Lately I have been reading through Berkshire Hathaway’s annual reports. While sometimes repetitive, there are gems within Warren Buffett’s prose. I consider myself both a value and a growth investor. In a perfect world, every investment would cheap compared to both the current shareholder returns and the future growth prospects of the business. Buffett has some great perspective to offer on how to measure the quality of management in terms of both quality and growth.
“Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor….. Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite – that is, consistently employ ever-greater amounts of capital at very low rates of return” – Warren Buffett
Return on Capital is one of Buffett’s favorite tools to measure management with. A well-managed company should have Return on Capital that is both strong and growing. If a company can yield returns on capital far above cost of capital for many years, it probably has a good business model and a good management team in place. Put another way, if you loan a kid $1 to start a lemonade stand, you would hope that they give you back at least $1. If the kid comes back and hands you a ten, consider firing your current financial adviser.
If the kid returns less than $1 to you, then they have destroyed a part of your equity. Basically we want ROC > WACC for many years. The higher the better. It is incredibly simple, yet many of the fad stocks of the day fail to meet this basic requirement (looking at you NYSE:TWTR and NASDAQ:ANGI).
The conundrum I have encountered is how to value ROC. How much is it worth? This is where some Buffett comments really helped out. Berkshire purchases companies when it can buy the cash flow stream for less than half of the return on capital. Price to Cash Flow and Enterprise Value to EBIT are both decent proxies for this. It is important for the investor to ensure that Operating Cash Flow represents the bulk of the Cash Flow or EBIT being applied.
Let’s look at Smith & Wesson (NASDAQ:SWHC). Paul Howanitz, a classmate, pitched this stock in September. I liked it so much I bought it for my portfolio, and intend to buy more soon. Paul can be thanked for finding this diamond-in-the-rough at: Paul_Howanitz@kenan-flagler.unc.edu
SWHC is up 17% since Paul pitched it, and I fully expect it to go higher. In 2009 a new CEO – James Debney stepped in to turn the company around. Mr. Debney was so confident that he could improve the situation that he bought shares of the company in the open market on several occasions. According to Return on Capital metrics, he was certainly not overconfident. Price to Cash Flow and Enterprise Value/EBIT indicate that the company is still undervalued despite the stock tripling within 2 years.
From April to October, Price to Cash Flow went up 23%. EV/EBIT has gone up 17%. Return on Capital has gone up a mind-boggling 43% thanks to strong top and bottom line growth and share repurchases. Debney has had only one year where both P/CF and EV/EBIT were not less than half of Return on Capital and has averaged significantly higher ROC than his predecessor. The trend can not continue forever, but it certainly indicates two things:
- The company is being very well-managed according to the returns on incremental cash flow
- At present, the stock is cheap relative to those same cash flows
Again, Paul Howanitz can be reached at: Paul_Howanitz@kenan-flagler.unc.edu. Thank Paul for this amazing find. He has a nice slide deck with many more salient points about the company and industry which he might let you see. Also, buy SWHC while it is cheap.