Masters Series: This Is Our Permanent Edge in the Market
Editor's note: In Digest Premium yesterday, Porter detailed a vital investing concept… how certain iconic businesses are able to generate almost unbelievable returns on the capital they hold. The question investors need to learn how to answer, he said, is how efficient a company is with its capital.
Longtime readers will recognize measuring a company's capital efficiency as one of Porter's fundamental tools for selecting the highest-quality equity investments. He calls it the "Greatest Investment Secret Ever Discovered."
In today's edition of the weekend Masters Series – originally published in the December 2007 issue of his Investment Advisory – Porter examines the flip side of the equation. He discusses what happens to shareholders who put their money into companies – even very successful companies – that plow their cash into employee stock options, investments, and questionable acquisitions… And he explains why understanding capital efficiency gives us an edge most investors ignore.
This Is Our Permanent Edge in the Market
By Porter Stansberry
Being a buyer of common stocks is a total screw job, most of the time.
In the average public company, management has zero concern for the well-being of its shareholders. Fiduciary obligations are a punch line at the water cooler. I know because I study stocks for a living and because I've been around the senior managers of dozens, if not hundreds, of publicly traded companies. Believe me, these guys are not geniuses. And they're certainly not saints.
The only real upside to being a common-stock investor is that it's very easy to be an owner. How hard is it to click over to Ameritrade and buy a share? It takes less than 30 seconds. That's a heck of a lot easier than buying real estate, let alone trying to run your own company. Once you're an owner, you have a board of directors that is supposed to represent your interests and a senior management team that is legally required to exercise stewardship of your assets. But... what actually happens?
What happens most of the time is that the senior managers use as much of the company's profits as they can to increase the size of the company's asset base, so that their job security, the size of their bonuses, and their power in the industry will all increase. As a result, precious little capital ever makes its way down to the lowly shareholder. Companies report earnings per share each quarter as an accounting function. But very little is mentioned about these earnings after they're announced. In most public companies, the shareholders get next to nothing.
Consider Oracle (ORCL). This must be one of the world's best businesses. Revenue growth is consistently more than 20% per year. The company's operating margins are extremely high – over 30%. And it makes billions and billions of dollars, year after year, in profit. Over the last three years, Oracle made more than $13.5 billion in cash from operations – after taxes. How much did shareholders get? Almost zero.
Yes, technically, Oracle did pay $129 million in dividends. But that's less than 1% of the cash the company produced. So where did the money go? Well, $5 billion went toward share buybacks. Isn't this a return of capital to shareholders? No, not when acquisitions and employee stock options produced even more shares than were bought back. In the last three years, the number of Oracle shares outstanding increased by 38 million.
Where did the rest of the money go? Toward investments. In fact, Oracle spent $19 billion on investments in the last three years – even more money than it earned. It bought a handful of woefully overpriced software companies, investments that are very unlikely to earn the company anything resembling a satisfactory return. On the other hand, owning these assets will keep Oracle's managers in their jobs and will probably lead to bigger paychecks, bigger staffs, and bigger bonuses. None of these things are good for shareholders...
As Oracle went on yet another spending spree, assets on its balance sheet ballooned, from $20 billion only three years ago to more than $34 billion, an increase of 70%. Naturally, as the size of Oracle's asset base grew, its return on assets plummeted – to only 12% per year. (Microsoft, which is Oracle's main U.S.-based competitor, earns 19% a year on assets, despite having a huge pile of cash – which it regularly pays out in the form of special dividends. Also there's SAP, which competes directly against Oracle in the database-software market. It earns 18% per year on assets.)
But Oracle's managers have no desire to be efficient with capital. Instead, they have pet projects to nurture, staffs to grow, new businesses to acquire. Oracle will soon find itself burdened with tens of billions of dollars' worth of very low-performing assets. In the next big tech downturn, billions in shareholder equity will be written off as the underperforming assets are sold or folded. Meanwhile, the managers who approved these deals will have long since cashed in their stock options and retired.
