In my last article, I wrote about the importance of assessing a company’s competitive position, with a strong competitive position giving us more confidence that a company’s demonstrated earnings power will persist into the future. In this article I am going to describe how I quantify a company’s demonstrated competitive advantage through an analysis of the company’s operating history.
When evaluating a company’s operating history, I assume that a sustainable competitive advantage will allow a company to consistently:
- Achieve above average returns on the capital employed in running the business,
- Retain a large portion of the value created for customers as profits,
- And – if the company’s market is growing - provide the opportunity to re-invest earnings at high rates of return.
Although profit margin and return on assets can vary widely by industry, I prefer to focus on the absolute (rather than relative) value of these metrics. My reasoning is that I would much rather own a company with average profitability in an extremely profitable industry – such as Glaxo Smith Kline (NYSE:GSK) in the pharmaceutical industry - than a company with above average profitability in a largely unprofitable industry – such as Southwest Airlines (NYSE:LUV) in the airline industry. My rationale for this is that the strength and sustainability of a company’s competitive advantage is intricately linked to the profitability and stability of the company’s industry.
Time in Industry:
When evaluating a company’s track record, I prefer to have at least ten years of data over which the company has operated in the same industry, and if the industry is cyclic, I would like enough years of data to capture a full industry cycle. This usually means evaluating a company’s operating history over the same period used to calculate the company’s demonstrated earnings power. Most often, ten years of history is sufficient, except in the case of some companies whose profits largely depend on the price of some commodity like oil or steel, or when the last ten years have witnessed abnormally stable economic growth.
Operating Profit Margin:
I calculate a company’s operating profit margin as the ten-year average of the ratio of operating profit (adjusted for non-recurring items) to revenue. I assess profitability using operating margin rather than profit margin because operating margin is a better metric of competitive advantage; this is because profit margin is distorted by differences in tax rate and interest expense that while important, do not relate directly to competitive advantage. The operating profit margin indicates the proportion of the value created for a company’s buyers (measured by revenue) that is captured by the company – as opposed to being competed away - and is therefore a useful measure of the extent of a company’s competitive advantage.
Sometimes operating margin can be distorted in industries where a company makes its profits by taking on credit risk (banks) or event risk (insurance). In this case, operating margins may be very high over long time periods (sometimes decades), until some event occurs (usually an economic downturn or natural disaster) where losses wipe out many years (or even decades) of earnings. Prior to an economic downturn, such a company’s operating margin might seem to be evidence of a competitive advantage, but when a recession hits, most of the profits end up being illusory. The banking industry is a good example of this; in the 1980’s a banking crisis wiped out many years of cumulative earnings, and a similar situation occurred in 2008, where incidentally the bond insurance industry also imploded. These types of business models are aptly described as “picking up nickels in front of steam rollers”; the profits may look impressive for a while, but if you stumble, it’s all over. Fortunately these business models can be easily spotted, as they are often characterized by a relatively low return on assets, which brings us to our next metric.
Return on Adjusted Assets:
Our second metric is a company’s return on adjusted assets, which we compute as the ten-year average ratio of operating profit (adjusted for non-recurring items) to adjusted assets. Here we adjust reported assets by subtracting net cash and cash equivalents, and subtracting goodwill and any intangible asset with an indefinite life (such as trademarks). We subtract cash net of debt from assets because we want to determine the rate of return on productive assets, and do not want to penalize a company that decides a cash buffer is prudent. The reason we subtract goodwill and trademarks is that they are not part of the capital employed in running the business, but rather they allow the company to earn a higher return on this capital, as well as on additional tangible assets purchased for expansion. This makes our definition of a company’s adjusted assets roughly equal to the capital employed in running the business.
It is fairly intuitive that return on adjusted assets is a good metric for determining company quality. Imagine two different businesses, each with $100,000 in productive assets. One generates $30,000 in operating income each year, and the other generates only $10,000 in operating income each year. If both were available at the same price, which one would you rather own? If there is any opportunity at all to expand production by using retained earnings to expand the business’s asset base, it is pretty clear that the company with a 30% return on assets will grow operating income faster than the company with the 10% return on assets – a dollar of retained earnings will produce $0.30 of additional operating income in the first case as opposed to $0.10 of additional operating income in the second case.
