There are numerous factors cited for investment success many of which are not particularly useful or relevant. In my experience the following six factors are the key to achieving superior investment returns.
- High free cash flow
- High return on invested capital
- Excellent capital allocation skills
- Competitive advantage
- Top class management
- Patience
Let me explain to you why these six factors are crucial in obtaining and maintaining excellent investment returns.
High free cash flow
High free cash flow is vital for the strength of the business. Why is this? Well unlike earnings which can be manipulated easily, free cash flow cannot be manipulated. The cash flowing into and out of the business’s bank account is a matter of fact. It cannot easily be hidden. Whereas earnings can be altered substantially thus presenting a less accurate picture of the company’s performance.
High return on invested capital
Once you have established high free cash flow you need to be sure that the company will achieve a high return on invested capital (ROIC). In this measure, a company is evaluated on how efficiently it allocates its capital to profitable investments based on its return on invested capital (ROIC). The ratio is calculated by 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 profit.
Excellent capital allocation skills
Investing a company’s capital efficiently in order to maximise shareholder equity is the goal of capital allocation.
Here are five ways you can allocate capital
- Grow organically. A company that grows organically uses its capital to expand or streamline its operations
- Mergers and Acquisitions (M&A)
- Repayment of debts
- Make dividend payments
- Buying back shares
Paying dividends is the worst option because it means giving away capital that cannot be used to grow the business. What’s more, it is tax inefficient because you have to pay tax on dividends rather than Capital Gains Tax on the eventual sale of the shares at, usually, a lower rate of tax, and on a later date, potentially many years later in the future, if at all. Remember Capital Gains Tax doesn’t apply on death!
The other four options make much more sense, especially the buying back of shares as log as they are bought at a good price.
Competitive advantage (economic moat)
An economic moat is an advantage a company has over its competitors that allows it to protect market share and profitability. An economic moat is one that is difficult to replicate or mimic (such as brand identity or patents) and therefore creates an effective barrier against other firms. Ideally the company is a monopoly, if not it is a duopoly and failing that it is an oligopoly.
There are generally 5 types of economic moats.
A low-cost production method. Be relentless when reducing costs in a commodity industry—the lower you go, the deeper your moat.
Switching costs are high.
There are network effects.
An intangible asset.
Scale that is efficient.
Top class management
The quality of management is one of the best factors. A visionary founder owner who still owns significant number of shares in the business, e.g. 10% or more, is a very good sign. These owners know their businesses inside out and are usually passionate about them. Also their interests are in line with the shareholders which usually results in a better outcome for shareholders. A good example of such a shareholder is Jeff Bezos of Amazon..
Also study the character of the management. If the founder owner is frugal, acts in the best interest of the shareholders and takes minimal salary or zero salary then that’s a really good sign. A great example is Mark Leonard of Constellation Software. Not only does he draw zero salary he even pays for his own business travel costs including first class flights. He was so conscious of not taking advantage of shareholders and fed up with travelling standard class, he decided to travel first class and pay for the flights personally. Mark Leonard’s company, Constellation Software, is an excellent business that has produced excellent returns for shareholders for many years.
Patience
Patience is a virtue. Literally. The greatest value investors exercise tremendous patience. If you have invested in a great business you will still experience large falls in value from time to time. Even Amazon has had at least four falls in share price of 50% over the last 25 years during which time its share price has risen 3000%. How many investors or fund managers stayed invested in Amazon shares for 25 years? Very few I expect.
So often investors make the mistake of selling shares in great businesses too early. Research shows that the share portfolios of deceased people’s estate perform far better than the portfolios of living investors! Bizarre but true!
So focus on these six factors and look forward to long term investment success. If you do not have the time, inclination or skill then invest in a fund that practises these six disciplines like the YFS Intelligent Wealth Fund managed by our very own team at Minerva Money Management. Our fund achieved a record calendar year return of 32.6% in 2023.* 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
*Source: Trustnet
**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.
