Is long-term value creation in equity markets possible?
Simon Brazier and Clyde Roussow, co-heads of Quality at Investec Asset Management, highlight high-quality growth companies in a low-growth world can be drivers of sustainable and long-term value for investors.
Normal cycles produce an abundance of economic growth, which create opportunities for higher earnings for all companies, and operational and financial leverage can improve returns materially. However, the current cycle is far from normal, causing many institutional investors to either allocate away from equities into bonds to assuage losses or to adopt risk-reducing passive strategies.
These may not necessarily be the best options for long-term investors, who need superior investment returns to meet their mandates and can take long-term equity risk.
Very few companies possess the rare and exceptional qualities required to create enduring competitive advantages that can sustain high long-term returns.
These companies have combined a sustainably high return on invested capital (ROIC), and a high conversion ratio of profits into cash, with a strong balance sheet and minimal capital requirements.
Yet by identifying companies with strong business models, brands and astute management that make good investment decisions, we think stock pickers can develop strategies that harness the compounding effects of long-term value creation, while dampening a portfolio’s volatility.
The search for high ROIC – Nirvana?
Nirvana for shareholders is a company with a high return on invested capital, a strong balance sheet and the ability to expand rapidly.
High returns should start to attract competition into the industry: as new competitors seek to gain market share it is likely they will begin to challenge the returns of the incumbent, causing those returns to decay or mean revert closer to the company’s cost of capital.
High returns are in effect ‘supernormal’ and end up being competed away. Yet, the fact that certain companies have sustained a high ROIC over the long term suggests that they are likely to possess one or more competitive advantages that are hard to replicate and can help them fend off would-be competition.
These enduring competitive advantages are often intangible assets, such as brands, patents, distribution networks, entrenched customers and other forms of unique content or networks of users. We believe that – all else being equal – a company generating a high ROIC deserves a higher relative valuation than a company generating a lower ROIC.
However, the performance of high- and low-returning companies essentially depends upon the market’s implicit assumption as to how quickly mean reversion will take place.
As a result, the market tends to assign too low an intrinsic value to certain quality companies with high ROICs that can sustain high returns via their competitive advantages. The share price of these types of businesses should, therefore, outperform over the long term.
Analysis highlights pockets of resilience within high-quality companies
We have tested this hypothesis by examining the ROIC progression, and resulting relative performance, of companies within the MSCI All Countries World Index between 1988 and December 2014, using five years of data at each annual increment. We found that mean reversion does occur over a five-year period, but that certain companies in certain sectors have proven more resilient.
They have been able not only to generate a high ROIC but also to defy mean reversion and sustain that high ROIC over time. In fact, according to our analysis, nearly three-quarters of companies that start with an above average ROIC have been able to sustain that over a rolling five-year period, and those companies that have achieved that, have outperformed the wider market by 4.5% on average.