Exploiting Gaps Created by The Exponential Power of Network Effects
Part I.
Two stories are frequently told to illustrate the power of the surprising growth of exponential compounding. I assume you probably have heard both. The first is the story of the inventor of chess who taught the game to the Emperor of China. The Emperor was so taken with the game that he wanted to reward the inventor for his genius. The inventor humbly asked for one grain of rice on the first square of the chess board; two grains of rice on the second square; four grains of rice on the third square, and so on, doubling the numbers of grains of rice for each square of the board. Although he humbly made this immoderate request, the explosive power of compounding either cost him his head or brought him 18.4 quintillion grains of rice, enough to cover, at a density of ten grains per square inch, the entire surface of the earth.
The second story is about the exponential growth of the water hyacinth lily, imported from South America, that doubles its growth on a Florida pond each day throughout the summer. Although it is doubling in biomass each day, no one notices the growth at first; no one notices until some time in the last few days; everyone notices the last day because the pond is completely covered. Not only does everyone notice, everyone is amazed by the explosive growth. One day before, it was half covered; two days before, it was one quarter covered; three days before it was one eighth covered, and so on. Explosive growth sneaks up on you without any change in the rate of growth. Imagine how the mounting grains of rice startled and alarmed the Emperor when he recognized the explosive power of compounding.
As a LTB&H investors, I assume you understand the power of compounding; it is an exciting example of increasing returns, of how he who hath gets, how having more begets even more. If you have some capital to invest, it will compound through time as a function of the rate of return. By inspecting a table of compound returns, it is easy to determine that TIME is, by far, the most important ingredient in the compound interest formula. Of course, even small differences in the rate of RETURN each year also significantly impact results over time. This is why we learned the "Rule of 72" that permits us to estimate, by dividing 72 by the expected rate of return, how many years it will take for our money to double. Considering the compounding of increasing returns, CAPITAL matters, but it matters relatively less than rate of RETURN, which, in turn, matters less than the biggie, TIME. If we have enough time, a little capital, and if the GG plays out, as we believe it will, we may all become wealthy.
Linking Investor and Company Value-Based Economics.
When you purchase stock, you hope to buy a share of a company's stream of future cash flows at a price that is less than the net present value of those future cash flows. A company creates economic value by generating a cash flow whose Return On Invested Capital (ROIC) exceeds it Weighted Average Cost of Capital (WACC). A positive spread (ROIC - WACC) measures the amount of shareholder value the company created, a significant measure of its quality. A positive ROIC - WACC spread is an unbiased index of the concept of "excess return." Given that economists consider return to be proportional to risk, an excess return is larger than that expected for a given degree of risk. Economic theory posits that excess returns attract competitors who will invariably drive excess returns back down to the cost of capital, back down to equilibrium where return equals risk.
As a method of evaluation, a Value-Based (or value-added) Economic Model (VBEM) examines cash economics, using financial figures that are purified by appropriately reassigning accrual accounting entries that bias cash accounting up or down. The VBEM is superior to other valuation tools because it systematically accounts for: (a) Risk-the opportunity cost of an investor or a company adjusted for risk, (b) Capital Requirements-which represent how much capital a company must invest in order to generate profits, and (c) Time Value of Money-the present value of a dollar today is worth more than a dollar promised in the future.
As a measure of the cash-return-on-cash-invested, ROIC is an unbiased metric regardless of capital structure. ROIC is computed as the ratio of Net Operating Profits After Taxes (NOPAT) divided by Invested Capital (IC). Empirical data reveal that about one third of U.S. companies create value by generating excess returns, another third earn at a rate that equals their cost of capital, and the last third destroy value by returning less money than their cost of capital.
NOPAT is the operating profits after taxes after the removal (net) of the effects of the capital structure. Our 500-year-old accounting system was developed with investment in tangibles, like fixed capital expenditures, as a core concern. In a knowledge economy, intangibles, like software, have become vitally important. Given that knowledge companies have a light business model, with relatively few tangible expenditures, accounting earnings are not adequately representing significant changes in new economic models. For example, in GAAP accounting, capital expenditures are depreciated; whereas, intangibles like R&D and marketing are expensed. This produces a disparity between cash flow and accounting earnings growth: traditional companies report earnings that are larger than their cash flows; whereas, knowledge companies report earnings that are less than their cash flow.
To create value, a company can use only four financial strategies: (a) improve the use of its existing capital by increasing the spread between its ROIC and WACC, that is, by generating larger excess returns (b) deploy more capital in its existing business to create more excess returns, that is, additional returns that are larger than its additional costs, (c) invest additional capital in new projects that successfully generate new excess returns, and (d) lower its cost of capital. Given that these are the only strategies which generate a stream of positive cash flows over time, what is their common denominator: a company must make a return on invested capital that exceeds its cost of capital. Eschewing growth for growth's sake, increasing value is therefore the ultimate standard for evaluating financial results. Value, not growth, is what counts because this is how shareholder value is created. You want to own a company that has a net positive cash flow after taxes because cash is what a company uses to pay its debts, invest in its business, and reward stockholders, just as you use your own free cash flow to pay your debts, invest in your future, and to enjoy life as it is lived.
