Finding stocks with great management (part II)
In the first part of this series, I mentioned the importance of return on invested capital (ROIC) as a metric for how well a business’ management is allocating capital. Today, we’ll go through a few case studies for how ROIC can be used in your investment analysis. The three stocks I’ll use are Google (GOOG), Yahoo (YHOO), and Autozone (AZO). Similar to the previous post, I’ll be defining ROIC as net income/(common equity + preferred equity + long term debt).
Here, we see historical trends in return on invested capital. I chose Google and Yahoo to illustrate how investment decisions made by these two companies have lead to decidedly different outcomes for shareholders despite the fact that both businesses could categorized as very similar. Autozone is a perfect example of a mature business can maximize shareholder return through prudent capital allocation decisions.
The Google-Yahoo Story
Google and Yahoo have decidedly different public histories. Yahoo’s IPO happened before it was truly profitable and was very much still in its growth phase. Furthermor, Yahoo quickly embarked on a course as an industry consolidator using its balance sheet to acquire new businesses in hopes of creating scale. Because the ROIC equation used relies on TTM net income versus debt and equity capital on the balance sheet at the end of a period, this measure is necessarily backward looking. Thus, for any earlier stage growth company, we’d expect to see initially low ROIC but an eventual rise as invested capital begins generating return. The problem, however, is Yahoo is unable to maintain ROIC anywhere above 10% on a sustained basis. Given that there are many attractive equity opportunities that return 10+%, it is hard to imagine why investors would want to keep their money invested at Yahoo which is continually reinvesting net income at such low return.
Google, on the other hand, debuted as a public company after creating a solid and profitable core business. It used its IPO to raise capital for accelerating its organic growth as well as complementary add-on acquisitions. What we see is an expected fall in ROIC as Google puts significant new capital on its books in 2004 (from the IPO), but the Company immediately shows results through net income growth and a stable ROIC >15% annually. This type of return justifies continued re-investing of profits as you’d likely be hard pressed to find 15+% return on investment elsewhere.
Let’s see how this is reflected in stock performance.
Yahoo’s stock between 1998 and 2008 shows an initial flurry of interest in the stock due to much investor exuberance over the Company’s potential for outsized growth. This exuberance collapses as Yahoo finds itself unable to realize ROIC in excess of 5% over its first 4 years as a public company. While the Company’s efforts seem to begin returning positively between 2003 and 2005, it is short lived and a history of poor acquisitions and investments in poorly timed strategic intiatives take its toll. From 2003-2008, the stock has tread water just as you’d expect from a business with a long run ROIC below its cost of capital. Yahoo would have done better by shareholders by distributing annual income and allowing shareholders to reallocate to other investments.
Here, we see Google since IPO. Management has shown an ability to deliver 15-18% ROIC every year since receiving IPO dollars as well as with all retained earnings from the business. Google, like Yahoo, has never paid a dividend and thus shareholders have chosen to entrust management with re-investing profits. Google, however, has delivered and valuation has increased at an annualized 31% since inception. It’s interesting to note, however, that valuation has expanded faster than the business has generated return on its invested capital. Might this be a worrisome sign? In both the Yahoo and Google cases, we’ve seen that stock appreciation tends to lead and over shoot steady state ROIC, but we’ve also seen that the market generally corrects itself as expectations become more reasonable.
Autozone: Maximizing ROIC at a mature business
We saw above that Autozone had a period of declining return on invested capital from 1997 to 2001. The Company’s management tried all it could to continue to invest in same store sales growth and all other traditional metrics of retail success and sometimes succeeded. Unfortunately, these moves generated a CAGR of 1% in net income despite a 16.5% growth in revenues. Looking back at historicals, it was clear that the business’ profitability versus scale peaked in 1998/1999 by and it just so happened that an investor named Edward Lampert was savvy enough to buy up shares in Autozone and demand that management rethink it’s strategy.
Instead of investing in new growth that never delivered excess earnings to shareholders, Lampert demanded the return of free cash flow to investors in the form of a stock buyback. From 1999 to 2008, the company has bought back over 50% of outstanding shares returning value to shareholders who participate in the buyback and improving the valuation of remaining outstanding shares.
This is quantified by ROIC as a result of a negative equity account created by the buy backs. Since the business is able to defend its earnings power without continued new investments while at the same time decreasing outstanding equity capital, ROIC actually increases substantially and so does share value.
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