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Interview with Michael Mauboussin company has no debt or a lot of debt, its ROIC Oct 18, 2016 at 4:47PM is the same. That's a useful feature.

Motley Fool analyst John Rotonti interviews John Rotonti: When you calculate ROIC or Michael Mauboussin about returns on invested return on equity (ROE), do you prefer to capital (ROIC), valuation, and behavioral keep goodwill in or take it out?

finance.

Michael Mauboussin: There are a host of John Rotonti: How do you define a high- practical issues that you need to deal with quality business? when you calculate ROIC, including the treatment of goodwill. The simple answer is Michael Mauboussin: A high-quality that I like to see it calculated both ways. For business is one that is profitable, typically as a some companies, the difference is huge. For result of high margins, has relatively low debt, example, in fiscal 2016, Cisco's (NASDAQ: a very capable management team, and a CSCO) ROIC excluding goodwill is roughly 3 business that is unlikely to change abruptly in times higher than it is including goodwill. the near term. So essentially it is a business with a high return on invested capital and The longer answer is if a company has been stable prospects. acquisitive and I would expect them to remain so, I would lean toward leaving in goodwill. If John Rotonti: How do you define a high- the company did a huge deal, is saddled with a quality management team? lot of goodwill, and is not active in M&A, I would lean toward removing it. The basic idea Michael Mauboussin: All roads in behind excluding it is that you get a better managerial evaluation lead to capital sense of the underlying economics of the allocation. A high-quality management team is business.

one that knows how to take resources, including capital and people, and put them to John Rotonti: I have found that in a lot of their best and highest use. Quality executives cases, a business's high ROIC is driven by are ethical, open-minded, thoughtful, judicious either high net operating profit after tax risk-takers, transparent, and long-term (NOPAT) margins or high invested capital oriented. turnover (sales/invested capital). What does it say about a business if its high ROIC is John Rotonti: Do you have a preferred driven by both high NOPAT margins and measure for the returns a business is high capital efficiency? Are these businesses generating? Return on assets? Return on of higher quality?

equity? Or return on invested capital?

Michael Mauboussin: Generally speaking, Michael Mauboussin: All of these measures companies that achieve a high ROIC through have limitations, but return on invested capital high margins and moderate to low capital is my favorite of that group for a couple of velocity are associated with what Michael reasons. First, there is a little less room for Porter calls a "differentiation" strategy. A high manipulation when you use ROIC, which is ROIC through low margins and high turnover net operating profit after tax, or NOPAT, is consistent with a "cost leadership" strategy. divided by invested capital. NOPAT is cash Very few companies have both high margins earnings before financing costs. You can and high turns, but you can certainly say they calculate invested capital from the left or right have an enviable strategic position. side of the balance sheet, which can provide insight into the efficiency of asset utilization My colleague at Columbia Business School, as well as financing choices. Bruce Greenwald, wrote a book called Competition Demystified in which he Second, ROIC is financing neutral. All of discusses three sources of competitive those other measures can be manipulated by advantage: consumer advantage (akin to changes in capital structure. So whether a differentiation), production advantage (cost

leadership), and economies of scale. The high- commensurate rise in research and margin, high-turn businesses have all three development as a percentage of sales. sources of advantage working for them. Information-technology and health-care companies, which rely more on intangible John Rotonti: U.S. companies are assets, have margins that are higher than those generating a lot of excess free cash flow of industrial, energy, and material companies right now because ROICs are high but that use more tangible assets.

reinvestment is low. Could you explain intelligent capital allocation? Should John Rotonti: In your opinion, is one source companies invest every penny they can of competitive advantage stronger and internally at high rates of return before more sustainable than another?

returning cash to shareholders through dividends and buybacks? Michael Mauboussin: This is a tough question to answer. The closest thing I've seen Michael Mauboussin: First you have to to an empirical study of this question is the answer the basic question of what the work by Michael Raynor and Mumtaz Ahmed, company is trying to achieve. Assuming that consultants at Deloitte, that was discussed in its goal is to build long-term value per share, I their book, The Three Rules. They analyzed would say that capital allocation is all about thousands of companies going back to the finding the opportunities with the best and 1960s and suggested that superior highest use. Certainly I would have a bias performance, results that are above and toward organic investments, such as capital beyond what luck allows, is the result of expenditures. But there may be instances when companies following two rules. The first rule repurchasing shares creates more value per is "better before cheaper." In other words, do share than a capital expenditure does. The not compete on price. The second rule is right answer to all capital allocation questions "revenue before cost." Successful companies is "it depends." Specifically, it depends on the focus on increasing sales rather than cutting relationship between price and value. costs. The title suggests a third rule, which, irritatingly, is that there are no other rules.

