When we set about a journey to make money as investors, one vital question that we must understand at the outset, is how that will be accomplished. Our answer must be deeper than a simple one like “buy a stock and see it go up”; we must understand how wealth is created by our investments. I will try to explain to you here how we at Mayar think about that question and why the framework we use is so vital to our success as investors. I will use an investment in a simple business as my example, but keep in mind that it equally applies to the more general case of equity investing (owning a stock is simply partial ownership of a business but is identical otherwise). It also applies to every other investment. The only case where it does not apply is when it is not an investment but a speculation, and the framework we use helps us differentiate the two. But let’s not jump to conclusions yet, let’s start with the basics. (Note to experienced readers: please bear with me, I will make it worth your time.)
What is investing? The Merriam-Webster Dictionary defines investing as follows:
verb: to commit (money) in order to earn a financial return
In other words, investing is the act of giving up money today (with all that it can purchase) in order to – hopefully – earn more money in the future. The difference between the value given up today and the value received in the future is called “return” or “performance” and that can be a negative or positive number. But what determines that? To answer this question, we need to dig deeper into how those returns are generated (in layman’s terms, how investors make or lose money).
The Sources of Return (aka Performance)
There are two sources of return (gain or loss) in every investment one makes. As mentioned above, they can be generalized to any kind of investment, but to simplify we will focus on owning businesses for now. Adding the two together gives us what is called Total Return. Let us call them:
- Fundamental Return
- Valuation Return
It’s easier to illustrate with an example, so let us look at Ali’s Grocery Store. Ali saved up $10,000 and opened a grocery store and called it “Ali G’s”. The $10,000 that Ali invested in the business went towards buying shelves, inventory, some decoration, and a sign outside the store. This money is called total invested capital. At the end of the first year, Ali sat with his accountant who proclaimed that the business has made a profit of $1,000, or 10% on Ali’s original investment. This 10% is Ali’s Fundamental Return for Year One of investment in his own business.
Ali now has one of two options. He can either take out that whole $1,000 as a dividend, “locking in” his 10% gain or re-invest part or all of that $1,000 to hopefully grow his business. This is where it gets tricky. Let us say that Ali decides to pay himself $300 and reinvest $700. The $700 that Ali decided to reinvest in the business can be either a good decision or a bad decision, depending what he ends up doing with that money. Either way, he will reduce his first year Fundamental Return to a mere 3% while keeping the balance of 7% in the business. If invested wisely, this 7% will be worth more in the future, compensating him for reducing his Year One Fundamental Return to 3%. If invested foolishly however, that foregone 7% will be worth less, perhaps even nothing, in the future.
Year Two turns out to be a great year, and the $700 that Ali reinvested into buying more inventory has helped his business earn a profit of $1200. This is equal to 11.2% on his total invested capital of $10,700 ($10,000 initially plus $700 reinvested from Year One’s earnings). If Ali chooses to pay himself the full $1,200 then his Fundamental Return in Year Two will be 11.2%. Again, Ali chooses to pay himself $300 and reinvest $900 in the business bringing his total invested capital to $11,600. This continues for several more years with Ali paying himself $300 and reinvesting the balance back into the business.
Six years later, Ali G’s annual earnings have reached $1,929 (see table below) and his total invested capital stands at $15,436. Further, over those years, Ali has paid himself a total of $1,800 in dividends. If we assume that Ali can liquidate his business at a value close to its total invested capital his Fundamental Return at this point would be equal to $15,436 (proceeds from liquidation) plus $1,800 (dividends received over the life of the business) minus his original $10,000 investment, which equals $7,236 or 72% Total Return on his original $10,000 investment. Not bad at all. (Valuation Return will come into play later).
Ali has proven to be a savvy grocer-investor. Had he chosen to pay himself all of the business’s earnings, it would not have grown and his annual earnings would have been stuck at $1,000, bringing his total Fundamental Return to a mere $6,000 or a 60% Total Return on his original investment. Had he been a really lousy grocer however, he could have ended up with a lower return by reinvesting badly. See the table below where Ali’s poor decision reduces his return to 55%, even below the scenario where he pays himself every penny that the business makes. Believe it or not, this is not uncommon in business and many businesses destroy value when they reinvest earnings.