None of the risks or the deplorable actions of Oracle's management team show up in its quarterly reports. Wall Street certainly isn't going to question the company's acquisitions – the banks get paid huge fees for putting these deals together, and they'll get paid down the road when the assets need to be sold.
To some extent, the same thing – this tendency of management teams to use up every available penny of capital – is true for almost every public company. This is the real secret of public companies: how much capital is wasted.
Two years ago, I was trying to buy a large public publishing company. Not a share of stock – the whole company. Its board of directors wanted to sell. My partners and I thought the deal might be interesting for strategic reasons. We'd be able to share certain back-office expenses with the new company, and we imagined we'd be able to use our new publicly traded stock to finance additional acquisitions when opportunities arose. (I knew there was a huge credit bubble when it was possible for me to arrange to borrow $90 million in pursuit of this deal...)
We traveled up to New York to meet with the management team. We all gathered in a big boardroom of a major investment bank on Fifth Avenue. There were probably a dozen bankers and lawyers in the room. I shudder to think about how much this meeting cost... but that's the way public companies do things. In the meeting, we proved that we had the financing required to do the deal and we showed up with the right bankers and lawyers – folks who get paid a fortune to essentially serve as real estate agents. Everyone was very nice to us. Everyone wanted to take us to dinner. (It's funny how having $90 million to spend makes you very popular in New York. Strangely, we haven't heard from anyone since the deal fell apart...)
Once we'd proven our bona fides, we got down to business. We were allowed to look at the company's books in detail and were given access to the nonpublic information we needed to figure out how much cost cutting we'd be able to accomplish, which products we'd choose to keep, which ones we could shut down, etc. Looking at the real books, we could see immediately that simply by putting this company on a private-company budget, we'd be able to cut 50% of its overhead and 50% of its employees, if not more. Out of a dozen products, only one or two made any sizeable amount of money. Getting rid of 90% of the company's products wouldn't have damaged the bottom line. Meanwhile, the company was spending a fortune on noncore functions, like a brokerage business (!) and a bloated IT department. And that's not to mention the absurd size of the senior staff's salaries relative to the size of this business.
The company was about as well-managed as a group of five-year-olds at recess. It was a total mess.
Our bankers weren't surprised at our conclusions. They simply shrugged their shoulders. That's just the way it is... That's how public companies do business. Management teams are very rarely judged by any harsh criteria. And senior management teams are almost never, ever replaced wholesale.
Why not? Most investors don't routinely look beyond reported earnings, beyond cash flows, and beyond the share buyback numbers to see what's really happening to the money the company earns. It should be obvious that companies that do not require ever-increasing amounts of capital to maintain their business operations and that routinely return most of their profits to shareholders should be prized far more than companies, like Oracle, which constantly spend every penny they earn (and more) to maintain their rate of growth and keep their employees happy.
This is only common sense. If a company is able to return more of what it makes every year to its shareholders, then the compound return of its stock will be much, much higher over time than the returns of another business that grows its sales and profits at a similar rate but reinvests all that it earns back into its business. There's no great wisdom in this conclusion: It's simply a matter of basic math. And yet this concept is utterly beyond the scope of almost every individual investor. I have never seen it mentioned in a single Wall Street report, either.
As I explained in my January 2007 issue, this idea – the importance of corporate capital efficiency – is the key to understanding Warren Buffett's success as an investor. He never mentions the words "capital efficiency." Instead, he talks about the importance of returns on net tangible assets and the value of economic goodwill. Don't let the accounting language distract you: Both concepts are measures of capital efficiency. As Buffett says, "Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets."
Where do you find stocks with these qualities? Buffett answers: "Consumer franchises are a prime source of economic Goodwill."
I have come to believe evaluating capital efficiency gives us a permanent edge in the market, as almost everyone else ignores – and few even understand – this crucial variable.
Regards,
Porter Stansberry
Editor's note: As we said, Porter discussed in yesterday's Digest Premium how to use capital efficiency to scout out high-quality, long-term investments. Porter launched the premium version of our Digest last year as a way to provide this kind of insight every day.
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