A strong empirical finding is that companies with rapid asset growth tend to have poor total Those rules seem closer to a differentiation shareholder returns and companies with slow, strategy than a cost leadership strategy. or even contracting, asset growth have good returns. This tells you that it's hard to grow John Rotonti: For companies with high rapidly and create a lot of value at the same ROIC, do you think it's useful to time. Also, actions such as divestitures, spin- incorporate enterprise value/invested offs, and buybacks can add value. capital as a valuation metric? I have sometimes found that companies that have John Rotonti: You recently pointed out that high ROIC and are trading at lower the current cash flow return on investment multiples of invested capital (let's say (CFROI) of U.S. companies is 9%, which is EV/invested capital less than 3) tend to also 50% higher than the long-term average of look attractive using other valuation 6%. What is driving such high returns? Is methodologies.

this sustainable?

Michael Mauboussin: Researchers Michael Mauboussin: I don't know, but one established the relationship between return on likely explanation is the shift in the nature of invested capital and price to book a while ago. our economy. A generation or two ago, most This is what Warren Buffett has called the "$1 businesses invested primarily in tangible test." The basic idea is simple: If you invest so assets. Think large factories capturing as to earn above the cost of capital, $1 economics of scale. But in recent years the deployed in the business is worth more than $1 economy has shifted toward intangible assets. in the market.

We see this in the 35-year fall in capital expenditures as a percentage of sales and a

I don't think it's a particularly good valuation part to address this potential scenario. metric for a couple of reasons. First, unless Economic profit reflects the magnitude of the you make a lot of adjustments, it is hard to get investment spread as well the amount of comparable figures. Take the example of two capital invested.

retailers. One leases its stores and the other buys them. The companies will have very To tie it back into my comment in question, it different accounting figures on the surface, but turns out maximizing economic profit is what would be much more similar if you capitalized maximizes the difference between enterprise leases for the first one. So comparability is value and invested capital.

tricky.

John Rotonti: I know that no one metric is Second, the ratio does not take growth into appropriate for all businesses. But do you consideration. Imagine you have a pair of have a particular measure of cash flow that businesses that have the same positive return you prefer when analyzing most businesses? spread in excess of the cost of capital, but one Operating cash flow less capital of the businesses is growing much faster than expenditures? EBITDA less capital the other. The faster-growing business will expenditures? Net income plus depreciation have a justifiably higher ratio of enterprise and amortization? Owner earnings?

value/invested capital.

Michael Mauboussin: I believe one of the My preferred way to value all business is a constants in our industry is that the value of a discounted cash flow (DCF) model. You can business is the present value of free cash flow. use multiples to supplement the core DCF It doesn't matter what kind of business it is. model, but I think DCF should be at the center Businesses have different paths to generating of valuation. free cash flow, but that's the universal source of value.

John Rotonti: In 1995 you wrote, "Although our analysis firmly suggests that Free cash flow (FCF) is technically defined as the market appreciates high-return net operating profit after tax (NOPAT) minus businesses, it is incorrect to conclude that a investments in future growth. You can think of manager's sole objective is to maximize NOPAT as the cash profit a company would returns on invested capital. In fact, have if it had no financial leverage. management's prime goal should be to Investments include changes in net working maximize the difference between enterprise capital, capital expenditures (commonly value and invested capital." Does your expressed as net of depreciation), and mergers recent research still suggest this to be the and acquisitions.

case?

Some of the measures you mentioned are Michael Mauboussin: Right, this is an proxies for FCF, but there's no reason not to extension of the prior point. Value creation calculate the correct number instead of using requires that a company invests above the cost proxies.

of capital. Once a company earns appropriate returns, growth amplifies value creation. John Rotonti: Is there a single best measure or proxy for growth of intrinsic value?

Here's how the issue might arise. Imagine that a company sets up an incentive program for Michael Mauboussin: I have never used a executives that rewards simply the spread proxy for this concept, but it would be a between ROIC and the cost of capital. combination of ROIC and growth. The basic Executives at that company may be tempted to idea is that for companies earning an ROIC only accept very high ROIC projects and similar to the cost of capital, growth does not indeed to reject value-creating projects that matter much. But as the spread becomes a diminish the spread of ROIC to the cost of larger positive, the importance of growth is capital. The measure of economic value added, amplified.

a version of economic profit, was developed in

John Rotonti: How do you evaluate a company's balance sheet? Do you look for a Operating unit heads should be paid on key particular coverage or debt ratio? value drivers of their business — typically sales growth, operating profit margins, and Michael Mauboussin: First, it is important to capital intensity. Finally, front-line employees make sure that you properly recognize all of should get paid on the metric they can control. the liabilities. Leases, underfunded pensions, For example, you might offer an incentive for and equity compensation are some examples an accounts receivable clerk to collect money of items that you need to capture. more efficiently.

