Stocks of Companies that Use Value-Based Management (VBM)
Beat inflation and preserve purchasing power.
Most advisors and investors think the stock market is risky and put too little of their wealth in stocks. That’s a big mistake.
We believe investors need to accept and embrace the idea of defining true safety in terms of the preservation (and even accretion) of purchasing power in retirement so our clients’ will always have enough income to to buy them dignity and independence.
There are really only two classes of investments: “Fixed income” or “Rising income” investments. Fixed income comes from bonds, CDs and money market funds. Rising income comes from the increasing dividends and/or incomes of the great companies in America and the world.
Therefore, we need to find, and create portfolios of, shares of those great companies.
Search
Screen for ValueAligned Companies
Value-Aligned Investing® starts with a search for companies that have publicly committed to the use of capital efficiency measures like economic value-added (EVA) or another economic profit (EP) measure that deducts a full capital charge from profits, and/or a “return measure” like Return on Invested Capital (ROIC) or Return on Equity (ROE). Despite the wide acceptance of the value of EVA and Value-Based Management – where decision makers at all levels are focused on increasing intrinsic value – less than 10% of the companies in the S&P 1500 use it. We contiunally search and then add and subtract companies to our Value-Aligned watch list.
Transform
Accounting into Economics
Conventional accounting often severely distorts the economic drivers of a business. It turns out that accounting earnings are a poor proxy for economic profitability because they do not accurately reflect the true cash flow of the firm. According to AFGview.com on average, corporate earnings represent only 45 to 50 percent of a company’s cash flow. And earnings do not reflect risk because earnings favor debt financing with its tax advantage and lower hurdle rate.
Accounting rules distort many aspects of economic reality. Research & Development costs, which are long term investments, are immediately expensed under GAAP accounting. Operating Leases, obligations which must be paid similar to debt never appear on company balance sheets.
Measure
Economic Performance Measurement
Once we convert the accounting numbers to economics, we evaluate how well the business has performed. The best companies and management produce positive economic profits (EVA) and grow those profits over time. Companies earn positive and growing EVA by earning returns on invested capital that are above the cost of that capital. Companies that have earned postive and growing EVA have proved to be good long-term investments, and that performance is a characteristic of a Value-Aligned company.
We avoid those firms that spend shareholders money but do not earn adequate returns to cover its cost of capital. Many companies grow at the expense of creating shareholder value. These mis-aligned companies can’t generate an adequate rate of return on their assets, but none-the-less they keep trying to grow their way out of their problems.
We go out of our way to avoid these wealth destroyers like Enron, Worldcom and the old Tyco, whose business models were fundamentally flawed which we learned before they went bust because their EVA went down even as accounting earnings were going up.
Value
Embedded Expectations. Compare Stock Price to our Estimate of Fair Value
In the next step we figure out what the market is paying for at the current market price. We use our EVA valuation model, the Applied Finance Group’s (AFG) Economic Margin Model and analyst research to understand the expectations embedded in stock prices. We apply this framework to estimate what are the sales growth, margin and capital efficiency expectations embedded in today’s stock price. We then compare those expectations against the company’s likely ability to deliver those expectations.
Manage
Margin of Safety. Position Sizing. Correlation.
During this process we also estimate an expected Fair Value for the company’s stock price. Then, after measuring our confidence in our estimate we set a “Buy Below” stock price at which we would buy the stock. Those required discounts, also called “Margin of Safety”, can be as much as 50% from fair value.
Once we decide to buy a particular stock we also must figure out how big the weighting should be in each of our clients’ portfolio. We typically will have 50 – 60 stocks with position sizes ranging from 1% – 6% of the value of the portfolio.
Size depends on each stock’s risk and correlation to the other members of the portfolio. Typically, smaller companies will be smaller positions; larger companies will be bigger.
Correlation measures the degree to which different stocks move in the same direction at the same time. The portfolio will be optimally diversified if we have stocks that don’t move together – we want low correlated investments to mitigate risk.
In 2002, the Company’s results reflected a focus on growth through adding new restaurants, with associated high levels of capital expenditures and debt financing. This strategy, combined with challenging economic conditions and increased competition in certain key markets, adversely affected results and returns on investment.
The measure of performance for the Incentive Cash Bonus is EVA. EVA in general terms is equal to the Company’s net operating income after subtraction of taxes and a charge for capital. The Committee believes that the utilization of the EVA measurement system, with its focus on maximizing the Company’s return on capital investments relative to its cost of capital, is an effective means of evaluating and rewarding executive performance. - Page 19, 2008 Herman Miller Proxy
Best Buy adopts EVA
In 1990 Best Buy operated just 49 stores and by 1998 the company operated 284 stores. During this growth period, return on invested capital (ROIC) averaged only 8%, gross margin declined from 24.5% in 1990 (getting as low as 13.7% in 1996) to 16.8% in 1998. The store growth consumed invested capital at a 40% rate per year. By the spring of 1998Best Buy’s profitless growth halted its stock advance. While institutional investors were interested in Best Buy’s concept and prospects for growth, many doubted whether the chain could grow without a more structured management platform.
Best Buy chose to implement the EVA management system to manage its ambitious growth plan. The 1999 annual report explained its commitment to the EVA Management System: “We believe the use of EVA will continue to improve decision-making and help us undertake investments that will maximize shareholder return. By fostering our entrepreneurial culture and guiding our management to think more like shareholders…”