In “The Outsiders”, one of the best investing books of all times, William Thorndike tells the story of eight CEOs who delivered exceptional returns to shareholders. These CEOs didn’t have superior leadership skills or a better business strategy. What they had in common and they excelled in was capital allocation.
Companies can use money in two ways: they can return it to shareholders, or keep it. This decision alone can make a mediocre business great. Berkshire Hathaway, which used to be a textile business, epitomizes this reality.
A company can return money to shareholders by distributing dividends, buying back shares, or paying down debt. This last one isn’t obvious, but remember that a business is worth the present value of its future cash flows; if you pay down debt, shareholders can claim a larger share of those future cash flows.
Alternatively, a company can retain money to reinvest in the business. For example, the company can build a new factory or buy a competitor.
The most common way to value a business is by building a discounted cash flow model (DCF). You project how much cash the company will generate (aka free cash flow) and discount it to present value.
Models are useful but dangerous because they give you a false sense of accuracy. It’s good to understand their limitations. One of the limitations of a DCF model is that there’s an implicit assumption that free cash flows will be returned to shareholders.
This assumption is generous because modern business strategy is about growth. This growth imperative means that management teams are incentivized to reinvest in the business, not to return money to shareholders.
Most companies focus on metrics such as sales growth, or EBITDA growth; however, not all growth is positive. You can think of growth as something a company buys. If today a company retains $1 worth of shareholder money, it should be buying growth worth more than $1 at present value.
For that to be true, the company’s return on marginal invested capital must exceed its cost of capital. A company that can reinvest in the business at a high rate of return and has a long runway for growth is a compounder. If you catch a company like that early, congratulations! You just found yourself a multi-bagger.
In reality, few companies can do that. Competition is a force to mean reversion. An average business, by definition, achieves average returns. Oftentimes companies will invest in projects that return less than their cost of capital. In this case, they are destroying shareholder value and, worst of all, rendering my excel spreadsheets useless.
Good managers are good capital allocators. They invest on high-return projects. They don’t care about the growth imperative. They know that, over the long-run, profitable growth doesn’t show in sales or EBITDA, but in free cash flow per share.
For shareholders, that’s all that matters.
An example of good capital allocation
RCI Hospitality (Nasdaq: RICK) is a nightclub and restaurant operator in the US. The business is profitable, asset-light, and has growth opportunities. But the best part is management’s capital allocation skills.
RICK has a clear framework for buying back shares, reinvesting in the business, or paying down debt based on after-tax returns for each strategy. I like the company’s simple and objective approach. I also like the +25% return hurdle management imposes on its growth projects.
The company’s strategy seems to be working fine. Over the last five years, RICK has grown free cash flow per share at a clip of +20% per year, mostly through a combination of stock buybacks and accretive acquisitions.
I think the stock looks extremely cheap. I’ve written about it HERE.
Portfolio Update
New position: RCI Hospitality (RICK).
Trimming Tesla (again)
I now have 60% of the shares I initially bought.
A week ago, Tesla held Battery Day. The company unveiled a new battery. I’m not an engineer and I don’t understand batteries. I rely on the opinion and analysis of people that do. This article explains it well to dummies like me.
Here’s the big picture: Tesla continues to innovate and has ambitious plans to scale battery manufacturing and reduce battery costs. They need to do so because supply is scarce and costs must decline so the company can produce a $25,000 car in three years. That would lead to a big jump in demand. By 2030, Musk believes the company could be producing 20 million cars a year if they execute well. Volkswagen and Toyota each produced close to 11 million cars in 2019.
If Tesla delivers on those plans, its stock is undervalued. Time will tell.
Buying more EWZ and Franklin Covey
EWZ is a diversification play with significant upside. Brazilian stocks haven’t recovered from the COVID-19 shock yet. EWZ is exposed to the USD/BRL exchange rate, which today is unfavorable to BRL based on historicals. The country still hasn’t fully reopened so there’s some overhang there. The dividend yield of ~3.5% isn’t bad. I have the time and patience to wait.
The thesis on Franklin Covey remains the same. The company is changing to a subscription model which should bring recurring revenues and lead to operating leverage and double-digit free cash flow growth. COVID-19 has impacted results, but subscription revenues are still increasing and margins are expanding.
The goal still is to reduce my cash position to <20%
I aim to add two or three high-quality names to my portfolio over the coming months. At that point, I will start thinking harder about portfolio composition and rotating to higher conviction ideas.
Top Performers
Tesla (+305%)
Revolve (+122%)
Duluth (+116%)
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Stay well,
Fred
Watchlist
See my updated watchlist HERE.