From there, I don't do anything fancy. I mostly In each case, the overarching goal is to match look at coverage ratios and the volatility of the compensation with what the employee can cash flows. The ratings agencies also have control.

very good base rate data on the rate of default by rating, so that can be a helpful input into John Rotonti: What is one question you the thinking. think investors should ask of each management team?

John Rotonti: Some high ROIC businesses have shareholder deficits (negative book Michael Mauboussin: I'm not sure there is value) because of large share repurchases. one question that all investors should ask. But Are businesses that lack book equity value I think there are three things that you should inherently riskier investments? bear in mind when you meet management.

Michael Mauboussin: No. The value of a First, how can you have a conversation that is business is the present value of the future free different than the conversations of other cash flow, and the accounting for book value investors? If you just let management walk has little bearing on that. The only caveat is if through their slide deck, you will not hear a company has commitments or instruments anything novel.

with covenants tied to measures such as book value. But from an economic point of view, Second, you should be aware that we all have negative book value is not a concern. a tendency to be optimistic about things that are important to us. So executives are typically When I started out as an analyst, I followed overly optimistic. Recognize that. At the same Ralston Purina, a company that was aggressive time, most people are pretty accurate in in buying back shares. I documented the evaluating those around them. So ask growing disparity between book value, which management about suppliers, competitors, and was going down, and market value, which was customers, and you may get more accurate going up. answers than if you ask them about themselves.

John Rotonti: Do you have any performance metrics that you prefer Finally, I always try to understand how management compensation be based on? management thinks about capital allocation decisions. I'm less interested in the details of Michael Mauboussin: Expectations Investing, what they might do, although that's important, a book I co-authored with my mentor Al and am more interested in how they think Rappaport, has a chapter dedicated to this about the topic in general.

topic. We argue that C-level executives can be compensated with equity but that the options John Rotonti: Which qualities lead to share or restricted stock units should be indexed to outperformance over a long period of time? the market or an appropriate peer group. The idea is that you should be willing to pay dearly Michael Mauboussin: There is no formula. for superior relative performance, rather than The excess returns for high ROIC businesses let the vagaries of the market determine the are not exceptional, because the market knows bulk of the pay. they are high ROIC businesses.

John Rotonti: Is there a question about The best answer is that a stock starts off with investing that I should be asking you that low expectations and then consistently I've missed?

delivers results better than what the market anticipated. Not very helpful but accurate. Michael Mauboussin: The work I'm excited by now has to do with reference-class John Rotonti: What step(s) should investors forecasting. Danny Kahneman has popularized take to try avoid value traps? this with the idea of the "inside" versus "outside" view. The basic idea is that we Michael Mauboussin: Value traps are usually naturally try to forecast by gathering the result of a business that is structurally information that we combine with our own disadvantaged. So the best advice is to think input. That's the inside view. Think of a deeply about sustainable competitive college student considering when she will advantage. Research also shows that analysts complete a term paper. She will think about tend to miss estimates more on the downside how hard the assignment appears to be, will than on the upside, and that's important to bear consider her schedule, and project a date that in mind. she will be done.

John Rotonti: What do you think is the The outside view, by contrast, considers the most important lesson investors should problem as an instance of a larger reference learn from the field of behavioral finance? class. It basically asks the question, "what happened when other people were in this Michael Mauboussin: There are really two situation before?" It is an unnatural way to threads. The first is the work on heuristics and think because you have to discount your biases. The basic idea is that we all tend to use personal information and then find and appeal heuristics, or rules of thumb, which save us a to a base rate. So in the case of our college great deal of time and are generally quite student, she would ask "when other students accurate. But these heuristics come with had a similar paper due, how long did it take associated biases, which can lead to poor them to complete it?"

decisions. There is a very long list of biases, but some of the most important ones for Perhaps it will come as no surprise that the investors include overconfidence, outside view commonly provides a more confirmation, framing, recency, and accurate, and pessimistic answer, than the anchoring. inside view.

The second thread is on prospect theory, Investors can incorporate the outside view in which shows that our decisions in risky many aspects of their jobs, from modeling settings are less than optimal. A classic corporate performance to assessing M&A. I example is loss aversion, the idea that we think it's a really powerful tool that is suffer losses roughly twice as much as generally underutilized.

comparably sized gains.

John Rotonti: What do you think is the most common behavioral bias?

Michael Mauboussin: I don't know which is most common, but confirmation bias is a dangerous one because it prevents us from appropriately updating our views when new information arrives. It is very hard to sidestep as an investor.