Besides providing the opportunity to invest retained earnings at a high rate of return, a high return on assets provides additional benefits. Because capital expenditures are necessary to keep a company’s asset base competitive, a low return on assets implies a high ratio of recurring capital expenditures to operating income. Moreover, these capital expenditures can be considered fixed costs in that if a company reduces these expenditures during a downturn, it will not be well positioned for the recovery. However, these fixed costs also make it likely that a company’s profits will have a high sensitivity to changes in revenue. Although financial companies do not have sizeable physical assets, a low return on financial assets creates the risk of small changes in asset value – often caused by loan losses - wiping out earnings. Finally, a low return on assets can encourage risk taking. To illustrate, if a company earns a low return on assets, it will likely feel compelled to use excessive leverage to provide its shareholders with an acceptable return on equity.
Unless a company possesses a competitive advantage, historically high returns on assets will attract new entrants into an industry and drive down returns. Therefore a history of consistently high returns on adjusted assets is indicative of a competitive advantage.
Return on Retained Earnings:
Although a high return on assets is good, it gets even better when a company can consistently invest new capital at high rates of return. We measure this by calculating a company’s Return on retained earnings, which is calculated as the change in a company’s per share earnings over a ten-year period divided by the sum of the company’s per-share retained earnings over the same period, with both earnings and retained earnings adjusted for both inflation and non-recurring items. A company’s return on retained earnings measures the return a company has achieved on earnings that are either re-invested back into the business over the period or used to repurchase the company’s stock.
The need for this metric is obvious when we look at extreme cases. If a company has retained half of its earnings over a ten-year period, and the earnings per share (adjusted for inflation) are the same as they were ten years ago, then the company has not created any shareholder value from the reinvestment of these earnings. This is not the same thing as saying that the company would have been better off paying out these earnings as dividends; without the earnings retention, it is quite possible that today’s earnings per share would be much less than what they are. Still, if you have the choice between purchasing this company today or another company that has doubled its earnings per share over the last ten years while retaining half of its earnings, and both companies are selling at the same ratio of price to sustainable earnings, which would you prefer? While there is no guarantee that a company’s return on retained earnings will persist going forward, it is also unlikely that the competitive advantage responsible for a high return on retained earnings will immediately disappear.
I prefer return on retained earnings to alternate measures of a company’s return on re-invested earnings, such as return on equity. One reason is that return on equity can become very large when a company uses debt to repurchase stock; not only do the earnings per share increase due to the stock repurchase, but shareholders equity decreases as well, due to the decrease in paid in capital.
Historical Performance Rating:
I quantify a company’s operating history on a scale from 1.0-4.0, with “4” being best, and “1.0” being my minimum where I would consider purchasing stock in the company. The following table illustrates the thresholds used to quantify the three metrics, and I use linear interpolation between the thresholds shown in the table (capping the maximum ranking at 4.0) to compute the actual rating for each metric. I then calculate the company’s combined historical performance rating by averaging the ratings for each of the three metrics. Note that to be eligible for purchase, I require a company to meet each minimum threshold for return on adjusted assets, operating margin, and return on retained earnings.
The minimum thresholds were chosen to be slightly above the median value computed from 1950 to the present. Of the 415 non-financial companies (financial companies tend to have return on assets in the low single digits) in the SP500 at the end of 2008, only 65 met all the minimum thresholds for these metrics, and only 15 were ranked three or higher for all three metrics. If you are wondering, the only companies to score a 3.2 or higher were: PG, BCR, JNJ, KO, MDT, MHP, MMM, UST & ZMH.
Of these same 415 companies, if we remove the requirement that a company score at least a “1” in each category, average all three metrics for each company, and look at the distribution of historical performance rankings, we generate the data presented in the following table. The distribution is almost identical when repeated at year-end 2007.
For a more detailed discussion of evaluating a company’s operating history, see Chapter 5 of my book, which is downloadable from my website. Although I believe that quantifying a company’s demonstrated competitive advantage is a necessary part of the company selection process, it is not sufficient, as there are many ways a company’s competitive advantage can erode over time. In my next article I will discuss how I analyze threats to a company’s competitive position.
Disclosure: I do not own shares in GSK, LUV, UST (which is now part of Altria), BCR, MDT, MHP, or ZMH. I do own shares of KO, JNJ, PG, and MMM.
>>> Go to Part III