Michael Mauboussin is a managing director and the head of global financial strategies at Credit Suisse. He was previously the chief investment strategist at Legg Mason Capital Management. He is also the author of three books, the co-author of another, and has published countless white papers on corporate finance and business valuation. Mauboussin has been an adjunct professor of finance at Columbia Business School since 1993 and is currently the chairman of the board of trustees of the Santa Fe Institute.
Here, Motley Fool analyst John Rotonti interviews him about returns on invested capital (ROIC), valuation, and behavioral finance.
John Rotonti: How do you define a high-quality business?
Michael Mauboussin: A high-quality business is one that is profitable, typically as a result of high margins, has relatively low debt, a very capable management team, and a business that is unlikely to change abruptly in the near term. So essentially it is a business with a high return on invested capital and stable prospects.
John Rotonti: How do you define a high-quality management team?
Michael Mauboussin: All roads in managerial evaluation lead to capital allocation. A high-quality management team is one that knows how to take resources, including capital and people, and put them to their best and highest use. Quality executives are ethical, open-minded, thoughtful, judicious risk-takers, transparent, and long-term oriented.
John Rotonti: Do you have a preferred measure for the returns a business is generating? Return on assets? Return on equity? Or return on invested capital?
Michael Mauboussin: All of these measures have limitations, but return on invested capital is my favorite of that group for a couple of reasons. First, there is a little less room for manipulation when you use ROIC, which is net operating profit after tax, or NOPAT, divided by invested capital. NOPAT is cash earnings before financing costs. You can calculate invested capital from the left or right side of the balance sheet, which can provide insight into the efficiency of asset utilization as well as financing choices.
Second, ROIC is financing neutral. All of those other measures can be manipulated by changes in capital structure. So whether a company has no debt or a lot of debt, its ROIC is the same. That's a useful feature.
John Rotonti: When you calculate ROIC or return on equity (ROE), do you prefer to keep goodwill in or take it out?
Michael Mauboussin: There are a host of practical issues that you need to deal with when you calculate ROIC, including the treatment of goodwill. The simple answer is that I like to see it calculated both ways. For some companies, the difference is huge. For example, in fiscal 2016, Cisco's (NASDAQ: CSCO) ROIC excluding goodwill is roughly 3 times higher than it is including goodwill.
The longer answer is if a company has been acquisitive and I would expect them to remain so, I would lean toward leaving in goodwill. If the company did a huge deal, is saddled with a lot of goodwill, and is not active in M&A, I would lean toward removing it. The basic idea behind excluding it is that you get a better sense of the underlying economics of the business.
John Rotonti: I have found that in a lot of cases, a business's high ROIC is driven by either high net operating profit after tax (NOPAT) margins or high invested capital turnover (sales/invested capital). What does it say about a business if its high ROIC is driven by both high NOPAT margins and high capital efficiency? Are these businesses of higher quality?
Michael Mauboussin: Generally speaking, companies that achieve a high ROIC through high margins and moderate to low capital velocity are associated with what Michael Porter calls a "differentiation" strategy. A high ROIC through low margins and high turnover is consistent with a "cost leadership" strategy. Very few companies have both high margins and high turns, but you can certainly say they have an enviable strategic position.
My colleague at Columbia Business School, Bruce Greenwald, wrote a book called Competition Demystified in which he discusses three sources of competitive advantage: consumer advantage (akin to differentiation), production advantage (cost leadership), and economies of scale. The high-margin, high-turn businesses have all three sources of advantage working for them.
John Rotonti: U.S. companies are generating a lot of excess free cash flow right now because ROICs are high but reinvestment is low. Could you explain intelligent capital allocation? Should companies invest every penny they can internally at high rates of return before returning cash to shareholders through dividends and buybacks?
Michael Mauboussin: First you have to answer the basic question of what the company is trying to achieve. Assuming that its goal is to build long-term value per share, I would say that capital allocation is all about finding the opportunities with the best and highest use. Certainly I would have a bias toward organic investments, such as capital expenditures. But there may be instances when repurchasing shares creates more value per share than a capital expenditure does. The right answer to all capital allocation questions is "it depends." Specifically, it depends on the relationship between price and value.
A strong empirical finding is that companies with rapid asset growth tend to have poor total shareholder returns and companies with slow, or even contracting, asset growth have good returns. This tells you that it's hard to grow rapidly and create a lot of value at the same time. Also, actions such as divestitures, spin-offs, and buybacks can add value.
John Rotonti: You recently pointed out that the current cash flow return on investment (CFROI) of U.S. companies is 9%, which is 50% higher than the long-term average of 6%. What is driving such high returns? Is this sustainable?
