Companies that grow constantly and inexorably are a rare breed indeed and they are the types of companies that we relish investing in. Such companies have a high return on invested capital and an ability to allocate capital very skillfully to achieve superior share price growth over the longer term. Think of Amazon as a classic example of this type of business.
Return on invested capital (ROIC) is a calculation used to assess a company’s efficiency in allocating capital to profitable investments. The ROIC formula involves dividing net operating profit after tax (NOPAT) by invested capital. ROIC gives a sense of how well a company is using its capital to generate profits.
Capital allocation means distributing and investing a company’s financial resources in ways that will increase its efficiency and maximise its profits. A firm’s management seeks to allocate its capital in ways that will generate as much wealth as possible for its shareholders.
Capital allocation is a strategic approach to investing financial assets to maximise a company’s profits. Five methods of capital allocation are organic growth; mergers and acquisitions; paying off debt; dividend payments; and buying back company shares.
Warren Buffett is widely considered to be one of the greatest capital allocators of all time. His Berkshire Hathaway investment achieved a compound return of almost 20% a year for more than 55 years which is the equivalent of turning £1,000 into £50 million.
There are many ways to assess a company’s performance but many of the metrics used are not reliable because they depend on figures produced by their accounts which are unreliable because of the wide scope accountants have to use estimates and judgements which create imprecise accounting results.
A far more robust approach is to focus on a company’s free cash flow which represents all of its cash from operations minus capital expenditure. In our experience, this is a far more reliable measure of a company’s true profitability than the profits from the profit and loss account.
We also prefer to value a business based on a multiple of its free cash flow per share rather than its earnings (or profits) per share.
Mark Leonard, the CEO of Constellation Software who is himself a great capital allocator, once said “Over the long term, stock returns will be determined largely by which capital allocation decisions the CEO makes. Two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.”
This 1997 letter to Amazon shareholders is a great example of how a company with high compound returns should work.
https://venturebeat.com/wp-content/uploads/2010/09/amzn_shareholder-letter-20072.pdf
Note the emphasis on generating high free cash flow and re-investing into the business.
As Charlie Munger, Warren Buffett’s long term business partner once said “If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
Companies where there is a visionary founder owner still working in the business who has skin in the game like Jeff Bezos achieve higher investment returns on average than other companies. If you combine this type of ownership with an approach of buying back its own shares the results are significantly better than for 96% of companies in the S&P Index.
We very much favour this approach because it really works. You know it makes sense.*
Tony Byrne, Managing Director
If you want to learn more about this topic, please find the link here.
More information about our fund the YFS Intelligent Wealth Fund can be found here: Hargreaves Lansdown or AJ Bell
*Risk warning
The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
