The Importance of Capital Intensity and Thoughts From Einhorn

It seems as though there has been a debate ongoing within the value investing community pertaining to ROE, ROIC and net-nets. At one end of the spectrum we have the argument that value investors are throwing in the towel and buying anything with a high ROE while using 20+ years discounted cash flows to support their thesis. The central argument is, there is no margin of safety if one pays more than NCAV or liquidation value. At the other end of the spectrum we hear that the most profitable way to invest over the long-term is continually buying and selling assets trading below NCAV, P/B or low P/E. I do agree that assets available below NCAV, low P/B or low P/E can be profitable, but we must ask ourselves why is Mr. Market willing to offer us a business at a price that values the business higher dead than alive?

According to Buffett “the risk in buying poor businesses is that much of the bargain element of the initial purchase discount may well be dissipated by the time a catalyst comes along to unlock what appeared to be the initial excess value.”

This is because 1) the market has discounted the asset for a reason, likely because the expectation is for the business to continue to destroy value as it is capital intensive in a declining industry where business metrics are deteriorating; 2) the economic value the business earns is not enough to cover the cost of the capital used to generate it, and 3) the company has poor corporate governance, questionable management practices and bad capital allocation.

Take a textile manufacturer as an example. This is a very simplistic example ignoring depreciation tax saving among other things. The company is currently earning $1,000 while revenues are declining (or stagnant) at $10,000 and the NCAV is $10,000.

Cash: $8,000

Accounts Receivable: $5,000

Inventory: $2,000

Long-Term Debt: $4,000

Accounts Payable: $1,000

The company is selling for $7,000 or a 30% discount from NCAV and a P/E of 7. Sounds like a good deal, right? Not so fast.

We need to examine the capital needs of the business. What if the company requires $1,500 a year to remain competitive in terms of maintenance capital expenditures? Simply stated, the company needs new machines and equipment to remain productive and keep costs low or face losing market share to competitors who do. Now the company has negative $500 free cash flow a year, and you get your equity in the form of machinery. Keeping all variables constant in five years the company will have NCAV of $7,500, cash will be $5,500, sales will be $10,000 (or less) and income will be $1,000 (or less).

Assuming the market revalued the company along the way (@ a 30% discount to NCAV), it will now be worth $5,250. The company would experience cash burn and have to make the difference through a secondary offering, debt or both in the long-term. Is this adequate margin of safety?

So what is the point? Context matters, and it is imprudent to invest blindly in anything.

ROE and ROIC arguably don’t matter nearly as much if the company is not capital intensive. The most important variables are how long the competitive advantage will continue and the rate of growth on unit volumes. Here is what David Einhorn had to say about the matter.

“I believe that it is irrelevant to worry about ROE or marginal return on capital in non-capital intensive businesses. If Coke[KO] or Pfizer [PFE] had twice as many manufacturing plants, the incremental sales would be minimal. If Greenlight Capital[GLRE] – and here I mean the management company that receives the fees, and not the funds themselves – had twice as many computers and conference room tables we wouldn’t earn twice the fees...in fact, they probably wouldn’t increase at all. When the capital doesn’t add to the returns, then ROE doesn’t matter. It follows from this that in non-capital intensive businesses the price-to-book value ratio is irrelevant. The equity of the company in the form of intellectual property, human capital or brand equity is not reflected on the balance sheet. All that matters is how long, sustainable or even improvable the company’s competitive advantage is, whether it is intellectual property, human resources or market position."

The place to find value in non-capital intensive companies is the earnings power. Think of Microsoft or another software company. The marginal cost associated with growing revenues are minimal, as the core infrastructure (the software) only requires small adjustments and tweaks overtime and costs pennies to duplicate. Each additional customer added or sold to actually costs less overall. Think if you could develop software for $100,000 total and sell each copy for $101 at a cost of $1. Once you achieve the break-even point of 1,000 customers, each additional customer sold to will only cost $1 or a hypothetical 10,000% ROE. There are two main risks for non-capital intensive businesses, reinvestment risk and risk the competitive advantage will be lost. Do they return cash to shareholders? Do they attempt to diversify their revenue stream? More often than not the capital is squandered by investing in capital-intensive businesses after generating more cash than they know to do with. The blessing becomes the burden.

Let us circle back to Einhorn.

“I believe it is very important to analyze ROE and marginal returns on capital...but only in capital intensive businesses. It may surprise you, but I prefer at the right price capital intensive businesses with low ROEs, where I think the ROE will improve, to high-, or at least medium-ROE businesses.

The problem with high ROEs in capital intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better performing competitor is doing to copy it. The new capital and the copycats often succeed in driving down the superior ROEs. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE.

This is why I prefer the low ROEs. Great things happen to earnings when a 10% ROE becomes a 15% ROE."




ROE can improve three ways: 1) better asset turns, 2) better margins and 3) by adding leverage. This analysis can be performed further in depth with the DuPont method. Now is there really no margin of safety in earnings power? If you and I were to agree to a deal where you lend me money ($X) for 10 years in return for $100, how much would you lend me?

I assume it wouldn’t be $100 or even $90. It would, of course, depend on the opportunity cost of your $100 during the next 10 years… but is everyone’s opportunity cost the same?

If I were in your situation I wouldn’t take less than $25 representing a 15% discount rate. If you were now to offer me $80 upfront for $100 in 10-years, I would take it and think of this as a margin of safety. Here is why. First the $80 represents a 2.25% discount rate or an ability to borrow at 1% less than the current prime rate. I would then invest the money during the next 10-years and collect the difference depending on the IRR.

Depending on my discount rate, for every $0.01 above my breakeven borrowing rate you offer me, I will be adding to my edge or margin of safety. Because the future is uncertain, and hard to predict we demand a higher margin of safety from intrinsic value and likely blend a range of values. I would rather be approximately right instead of precisely wrong.

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

This brings us to the triple play. What is a triple play? Most baseball fans will understand the sports reference, but how does it relate to investing?

There are three ways to earn an investment return.

1) Revenue growth

2) Margin or inventory turn expansion leading to higher net income

3) Multiple expansion

I like to invest in companies that I think are capable of all three to maximize my overall expected return. The point of the post is there are many different ways to build wealth each with its own risks. It is up to the individual investor’s style and personality to determine which strategy (or combination of strategies) he or she pursues.

• “All intelligent investing is value investing – acquiring more than you are paying for. You must value the business in order to value the stock.” - Charlie Munger (Trades, Portfolio)
  
  
  Reference: Financial Learnings for Make Benefit Glorious Wiseguys