 50% of its earnings, real dividend growth has been just 0.4% per annum!
The architect Edwin Lutyens once said, “No man is so rich that he cannot be bankrupted by his architect.” Well no company is so great that its investment case cannot be obliterated by profligacy. Even for the biggest and greatest, a few billion here and there soon adds up. Thus, different attitudes to spending have enormous effects on long run, compound returns.
In reality, most firms swing between periods of profligacy and parsimony. And this is the second reason the Capital Discipline Anomaly is so powerful: it helps time the capital cycle. When companies are cutting costs everywhere, making disposals and paying down debt as fast as they can, you’re probably getting near the trough. When companies are spending hand-over-fist, it’s a sure sign they’re making supernormal returns, the outlook is great and capital markets are willing to lend them all the debt or equity they could ever want. All these signal an imminent peak in the capital cycle.
The commodity boom and bust of the past decade is a great example. Back in 2006-2010, commodity companies were spending like crazy on everything. Everyone wanted to give them money: there were endless roadshows, IPOs and new bonds on top of the eye-watering profits being made already. Now we’re starting to see the opposite. However, it really took until 2015 before real industry-wide capital discipline started coming through, as resources projects typically take several years to complete. Once again, the Capital Discipline anomaly may now be signalling a bottom.
Similarly, capital indiscipline is a great indicator of corporate hubris. This is when a management team becomes delusional, overconfident and narcissistic. However, building an empire is expensive – all that M&A, inflated salaries and vanity projects. From Napoleon to Royal Bank of Scotland, hubris tends to end in disaster and enormous losses. Meanwhile, those companies spending conservatively are normally at the other end of the hubris cycle. They remain humble, focused and cautious. From here it is easy to surprise on the upside.
There is a final benefit to the Capital Discipline anomaly. And this is particularly apposite for emerging market investors. Many companies – especially in countries where governance is weak – turn out to be fraudulent or grossly mismanaged, with the majority owners using company assets for themselves. If you look at almost every example of this, there is one dead giveaway – year after year of positive cash from financing and little in the way of shareholder returns. This is self-evident: Ponzi schemes don’t pay out! Picking the low spend–high payout names avoids these frauds. This may explain why a simple high yield strategy has been one of the most effective approaches for emerging market investors.[iv]
Forget Coke, have you ever heard of Mesabi Trust?
When investors talk about the benefits of investing in great businesses, they love to talk about stocks like Coca-Cola, with its consistent growth, global appeal and strong franchise. Yet people rarely talk about Capital Discipline as a defining feature.
When Jeremy Siegel went back and looked at the best possible stocks you could have bought and held since the advent of the S&P 500,[v] the commonality among all the top long-term winners was big, consistent and generous dividends.
A more recent, yet equally intriguing example is Mesabi Trust. You’ve probably never heard of Mesabi trust. Mesabi trust owns the iron ore mining rights to a mountain in Minnesota. A subsidiary of Cliffs digs the stuff out and pays the trust a royalty. Sounds awful right? You’re selling a commodity to a nation that has been de-industrialising for decades. But here’s the thing, Mesabi Trust has delivered a 148-fold return since 1987! The trustees simply kept their costs down, kept focused and paid out year after year.
Then there’s the Alliance coal companies – Alliance Holdings and Alliance Resource Partners. These are low cost US coal producers. Once again, here is an ugly, declining, commodity business that’s been in a massive bear market. Yet read the annual reports and it becomes pretty clear the owner-managers are obsessed with costs, while the MLP structure mans they end up paying out almost all their earnings. The result: From their 1999 IPOs to 2015, both these companies delivered in excess of a 24-fold total shareholder return.
The point is, Capital Discipline over the long run matters more to returns than conventional notions of quality. All those little cost savings add up. It’s the hidden magic behind great long run returns.
Reading through Buffett’s letters and I interviews, this is perhaps the most salient yet neglected point. Whenever he’s bought controlling stakes in businesses, he’s juiced them. He doesn’t let them spend much. They don’t get a chance to waste a dime. He simply keeps taking their money away!
Everyone remembers the story of Scrooge – the miser in Charles Dickens’ tale, “A Christmas Carol.” While no one liked Scrooge he was the richest guy in town.
Similarly, the Capital Discipline Anomaly is the great unloved anomaly. Picking companies when they’re spending little and paying out a lot, and then selling them when the spending grows is a really powerful approach.
Moreover, it is incredibly complimentary to value strategies; enhancing returns by improving timing and avoiding fraudulent or mismanaged value traps.
For quality investors, Capital Discipline should be at the heart of the investment process, even though it may seem less intuitive than say, profitability or defensiveness.
Maybe at some point we’ll see a whole new class of successful investors who don’t define themselves along the conventional lines of Quality, Growth, Value, Income or Momentum, but proudly call themselves “Capital Discipline Investors” instead.
About Andrew Hunt
Andrew Hunt is an Investment Manager and author of Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor:Better Value Investing: A simple guide to improving your results as a value investor
[i] Quality Minus Junk, 2013, Asness, Frazzini, Pederson:
Size Matters, if you control for junk, 2015, Asness, Frazzini, Israel, Markowitz & Pederson:
[ii] See e.g. Goldstein, M. L., Cho, B. J. and Price, N., ‘Deeds, Not Words: Capital Deployment, Financing and Their Consequences. Surprisingly, Cash Is Not Trash’ (Empirical Research Partners LLC, February 2004); Adrian, S., Yang, S. and Sapp, W., ‘International Portfolio Strategy: Emerging Market Modelling (Part II): Using Capital Deployment and Earnings Quality to Pick Stocks’ (Empirical Research Partners LLC, October 2009); Goldstein, M. L., Cho, B. J., Price, N. and Dix, L., ‘The Small-Capitalization Value Stock Selection Model. Trust, But Verify’ (Empirical Research Partners LLC, November 2004).
[iii] Montier, J. ‘Global Equity Strategy: Capital discipline as an alpha source, or, pay me my money down’ (Dresdner Kleinwort Research, June 2007).
[iv] See e.g. Kapur, A., Luk, P. and Samadhiya, R., ‘Stock-picking – Minefields, Fertile Acres’ (Deutsche Bank AG/Hong Kong Global Markets Research, January 2011)
[v] Siegel, J. J. The Future for Investors: Why the tried and true triumph over the bold and the new (Crown Business, 2005).