The volatility in the stock markets last year led many institutional investors either to allocate away from equities into bonds to mitigate losses or to adopt risk-reducing passive strategies. For long-term investors, however, such a strategy might not be the best course of action.
According to modern financial theory, an investor should put money into a company only if its management can generate returns above the cost of its capital. If the management team has consistently pursued strategies that have achieved this aim, then shareholder value will grow as the company expands. Nirvana for shareholders is a company with high return on invested capital (ROIC), a strong balance sheet and the ability to expand rapidly. These characteristics mean that the company needs to invest proportionally less when compared with a low-return business for the same level of growth. Consequently, the company can return more cash to shareholders, in the form of dividends and share repurchases, without negative knock-on effects to future growth.
High returns should start to attract competition to the industry. As new market entrants seek to gain market share, it is likely they will begin to challenge the returns of the incumbent, causing those returns to decay or mean-revert closer to the company’s cost of capital. High returns are thus effectively supernormal and end up being competed away. Yet the fact that certain companies have sustained high ROIC over the long term suggests that they are likely to possess one or more competitive advantages that are hard to replicate and can help them fend off would-be competition. These enduring competitive advantages are often intangible assets, such as brands, patents, distribution networks, entrenched customers and other forms of unique content or networks of users.
We at Investec Asset Management believe that — all else being equal — a company generating high ROIC deserves a higher relative valuation than does a company generating a lower ROIC. The performance of high- and low-returning companies essentially depends upon the market’s implicit assumption as to how quickly mean reversion will take place, however. As a result, the market tends to assign too low an intrinsic value to certain quality companies with a high ROIC that, because of their competitive advantages, can sustain high returns. The share price of these types of businesses should, therefore, outperform over the long term.
We have tested this hypothesis by examining the ROIC progression and the resulting relative performance of companies within the MSCI all country world index between 1988 and December 2014, using five years of data at each annual increment. We found that mean reversion does occur over a five-year period but that certain companies in certain sectors have proved more resilient. They have been able not only to generate a high ROIC but also to defy mean reversion and sustain that high ROIC over time. In fact, nearly three quarters of companies that start with an above-average ROIC have been able to sustain that over a rolling five-year period — and those companies that have achieved that have outperformed the wider market by 4.5 percent on average.
These quality companies have used intangible assets such as brands, patents and distribution networks to create significant and enduring competitive advantages for themselves that, in turn, have created barriers to entry. This has provided them with an economic moat around their businesses that protects them from competitive threats. With strong and established market positions, they are extremely difficult to unseat. Compelling business models, disciplined management teams and typically low levels of financial leverage have enabled quality companies to sustain a high ROIC and grow their profits through the cycle.
Very few companies possess the rare and exceptional qualities required to create enduring competitive advantages that can sustain high long-term returns. These top-caliber companies have combined a sustainably high ROIC and a high conversion ratio of profits into cash, with a strong balance sheet and minimal capital requirements. By identifying companies with strong business models, enduring brands and astute management that makes good investment decisions, we think stock pickers can develop strategies that harness the compounding effects of long-term value creation while dampening a portfolio’s volatility.
Simon Brazier, based in London, and Clyde Rossouw, based in Cape Town, are co-heads of quality at Investec Asset Management.
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