This perspective of a VBEM is in sharp contrast to the impression given by analysts and the media when they emphasize growth, rather than value, as the touchstone. Do you realize that the true bottom-line for shareholder value is not earnings, earnings growth, EPS, P/E, or P/EG? Why? This is so because these indices fail to capture the creation of value. Earnings fail as a measure of the economic value of the firm (Rappaport, 1998, pp. 14-21) for three reasons: (a) Because they can be measured by alternative methods that are equally acceptable according to GAAP rules, the reported earnings numbers can be "managed" by changing inventory accounting from LIFO to FIFO, by deciding to recognize or defer sales, by choosing to depreciate assets by straight-line or accelerated methods, and by treating acquisitions as a purchase or pooling. This is why Rappaport asserts, "cash is a fact, and profit is an opinion." (b) Earnings exclude investment requirements for fixed and working capital. For working capital, earnings "appear" better than actual cash flow when inventories and accounts receivable expand and accounts payable shrink. For fixed capital, accounting net income does not exclude new capital expenditures, which reduce cash flow, and it ignores the positive cash flow value resulting from depreciation. (c) Earnings ignore risk and the time value of money that must be considered to discover whether accounting growth achieved real economic value. Managers seeking growth at any cost may regard built-up cash as found money, that is, as without any opportunity cost or risk, merely as "free cash" available for investment in growth. However, a company that invests capital below its cost of capital grows accounting earnings as it destroys value.
For these three reasons, an increase in accounting earnings may not be linked to an increase in shareholder value; at best, it is a poor proxy for cash flow. In fact, empirical data reveal that a substantial relationship (R-squared = .79) exists between excess returns and enterprise value (equity and debt) and that no significant relationship (R-squared = .01) is present between enterprise value and EPS.
Thus, oversimplified "rules of thumbs," like earnings growth and EPS, generate error-prone mental models in managers and investors because they fail to consider the true drivers of value. Investors should take seriously what the empirical data reveal: neither EPS nor earning growth positively correlate with increases in stock prices; instead, it is excess returns that drive value and stock prices. By definition, successful stockholders must buy companies that create shareholder value.
What does create shareholder value? The ultimate size of the net cash flow that flows to investors is driven by three financial factors: (a) the size of the spread between a company's ROIC and its WACC, (b) the amount of capital that can be invested at such spread, and (c) the length of time that such spread persists. According to Paul Johnson, "The larger the positive spread, the longer it can be sustained, and the more capital that can be invested in the company's business, the greater will be the net positive cash flow generated by the company."
Isn't this financial thinking familiar? The worlds of the investor and the company are in harmony: both pursue shareholder value. The larger the rate of positive returns in a stock, the longer a stock can sustain its positive spread, and the more capital that can be invested in the stock, the more value over time will accrue to both company and stock investor. Both seek exponential compounding.
Not only that, there is a bonus. Buying and holding a stock through time decreases the investment risk arising from market volatility. Increasing returns while reducing risk is an unbeatable bargain for investors-the heart of the gorilla game. We want getting rich to sneak up on us.
The Overriding Importance of Sustainable Competitive Advantage.
Competitors are attracted to excess returns. Yet, shareholder value comes from the added value created by a business that generates excess returns because it has a competitive advantage. If competitors prove successful, then there were no competitive advantages, no barriers to entry, and no high switching costs. Time remains the most important variable in increasing shareholder value; thus, only a sustainable competitive advantage can produce the exponential effect of compounding.
This is why we hunt for Gorillas: their sustainable competitive advantage of a proprietary open architecture with high switching costs. The excess returns of Gorillas were area-graphed by Moore in the DCF model as high GAPS and long CAPS. The Gorilla Game uses a value-added model, which is included as a member of the class of VBEMs. If you haven't discovered this, go back and RTFM.
Investing is fundamentally a game of dynamic expectations. According to Rappaport (1998, p. 184), "Only investors who anticipate a company's improved prospects before they are incorporated in the stock price will earn superior returns." To invest successfully, we must exploit the gaps between our expectations and the majority's expectations, gaps resulting from our superior analysis of the drivers of value: cash flow, risk, and time horizon.
In the Gorilla Game, a GAP is defined as an excess return above the risk-adjusted rate of return. Because the majority uses "rules of thumb," like the P/E ratio, their traditional mental models produce responses like "The P/E ratio is too high; this stock's price is extended; it is over-bought and will retrace until it reaches a realistic multiple." When high price is equated with high risk, then the majority may wait indefinitely for an "over-valued" Gorilla to meet their price target. These gaps in expectations spell "o p p o r t u n i t y."
CAP is defined as the length of time a company can generate excess returns on incremental investment that exceed its cost of capital. Mauboussin and Johnson called CAP "the neglected value driver." It is neglected by most for two reasons. First, most market participants use accounting-based metrics to estimate value, for example, multiplying a projected future EPS by a P/E multiple to estimate value. Second, for strategic planning, most companies use a period of three to five years, but the CAP of the U.S. stock market is estimated to be 10 - 15 years, with the better companies at 20 years or more. Most DCF analysis also uses EPS estimates of five years taken from Value Line, yielding too large a terminal value. However, empirical data reveal that the stock market not only deems cash flow to be more important than earnings but also implicitly recognizes cash flow many years into the future.
Not only does successful investing take TIME, the majority's foreshortened time-perspective means that the long competitive advantage period of the Gorilla provides a huge gap in expectations about a company's potential for excess returns. The concept of value-duration (CAP) is simply not represented in the mental models of most investors. The ability to generate and sustain excess returns, and at less risk, is fundamental to the concept of competitive advantage. We search for competitive advantages that are sustainable because we want to hold stock that will generate excess returns not only this year but for many years to come.
In conclusion, sustainable competitive advantage is the key concept in qualitative stock analysis, and its tight linkage to the value-added economic model insures that sustainable competitive advantage, in actuality, does drive shareholder value.
Part II follows.
Don
Don |