Michael Mauboussin: I don't know, but one likely explanation is the shift in the nature of our economy. A generation or two ago, most businesses invested primarily in tangible assets. Think large factories capturing economics of scale. But in recent years the economy has shifted toward intangible assets. We see this in the 35-year fall in capital expenditures as a percentage of sales and a commensurate rise in research and development as a percentage of sales. Information-technology and health-care companies, which rely more on intangible assets, have margins that are higher than those of industrial, energy, and material companies that use more tangible assets.
John Rotonti: In your opinion, is one source of competitive advantage stronger and more sustainable than another?
Michael Mauboussin: This is a tough question to answer. The closest thing I've seen to an empirical study of this question is the work by Michael Raynor and Mumtaz Ahmed, consultants at Deloitte, that was discussed in their book, The Three Rules. They analyzed thousands of companies going back to the 1960s and suggested that superior performance, results that are above and beyond what luck allows, is the result of companies following two rules. The first rule is "better before cheaper." In other words, do not compete on price. The second rule is "revenue before cost." Successful companies focus on increasing sales rather than cutting costs. The title suggests a third rule, which, irritatingly, is that there are no other rules.
Those rules seem closer to a differentiation strategy than a cost leadership strategy.
John Rotonti: For companies with high ROIC, do you think it's useful to incorporate enterprise value/invested capital as a valuation metric? I have sometimes found that companies that have high ROIC and are trading at lower multiples of invested capital (let's say EV/invested capital less than 3) tend to also look attractive using other valuation methodologies.
Michael Mauboussin: Researchers established the relationship between return on invested capital and price to book a while ago. This is what Warren Buffett has called the "$1 test." The basic idea is simple: If you invest so as to earn above the cost of capital, $1 deployed in the business is worth more than $1 in the market.
I don't think it's a particularly good valuation metric for a couple of reasons. First, unless you make a lot of adjustments, it is hard to get comparable figures. Take the example of two retailers. One leases its stores and the other buys them. The companies will have very different accounting figures on the surface, but would be much more similar if you capitalized leases for the first one. So comparability is tricky.
Second, the ratio does not take growth into consideration. Imagine you have a pair of businesses that have the same positive return spread in excess of the cost of capital, but one of the businesses is growing much faster than the other. The faster-growing business will have a justifiably higher ratio of enterprise value/invested capital.
My preferred way to value all business is a discounted cash flow (DCF) model. You can use multiples to supplement the core DCF model, but I think DCF should be at the center of valuation.
John Rotonti: In 1995 you wrote, "Although our analysis firmly suggests that the market appreciates high-return businesses, it is incorrect to conclude that a manager's sole objective is to maximize returns on invested capital. In fact, management's prime goal should be to maximize the difference between enterprise value and invested capital." Does your recent research still suggest this to be the case?
Michael Mauboussin: Right, this is an extension of the prior point. Value creation requires that a company invests above the cost of capital. Once a company earns appropriate returns, growth amplifies value creation.
Here's how the issue might arise. Imagine that a company sets up an incentive program for executives that rewards simply the spread between ROIC and the cost of capital. Executives at that company may be tempted to only accept very high ROIC projects and indeed to reject value-creating projects that diminish the spread of ROIC to the cost of capital. The measure of economic value added, a version of economic profit, was developed in part to address this potential scenario. Economic profit reflects the magnitude of the investment spread as well the amount of capital invested.
To tie it back into my comment in question, it turns out maximizing economic profit is what maximizes the difference between enterprise value and invested capital.
John Rotonti: I know that no one metric is appropriate for all businesses. But do you have a particular measure of cash flow that you prefer when analyzing most businesses? Operating cash flow less capital expenditures? EBITDA less capital expenditures? Net income plus depreciation and amortization? Owner earnings?
Michael Mauboussin: I believe one of the constants in our industry is that the value of a business is the present value of free cash flow. It doesn't matter what kind of business it is. Businesses have different paths to generating free cash flow, but that's the universal source of value.
Free cash flow (FCF) is technically defined as net operating profit after tax (NOPAT) minus investments in future growth. You can think of NOPAT as the cash profit a company would have if it had no financial leverage. Investments include changes in net working capital, capital expenditures (commonly expressed as net of depreciation), and mergers and acquisitions.
Some of the measures you mentioned are proxies for FCF, but there's no reason not to calculate the correct number instead of using proxies.
John Rotonti: Is there a single best measure or proxy for growth of intrinsic value?
Michael Mauboussin: I have never used a proxy for this concept, but it would be a combination of ROIC and growth. The basic idea is that for companies earning an ROIC similar to the cost of capital, growth does not matter much. But as the spread becomes a larger positive, the importance of growth is amplified.
John Rotonti: How do you evaluate a company's balance sheet? Do you look for a particular coverage or debt ratio?
Michael Mauboussin: First, it is important to make sure that you properly recognize all of the liabilities. Leases, underfunded pensions, and equity compensation are some examples of items that you need to capture.
