Equity mutual fund managers employ a wide variety of investing approaches in an attempt to outperform the market, but very few stand out from the crowd. The approaches that do work over the long term tend to be very distinctive, focusing consistently on a specific methodology that is executed regardless of the market environment.
One such approach yet to achieve wide acceptance in the investment community is an economic valuation process designed to assess a company’s long-term history of delivering a consistently high Return on Invested Capital (ROIC). This methodology gives a manager the ability to hone in on companies with enduring competitive advantages that position them to deliver superior long-term returns to their shareholders.
In contrast to traditional methods used to assess a company’s historic ROIC, this approach avoids ratios and metrics derived from corporate financial figures prepared using Generally Accepted Accounting Principles (GAAP). An economic value-oriented process uses financial data inputs that eliminate the balance sheet “distortions” caused by GAAP accounting. These adjustments produce historical ROIC numbers that can differ markedly from traditional methodologies and provide what we believe is a more meaningful and useful result.
Employing this self-designed approach allows Frank Alexander, manager of the Jacob Wisdom Fund, to find companies which could be more likely to generate above average returns on capital over the long term. These companies are typically high value added franchises, which are only minimally subjected to the
cutthroat commodity-based pricing that erodes profitability and investment returns.
Why Return on Invested Capital
We believe ROIC is one of the most basic and important ratios in all of finance. It is the key criterion for making any investment, whether purchasing capital equipment, stocks, bonds, real estate, or virtually any asset. The internal ROIC of a company is probably one of the best indicators of the overall health and quality of its business. Some of the best businesses have a high ROIC, evolving from some enduring competitive advantage that they have over their peers. These competitive advantages, or “protective moats” as many like to call them, can arise from different sources but always allow a company to have some level of pricing power over the goods or services provided to its customers.
Accounting Valuation Models
Traditional GAAP based methods of assessing a company’s ROIC may not always yield long-term value for many mutual funds and their investors. Even those investment decision processes based on a relatively sound value-oriented methodology have a hard time consistently delivering superior returns. GAAP book value accounting can dilute the value of assets invested in a business by depreciating and writing down fixed assets. The principle of conservatism that informs GAAP accounting requires that the value of assets on the balance sheet never be overstated. In searching for a true and conservative statement of asset worth at any given time, GAAP accounting disregards the historic inputs of capital made by the owners. These inputs, however, are most meaningful in calculating historic ROIC. Furthermore, one can argue even from a current valuation of fixed assets on the balance sheet, GAAP accounting rarely reflects true market value. While fixed-asset values undoubtedly erode over time from wear and tear, GAAP’s depreciation methods are often arbitrary and do not reflect the reality of how assets are used. Furthermore, intangible assets including goodwill reflect the going-concern value of a business enterprise, and more often than not appreciate in value over time either through inflation, brandbuilding, or other enhancements that management may impart to a company’s going-concern value.
Economic Valuation Model
In order to arrive at what we believe is a better sense of how management has employed the capital invested in a business, we must filter out the distortions of GAAP balance sheet accounting. Using historic capital inputs instead of GAAP-derived data allows us to provide a far more comprehensive picture of the relationship between the cash available to the shareholder that a company is generating versus the capital it employs in generating that cash. For example, in calculating ROIC, an economic valuation approach adds back all depreciation, amortization and restructuring charges to the GAAP asset base. This approach has the effect of creating a larger asset base that may better represent the true capital inputs for the period than an arbitrary calculation of current GAAP assets. Calculation of the economic value ROIC We calculate the economic value of ROIC based on 10 years of accumulated adjustments to the asset base. It is derived by dividing the current year’s operating cash flow by the adjusted asset base:
Economic Value ROIC = OCF (10) X 1/AAB (9)
OCF (10) = operating cash flow in year 10.
AAB(9) = adjusted asset base in year 9 = total accounting assets at the end of year 9 plus accumulated depreciation and amortization charges between years one and 9 plus accumulated restructuring charges between years one and 9.
We use operating cash flow in the numerator as opposed to net income, since we believe that this is a more realistic estimate of the cash generation that is available to the shareholder. Other calculations of EV ROIC are made to smooth the ratio out over the 10-year period. The end result provides an important glimpse at the long-term contribution of management, as well as the company’s inherent enduring competitive advantages, to the overall return on invested capital. This model is designed to identify stable companies with high ROIC. This isn’t a model that is necessarily designed to find growth companies; that isn’t the point. The emphasis is on discovering established and stable companies that have reliably generated high EV ROIC’s over long periods of time. These invariably are companies that can have significant franchise value based on enduring competitive advantages. If management is astute and shareholder-friendly and if reasonable prices are paid for the stocks, the high EV ROIC can inevitably translate to high returns for the shareholder.
Owners’ Initial Cash Investment: $1,000,000
Cash Costs -770,000
OCF/Net Income 30,000
Owners’ Year-End Cash Investment: $1,030,000
Year-End Audit: Accountants decide fixed assets are impaired
Restructuring Charge at Year-End $ 700,000
Accounting Valuation Result
OCF/Net Income $ 30,000
Restructuring Charge -700,000
Accounting Net Income -670,000
Beginning Owners’ Capital Contribution $1,000,000
Plus Net Income -670,000
Year-End Owners’ Capital Contribution $ 330,000
Economic Valuation Result
Beginning Owners’ Capital Contribution $1,000,000
Plus OCF 30,000
Year-End Owners’ Capital Contribution $1,030,000
Accounting Valuation Result
Owners’ Beginning Capital Contribution $ 330,000
Cash Costs -870,000
OCF/Net Income 30,000
Owners’ Year-End Capital Contribution $360,000
ROIC = Net Income/Beginning Capital = 30,000/330,000 = 9.1%
Economic Valuation Result
Owners’ Beginning Capital Contribution $1,030,000
OCF/Net Income + 30,000
Owners’ Year-End Capital Contribution $1,060,000
ROIC = OCF/Beginning Capital = 30,000/1,030,000 = 2.9%
Illustration based on hypothetical company. Past performance does not guarantee future results.