Note that in all the above scenarios, all of Ali’s returns have come from a single source: Fundamental Return. But that’s not always the case. Let’s see how a turn in events can change things but first, let’s go back to assuming that Ali is savvy and is about to liquidate his business to get back his $15,436.
Just before Ali goes ahead with his plan, an honest investment banker – this is fiction after all – approaches Ali about buying Ali G’s for $15,436 arguing that he would be saving him the hassle of liquidation. If Ali accepts the banker’s offer, his return would not change and will remain the 72% of Fundamental Return explained above. However, Ali is a savvy investor, and can pretty much see the banker salivating over this opportunity. Ali offers to sell the business for $20,000 and after a bit of back and forth, the banker accepts. What is Ali’s Total Return now? $20,000 from the sale plus $1,800 in dividends he’s received to date minus the $10,000 original investment equals $11,800 or 118%. Well done, Ali! Let us now break down Ali’s sources of return:
- His Fundamental Return does not change and is still equal to $7,236 or 72%
- Given that his Total Return in this scenario equals $11,800 (or 118%), the balance of $4,564 or approximately 46% is what we will call his Valuation Return.
The above example illustrates a very important lesson that applies to any investor in a business whether he/she owns 100% of the business, like Ali does above, or a small fraction of the business such as usually the case when one invests in a company’s stock. It is very important for the investor to understand the two sources of return and evaluate each beforehand to determine what the expected Total Return will be. To evaluate the first source, Fundamental Return, the investor needs to look at the current state of the business and more importantly, try to estimate what its future will look like. The investor also needs to figure out whether management is going to create or destroy value when they reinvest in the business. This evaluation will help the investor form expectations of projected Fundamental Return. But, as we’ve seen above, that is not enough. The investor’s Valuation Return will depend on the value of his initial investment and the final price he receives when he sells it. Because the investment banker above agreed to pay $20,000 for the business, $4,564 above its total invested capital, his future Valuation Return will be lower than if he’d paid $15,436.
Returns on Capital
But that’s not the end of the story, there’s another even more important lesson to be learned here. One might suggest that in the dumb-Ali scenario, Ali’s bad reinvestment decisions wouldn’t hurt him in the end since he would be able to sell his business at $20,000, achieving the same Total Return as in the Savvy Ali scenario. And that is precisely the assumption that causes many investors to make mistakes. No matter how honest, the same investment banker would never agree to pay $20,000 for the poorly-run Ali G’s store, which earned a mere $683 in Year Six. The banker would probably go up to $7,000; in which case Ali’s Total Return would be: $7,000 (sale proceeds) plus $1,800 (dividends) minus $10,000 (original investment) equals a loss of $1,200. Ouch! Ali’s poor reinvestment decisions have produced a negative Total Return despite the business being profitable in every year since its founding. How did that happen?!
(If you’ve been dozing off, now is the time to wake up.)
Notice the third line in the tables above titled “Return on Capital”. A business that is run by able managers (Ali G’s under Savvy Ali) has high and even increasing Returns on Capital, while a poorly-run business (Ali G’s under Dumb Ali) has low and declining Returns on Capital. The latter, if it continues, will eventually produce very negative Valuation Return numbers that eat up any positive Fundamental Return and cause the overall investment results to be unsatisfactory or even negative.
And this is where the importance of high returns on capital shows. The Valuation Return depends a lot, on the progression of the business’s returns on capital which has a huge impact on the price at which an investment can be sold in the future. A business with low and/or declining returns on capital will “leak” value over time and the Valuation Return will slowly eat into the Fundamental Return. What you want is a business with high and sustainable (or increasing) returns on capital. In order to achieve that you will need two necessary conditions: (1) a business with a durable economic moat or a barrier to entry and (2) run by savvy managers. In the absence of a moat, competition will push down profits until returns on capital become mediocre, whilst in the hands of dumb managers making poor reinvestment decision, even a business with a moat (such as Ali G’s) can end up with low returns on capital, destroying value for its owners.
This post has been excerpted from the Mayar Fund June 2015 Letter.
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