Chagsy
Excellent work @Solvetheriddle
I am trying to follow a similar path after years of practice. @Strawman pointed out the Philip Morris fly in the ointment example. In a timely piece Morningstar also covered this example and used the following quote “The long-term return on a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth that investors expected.” They go on to discuss "reverse monopolies" link and being a contrarian.
That doesnt change anything you have said, but does reinforce that the high ROE growth stocks at any price, is not the answer, we still have to find those at reasonable prices. Secondly, whilst I do not consider myself a trader, I am quite happy to invest in low ROE stocks when they are very cheap and exit some 2-3 years later when fully valued. I realise your graph is over ten years and represents a buy and hold approach, which is not something I would consider for this group.
Thank you for the time and effort put into that (and all your other) work. Much appreciated
C
Solvetheriddle
LONG TERM INVESTING—My North Star
First up this post is about LT investing not speculating or trading. Secondly, as I have stated before, my share portfolio is significant in terms of my net wealth and by far represents my largest asset. The upshot of this is that I must get it right and that means being aware of where I sit on the risk/return spectrum. IMO that means focusing on quality growth names as they can offer the best LT returns if acquired well. Since it is a lull before results season, I thought I would look at long-term returns for a group of quality /growth stocks and compare them to a bunch of what I call go-nowhere stocks, being those stocks that in the LT return around their cost of capital. Is my North Star worthwhile?
Thirdly, if I had the data, time and computer firepower I would do an extensive quant-style study but I don’t, so in this case I have taken a big shortcut but have no incentive to doctor the numbers, far from it.
What I have done I pick a dozen stocks that (sort of) sit comfortably in each group. Then look at SP returns over 10 years. Look at the RoE’s and come to some conclusions. Then I comment on issues with the sample and what can go wrong with the execution.
For the stocks I chose for each sample, I tried to spread the sectoral concentration. Secondly, I also tried to exclude the huge winners or losers in each category. Each stock must have been listed for 10 years or very close.
For the quality growth stocks I choose, CSL, RMD, ALL, TNE, CAR, REA, JHX, DMP, CHC, BRG, AUB, and JBH. I left out the exciting WAAX stocks, WTC, XRO, ALU and also PME. The reason for this is that I think 10 years ago these companies would not have had the record to be quality growth but were on their way there, so inclusion would have biased the results too much. I could have gone mad in health but only included two and tried to spread the rest across various sectors. This was done not to bias the sample. The average Roe for this group is 26% (range 12-35%) but that is a hodge podge of varying duration but includes at least the last 5 years for all.
For the “go nowhere” stocks I again tried to spread the sector selection but found a lot of finance and property so tried to cap them. Secondly, I did not include some of the big disasters such as HLS, SGR, IFL and AMP. The stocks I decided on are all institutional-grade holdings and would be a part of many insto portfolios especially 10 years ago. Those stocks are, WBC, ANZ, SUN, SGP, ABC, BAP, GUD, ORG, ORI, PPT, IPL and LLC. I have been kind including BAP, since it was mainly regarded as a growth stock for much of the last 10 years and its inclusion notably assists returns. The ROE for this group is about 7% but probably around 8% if the Org losses are excluded. 8% puts them right around the usual cost of capital. The range was 5-11%, quite tight.
For each group, I then indexed the 10-year share prices and made an equally weighted index of each, growth and go nowhere. The two charts are below.
Over the 10 years, the growth stocks returned 15% pa before dividends and the “go nowhere” stocks returned 1%. Adding approximate dividends of 1% for growth and 4% for “go nowhere” brings them slightly closer but not much. The usual cycle in economics is regarded as 5 years but I have doubled this to reduce macro noise on these results, such as the big move up and then down post-C19 in growth stocks
Conclusions
What are we looking at here?
To me, this speaks to the difference between growth and value investing. Both are valuation-based but quite different. The LT value of the stock is equity*spread above cost of capital*change in equity deployed. In other words, real value comes from adding assets that return above the cost of capital. For companies that return the cost of capital, book value is their LT valuation, it doesn’t matter what assets they add or subtract, if they don’t change the returns no value is added. That is seen by grouping the stocks and looking at the long term. Generating returns from these styles of stocks is then reliant on buying at a discount to book or attempting to trade the cyclical trends that push earnings above CoC. The big returns are made when you can successfully pick a cost of capital returner that sustainably moves to a positive spread type of business. They do occur but rarely and usually entail a changed business. Value investing is based on the company doing stuff it has done before whereas in growth investing the company must do something extra, and keep compounding.