Accounting vs. Economic ROIC: Conceptual Example
A conceptual example of how a new company is formed and manages investments in its first two years illustrates how significant differences between accounting and economic ROICs can develop. The restructuring charge in Year 1 in the conceptual example is a deduction from net income that is considered non-recurring and is reported separately from the normal operating expenses of the company. This restructuring charge assumes a write down of an asset owned by the company.
As with any investment, the major issue for the shareholder is whether a company is adding economic value or destroying it. The differing methodologies present a quandary there because they reach different conclusions. Here’s how it looks when using a risk-free rate of return of 4 percent:
Accounting Value Methodology 9.1% - 4% = 5.1%
Economic Value Methodology 2.9% - 4% = -1.1%
The accounting-value methodology suggests that the company is adding value by returning 5.1% more than the risk-free rate that is the ready alternative for any shareholder. The economic value methodology suggests the opposite, where the company is actually destroying shareholder value by returning 1.1 percent less than the risk-free rate. This example is more illustrative than realistic in that the distortion described is unusually large for one year. The cumulative effect, however, of seemingly minor accounting distortions to the capital base from year to year can have a major impact on ROIC calculations over time. Let us now look at a real world example.
Coke vs. Pepsi: Real World Example
One company that possesses many of the characteristics favored by the economic value approach for calculating ROIC is The Coca-Cola Company (NYSE: KO). Coke is an American icon that possesses a brand of enduring value during a distinguished 127-year history. Coke’s main competitor, PepsiCo, Inc. (NYSE:PEP) is another potential candidate that might do well when analyzed under this lens. Both of these companies, from the traditional accounting viewpoint, possess similar valuation metrics, making it somewhat difficult from an investor’s point of view to choose between the two. But it becomes clear that Coke has a better market valuation based on the economic valuation model.
The fact that Coke’s economic value ROIC figure is 36 percent higher than Pepsi’s is extremely significant. For every dollar of assets invested in each company, Coke generates 36 percent more in operating cash flow than does Pepsi. Furthermore, while Coke has a much higher economic value ROIC than Pepsi, its market valuation as indicated in the OCF/Enterprise Value calculation does not reflect that difference. Thus, the price of Coke’s stock is not reflecting its superior return characteristics. Coke’s superior ROIC and its lower market valuation makes it a more attractive choice over Pepsi.
Also illuminating in the standard accounting valuation table is that the one metric that reveals significant differences between the two is Coke’s far superior operating profit margin. Interestingly enough, operating profit margin is one of the few accounting based ratios that is completely free of GAAP balance sheet “distortions”. Accordingly, it often reflects some of the unusual value disparities unearthed by the economic value calculation of ROIC.
An approach that emphasizes an economic valuation rather than an accounting valuation of ROIC in seeking companies with enduring competitive advantages has the potential to stand out in the crowded field of equity mutual funds. These companies generally are high-value added franchises that generate high returns on the capital they employ.
Importantly, the economic value approach is rarely used in the world of equity mutual fund investing. Most mutual fund managers are tied to the traditional GAAP accounting methods of calculation ROIC and are most likely totally unaware of the potentially superior attributes of the economic value approach. This reality makes the approach all the more powerful since the values unearthed are often unrecognized in the market place. This is why – as in the case of Coke vs. Pepsi – a plethora of outstanding high-return companies often sell at valuations well below their inherent economic value. Such valuation disconnects would be rare in a world where the economic value approach was widespread.
The opinions expressed above are those of fund and are subject to change and cannot be guaranteed.
Cash Flow: The amount of cash a business generates and employs during a specific period of time.
Book Value: The value at which a company carries an asset on its balance sheet.
Return on Equity: A calculation that assess a corporation’s profitability by dividing net income by shareholder’s equity
Economic Value: A methodology of assessing how well a company employs its invested capital that uses historical capital inputs rather than GAAP accounting values.
Risk Free Rate of Return: The return that an investment that is completely free of risk generates, which in this case is the 3 month treasury bill.
Price Earnings Ratio: A ratio that expresses the value of a company by comparing its stock price to its earnings per share.
Return on Assets: An assessment of management’s ability to employ it’s assets to generate earnings, calculated by dividing a company’s earnings by its total assets.
Please note that the Jacob Funds referred to in this white paper are offered and sold only to United States residents, and the information on this website is intended only for such people. The Fund is not offered for sale in countries other than the U.S. and it’s territories. This white paper should not be considered a solicitation to buy or an offer to sell shares of the Jacob Funds in any jurisdiction where it would be unlawful under the securities law of that jurisdiction.
As of 4/30/13, the fund held a 2.3 percent position in Coke and no position in Pepsi.
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Investments in foreign securities involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities may decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. The Jacob Wisdom Fund may invest in Real Estate Investment Trusts (REIT s), which may be affected by economic, legal, cultural, environmental or technical factors that affect property values, rents or occupancies of real estate related to the Fund’s holdings.
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