by Alex Schay (TMF Nexus6)
ALEXANDRIA, VA (Oct. 19, 1998) -- Taking a quick glance in the rearview mirror, we can see that a basic investment framework is beginning to evolve in this rather Boring, didactic space. For the uninitiated, we began the month with an introduction and some columns concerning the investment philosophy that undergirds the Boring Portfolio. Those clamoring for some "useful" information were hopefully satiated by Dale's overview of Return on Capital and how Return on Invested Capital Builds Value. We will be discussing valuation ad nauseam (oh goody!), so don't be concerned if you have a lingering sense of concern in this area. Placing a value on a company is a dynamic process requiring many, many, many data points, but what we really want to impress upon readers is that the whole endeavor is really fun! Hang on, not just fun, but...
Fun, Exciting & Profitable.
What do you think? Is the price of heating oil going to rise this winter?
Sorry about that. (If you don't get it, just ask someone who has been forced to watch CNBC for more than an hour on any given day in recent memory.)
One element that ties together a lot of the concepts that we've discussed is capital allocation. Understanding capital allocation leads to superior results both as a manager and as an investor. That may sound trite, but give me a moment to try and examine some of the more subtle implications of that statement. Looking at the freshly minted Boring Ratio, here's how it breaks down mathematically (this was also done by Matt4Vols on the Boring message board, a great place for discussion of these topics and more, thanks):
Boring Ratio = ROIC/ EV-to-Invested Capital After Tax Op. Earnings Enterprise Value = -------------------- ï¿½ ---------------- Invested Capital Invested Capital After Tax Op. Earnings Invested Capital = --------------------- x ---------------- Invested Capital Enterprise Value It yields a basic yield calculation: After Tax Op. Earnings ---------------------- Enterprise Value
The important thing to remember here is that a key measure of financial performance -- how much a company is returning above and beyond its cost of capital (the return on invested capital to weighted average cost of capital spread) -- is also a key driver in determining the enterprise to invested capital multiple. That's right. Although easily forgotten, it's a fact that valuation multiples are awarded in the marketplace as a result of business performance. So as an investor, what's the most fruitful exercise when trying to evaluate a business? Although sniffing around the liabilities area and looking at weighted average cost of capital (WACC) can be Fun, Exciting & Profitable, examining return on invested capital (ROIC) is really where it's at.
Now, I don't have an R-squared here, but my guess is that operating earnings after tax correlate pretty well with net earnings over time. (Yeah, yeah, over time everything does, but I will take the sneaky lawyerly route and qualify this comment, over a reasonable amount of time.) This is the primary reason why many people can get by using only bottom line, shorthand accounting-based metrics almost exclusively. The analytical area that always gets shunted aside, though, is invested capital, and that of course is just as important (in mathematical terms) as after-tax operating earnings. In reality though, it's even more important, because what happens on the income statement is a direct consequence of what happens on the balance sheet.
Understanding the allocation of capital and the possible returns that will be generated from the capital employed is really what it's all about. Indeed, getting a feel for all the balance sheet items that add to invested capital (not just capital expenditures) will help an investor gain an understanding of the future earnings power of a company and the subsequent direction of popular investment multiples. Capital allocation is really the epicenter of the corporate blast -- while P/E is the shock wave felt many miles away. In this way investors are like business managers and vice versa, for the same skill set is needed. Where is the capital going? How much is there? What kind of return is being generated.
A natural corollary here is that we can't be capital allocation fascists when we look at companies, but then get all mushy when we conduct the Boring Portfolio. In that way, we will be focused on low turnover and the minimization of our tax burden. We're not going to be turning the portfolio over 100% a year -- although we also won't sit on something if the business has fundamentally changed. For each dollar you pay to invest, you have to make back that dollar plus some more in order to make any money at all. Hence, Dale and I are highly concerned about all the costs that rob future returns. However, we have a big benefit in that taxes are paid only when an asset is sold. More on this later in the week.
For discussion, as always, please visit the Boring message board.
Stock Change Bid ANDW - 3/8 14.06 CGO +2 5/8 30.38 BGP --- 25.06 CSL +1 3/4 39.88 CSCO + 7/8 56.25 FCH --- 21.44 PNR +2 7/16 35.81 TBY + 1/16 6.19
Day Month Year History BORING +2.14% 0.53% -13.98% 8.24% S&P: +0.57% 4.46% 9.48% 70.91% NASDAQ: +1.71% -2.66% 4.99% 58.39% Rec'd # Security In At Now Change 6/26/96 225 Cisco Syst 23.96 56.25 134.81% 2/28/96 400 Borders Gr 11.26 25.06 122.65% 8/13/96 200 Carlisle C 26.32 39.88 51.47% 3/5/97 150 Atlas Air 23.06 30.38 31.73% 4/14/98 100 Pentair 43.74 35.81 -18.13% 5/20/98 400 TCBY Enter 10.05 6.19 -38.40% 11/6/97 200 FelCor Sui 37.59 21.44 -42.97% 1/21/98 200 Andrew Cor 26.09 14.06 -46.10% Rec'd # Security In At Value Change 6/26/96 225 Cisco Syst 5389.99 12656.25 $7266.26 2/28/96 400 Borders Gr 4502.49 10025.00 $5522.51 8/13/96 200 Carlisle C 5264.99 7975.00 $2710.01 3/5/97 150 Atlas Air 3458.74 4556.25 $1097.51 4/14/98 100 Pentair 4374.25 3581.25 -$793.00 5/20/98 400 TCBY Enter 4018.00 2475.00 -$1543.00 1/21/98 200 Andrew Cor 5218.00 2812.50 -$2405.50 11/6/97 200 FelCor Sui 7518.00 4287.50 -$3230.50 CASH $5750.59 TOTAL $54119.34