For growth stocks, the valuation is based on accurately assessing the spread over the cost of capital and the growth in equity. In other words, how much (volume) and at what rates (spread) can the company deploy capital? That is a bit more complicated than value investing.
Usually, a reasonable guess can be made at spread and growth scenarios and with an appropriate margin of safety when buying these stocks a pleasing return can be generated at relatively low risk.
What can go wrong?
The critical assumptions here are knowing what drives the positive spread above the cost of capital and how large the opportunity is for these stocks. The world is a dynamic place and sustainable advantages can disappear and the result can be frightful for returns of growth stocks. An example was A2 milk. A2 was a growth company that had built a reasonably long record of attractive returns, so could be regarded as a quality growth stock. What was probably not appreciated by the market was that despite a lot of theories for how its returns were made, in hindsight, they were based on a low-cost distribution model with the help of some good branding that produced great returns. When that low-cost model disappeared so did A2’s differentiation. Either its spread or growth or both were now threatened. I am not trying to get into a discussion on the ins and outs of A2 but to point out that all business models have an Achilles heel and knowing that, or discovering it quickly, is very important in growth investing as you are usually paying up.
In summary, this short study is an affirmation that the theory does measure up over the long term and evens out over a bunch of stocks. The real message to me is the investing approach for “no growth” and growth stocks are quite different, but knowing your companies in detail, especially their weaknesses is critical. Let the compounding take place but have an idea of what is driving it and a broad idea of what it is worth.
Hope that is of interest to some.
disc I hold 9/12 high roe, none of the low roe at this stage.
Chagsy
I thought I would re-visit this topic - as I am trying harder to identify companies in this category that do not currently have a fully priced premium attached to them.
To add some more weight to the graphs @Solvetheriddle published, I thought I would reproduce a table from a recent presentation I watched from Morningstar about moats.
It basically shows the same result:
Here is a list of Morningstar's Wide moat companies (note they only analyse ASX 300 companies I believe):
The big 4 banks, ASX ltd, Auckland International airport AIA, Brambles BXB, Cochlear COH, Computershare CPU, Deterra Royalties DRR, Endeavour Group EDV, Fineos FCL, James Hardie JHX, PEXA group, PXA, REA group, Technology one TNE, The Lottery Group TLC, Transurban TCL, Wesfarmers WES.
Filtering for ROE the best performers are DRR, TNE, JHX, WES, BXB, CPU in descending order, and including only those with a trailing ROE over 20%
(You will note a certain number of these are in @Solvetheriddle 's portfolio - and I'm sure a lot of other peoples too)
Of these only the following appear cheap (and not by coincidence have the lowest ROE) and I have divided these companies into two groups: "fallen angels" and "compounders of the future"
Having identified fallen angels that have decent moats the difficult bit is working out whether the current poor performance is likely to change in the medium term
Currently my fallen angels list is:
ASX - probably not going to lose its regulatory monopoly, short term painful re-structuring, medium- long term will likely generate high returns. Big question is if companies continue to list on ASX, or slowly it gets hollowed out by international take-overs.
AIA - took on a lot of debt during COVID so impaired profitability short term. Medium term will return to high returns
EDV - not sure why this is so cheap, probably because of gaming/hotels exposure?
Th future compounders list:
PXA - building out digital real estate settlement infrastructure in the UK to replicate its near monopoly in Australia
FCL - building out and selling software for Life accident and Health insurance companies, still a few years from profitability.
I have also added to my watch list the following "fallen angel" narrow moat companies:
SKC - short term painful fines and re-opening of hotels/restaurants etc, recovering from COVID induced hit: short-medium term recovery to better returns, but long term should be very strong. Unless they do a Crown.
DMP - actually not that cheap, but if worldwide domination eventuates will be kicking myself
Or maybe just buy a Quality/Moat ETF instead and save yourself all the hard work.