From there, I don't do anything fancy. I mostly look at coverage ratios and the volatility of the cash flows. The ratings agencies also have very good base rate data on the rate of default by rating, so that can be a helpful input into the thinking.
John Rotonti: Some high ROIC businesses have shareholder deficits (negative book value) because of large share repurchases. Are businesses that lack book equity value inherently riskier investments?
Michael Mauboussin: No. The value of a business is the present value of the future free cash flow, and the accounting for book value has little bearing on that. The only caveat is if a company has commitments or instruments with covenants tied to measures such as book value. But from an economic point of view, negative book value is not a concern.
When I started out as an analyst, I followed Ralston Purina, a company that was aggressive in buying back shares. I documented the growing disparity between book value, which was going down, and market value, which was going up.
John Rotonti: Do you have any performance metrics that you prefer management compensation be based on?
Michael Mauboussin: Expectations Investing, a book I co-authored with my mentor Al Rappaport, has a chapter dedicated to this topic. We argue that C-level executives can be compensated with equity but that the options or restricted stock units should be indexed to the market or an appropriate peer group. The idea is that you should be willing to pay dearly for superior relative performance, rather than let the vagaries of the market determine the bulk of the pay.
Operating unit heads should be paid on key value drivers of their business — typically sales growth, operating profit margins, and capital intensity. Finally, front-line employees should get paid on the metric they can control. For example, you might offer an incentive for an accounts receivable clerk to collect money more efficiently.
In each case, the overarching goal is to match compensation with what the employee can control.
John Rotonti: What is one question you think investors should ask of each management team?
Michael Mauboussin: I'm not sure there is one question that all investors should ask. But I think there are three things that you should bear in mind when you meet management.
First, how can you have a conversation that is different than the conversations of other investors? If you just let management walk through their slide deck, you will not hear anything novel.
Second, you should be aware that we all have a tendency to be optimistic about things that are important to us. So executives are typically overly optimistic. Recognize that. At the same time, most people are pretty accurate in evaluating those around them. So ask management about suppliers, competitors, and customers, and you may get more accurate answers than if you ask them about themselves.
Finally, I always try to understand how management thinks about capital allocation decisions. I'm less interested in the details of what they might do, although that's important, and am more interested in how they think about the topic in general.
John Rotonti: Which qualities lead to share outperformance over a long period of time?
Michael Mauboussin: There is no formula. The excess returns for high ROIC businesses are not exceptional, because the market knows they are high ROIC businesses.
The best answer is that a stock starts off with low expectations and then consistently delivers results better than what the market anticipated. Not very helpful but accurate.
John Rotonti: What step(s) should investors take to try avoid value traps?
Michael Mauboussin: Value traps are usually the result of a business that is structurally disadvantaged. So the best advice is to think deeply about sustainable competitive advantage. Research also shows that analysts tend to miss estimates more on the downside than on the upside, and that's important to bear in mind.
John Rotonti: What do you think is the most important lesson investors should learn from the field of behavioral finance?
Michael Mauboussin: There are really two threads. The first is the work on heuristics and biases. The basic idea is that we all tend to use heuristics, or rules of thumb, which save us a great deal of time and are generally quite accurate. But these heuristics come with associated biases, which can lead to poor decisions. There is a very long list of biases, but some of the most important ones for investors include overconfidence, confirmation, framing, recency, and anchoring.
The second thread is on prospect theory, which shows that our decisions in risky settings are less than optimal. A classic example is loss aversion, the idea that we suffer losses roughly twice as much as comparably sized gains.
John Rotonti: What do you think is the most common behavioral bias?
Michael Mauboussin: I don't know which is most common, but confirmation bias is a dangerous one because it prevents us from appropriately updating our views when new information arrives. It is very hard to sidestep as an investor.
John Rotonti: Is there a question about investing that I should be asking you that I've missed?
Michael Mauboussin: The work I'm excited by now has to do with reference-class forecasting. Danny Kahneman has popularized this with the idea of the "inside" versus "outside" view. The basic idea is that we naturally try to forecast by gathering information that we combine with our own input. That's the inside view. Think of a college student considering when she will complete a term paper. She will think about how hard the assignment appears to be, will consider her schedule, and project a date that she will be done.
The outside view, by contrast, considers the problem as an instance of a larger reference class. It basically asks the question, "what happened when other people were in this situation before?" It is an unnatural way to think because you have to discount your personal information and then find and appeal to a base rate. So in the case of our college student, she would ask "when other students had a similar paper due, how long did it take them to complete it?"
Perhaps it will come as no surprise that the outside view commonly provides a more accurate, and pessimistic answer, than the inside view.
Investors can incorporate the outside view in many aspects of their jobs, from modeling corporate performance to assessing M&A. I think it's a really powerful tool that is generally underutilized.