Hidden Value Stocks issue for the fourth quarter ended December 31, 2020, featuring an interview with Shreekkanth “Shree” Viswanathan, CFA, CPA, the President and Portfolio Manager of SVN Capital, LLC. In this part, Shree discusses the regions where he will not invest, the most important ingredient to growth in intrinsic value, and how he calculates high ROIC.
The fund has a broad investment mandate. Are there any regions you won’t look at?
Yes, the fund has a broad mandate because I feel that investment opportunities can and do come from many different countries. But this global approach doesn’t mean that I am interested in any company from any country; while there is nothing wrong with countries like Mongolia or Nigeria, I have no idea about those markets and so will avoid such markets. Since there are more than 30,000 publicly traded securities, to help me focus on the truly outstanding opportunities that satisfy my criteria, I have a few self-imposed constraints.
First, since accounting is the language of business, I look for countries that require their companies to file their financials in either U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). But there are more than 140 countries that follow IFRS. To help refine the list further, I apply the following two constraints.
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First is my understanding of the local governance and intellectual property (IP) laws. As a patient, long-term investor, I’d like to have the confidence that the local laws of the land protect the minority investor, acknowledging the fact that local practices and politics will move certain countries along the spectrum of low to high risk over time. One such country that I find interesting and am invested in is Poland. Another that I find appealing, but am not currently invested in, is India.
Finally, I’d like these companies to file their financials in English. I don’t want to be spending time translating them into English. I find this to be an issue mostly in Japan, where many companies file their financials only in Japanese.
With these self-imposed constraints, I find myself fishing in the U.S., Canada, Western and Eastern Europe, as well as in some advanced Asian countries.
Your past positions suggest you have a preference from owner-operated firms. Can you talk a bit about why you prefer these businesses?
Sure. Yes, one of the important investment criteria I follow is to partner up with highquality management teams. Management’s primary governing objective should be to allocate capital so as to earn a return on capital that is in excess of the cost of capital. As a minority, patient, long-term investor, I believe it is only reasonable to expect my share of the capital to be allocated efficiently.
Warren Buffett wrote about the importance of capital allocation skill in his 1987 annual letter. “After 10 years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all capital at work in the business,” he wrote. Since reinvestment is an important ingredient to growth in intrinsic value, capital allocation is the most important job of a CEO. In the same annual letter, Buffett made the following observation, “The heads of many companies are not skilled in capital allocation, and…it is not surprising because most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration, or sometimes, institutional politics.”
What I have found in my experience is that many owner-operated companies are able to address this important issue of capital allocation very efficiently. Owner-operated entities that I find appealing have some more unique features. CEOs and the boards of directors of such companies embrace the role of capital allocators. They tend to focus on cash flow and per-share metrics. Usually, these owner-operated businesses have a good compensation program, well-aligned incentive structure, and an ownership culture throughout the organization. Currently, 10 of the 12 portfolio companies are either owner operated or family controlled.
While I am a fan of owner-operated businesses, I become concerned when I find such businesses are controlled through multiple share classes, e.g., when the family owns 20% of the outstanding shares but controls it through a super-voting share class.
SVN Capital also has a preference for firms exhibiting a high ROIC. Can you explain how you calculate this figure?
Yes, I have a preference for high-quality businesses that can grow their intrinsic value at high rates over long time horizons. Let me try and explain why. As a long-term investor, I seek to buy and hold securities that I believe will compound in value over the years. In my estimation, quality is more important over long-term holding periods, as one’s longterm returns will approximate the company’s internal returns on capital over time.
If reversion-to-mean is the one constant affliction in business environments, then these high-quality businesses are either able to avoid such reversion or, more likely, defer such affliction far into the future due to some unique features, e.g., dominant market share as a result of being a monopoly or duopoly player, patents, distribution networks, installed bases and client relationships. Such competitive strength manifests in healthy gross margin, high free cash flow conversion of net income, which then leads to generating high ROIC in cash.
An important element of a high-quality business is high ROIC. The type of high-quality businesses that I prefer not only generate high ROIC, but also have good reinvestment opportunities. The combined effect of high incremental ROIC and reinvestment rate leads to growth in intrinsic value. In addition, they tend to have management teams that allocate excess cash flow (if reinvestment rate is less than 100%) efficiently.
I use the textbook definition of ROIC, which says ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital. However, I’ll make adjustments to both the numerator and denominator, e.g., type of growth (organic vs. acquisitions), working capital needs, and capital expenditure needs.
One approach to computing Invested Capital is Total Equity + Net Debt. While this method is widely used, it only shows how much capital the firm has and how it has chosen to finance the business. Instead, I prefer using the net assets approach, i.e., Invested Capital = Net Working Capital + Net, Property, Plant & Equipment + Goodwill + Other Operating Assets. This approach allows me to see how efficiently the company is using its capital.
See the full interview.