David Einhorn and Return on Equity

einhornHere at Wide Moat Investing our primary task is to pinpoint the characteristics that separate good businesses from the great. So far, we’ve highlighted some qualitative characteristics that may not yield well to quantitative assessment (e.g., Coke has no “taste memory” and appeals to a basic, enduring preference). Yet, many investors begin their search for great businesses by using a handful of quantitative metrics. Margins are often important, for as we observed in our analyses of eBay and Microsoft, high gross margins may signal a business with significant competitive advantages.

Another important quantitative metric for many investors is return on equity (ROE).  For example, Francis Chou looks for excellent companies with a 15% ROE sustained over 10 years or more.*

David Einhorn, President of Greenlight Capital and hedge fund manager, addressed the topic of ROE in his November 2006 talk at the Value Investing Congress. There Einhorn argued that ROE is only a meaningful metric for capital-intensive businesses—like traditional manufacturing companies, distribution companies, most financial institutions, and retailers (4). For businesses that are not capital intensive—whose profits derive primarily from intellectual capital or human resources (e.g., pharmaceutical companies, software companies, etc.)—it is “irrelevant to worry about ROE” (4). Why? Because businesses that are not capital intensive do not generate substantial returns from retained earnings or capital expenditures. For example, if you are an insurance agent, you will bring in much more business and profit by getting on the phone and meeting more potential clients, rather than tripling your office space, or adding that new water feature to the atrium, or buying that highly efficient “document station.” In short, it’s not the “equity” which provides the retums, but the people, the brand, or the proprietary product—things which don’t show up on the balance sheet. ROE then is insignificant. For the most part.

You see, Einhorn observes, and experience confirms, that most non capital intensive businesses have an irresistible urge to direct excess returns back into the business that doesn’t need them, or to acquire businesses that do (i.e., capital-intensive businesses). And so the investment bank, which generates fees upon fees, largely due to its personal relationships with clients and its perceived brand, starts to pour excess capital into lending, trading, hedging, and gambling. Seemingly all of a sudden you have that old investment bank now asking its government for tens of billions of dollars, and it intensely needs the capital!

For Einhorn, the best explanation for such capital (mis)allocations is that such businesses are being run for their employees rather than their shareholders, employees running them just well enough to achieve a respectable 15% ROE, and sure enough, the shareholders’ respect keeps coming.

All told, we find Einhorn quite perceptive on these points. And we find his distinction between capital-intensive businesses and the rest to be crucial. For those numerous investors who use ROE to filter the castles from the shacks, they may be missing valuable investing opportunities. The lesson for the castle lover is clear—while the signs of some moats lurk on the balance sheet, not all do. Quantitative metrics will not uncover them all.

*[In the original post, I said “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”  This was sloppy writing.  Greenblatt’s Magic Formula screens for high returns on capital (EBIT/net working capital+fixed assets).  ROE can give misleading numbers for companies with high debt or cash levels.]

8 responses to “David Einhorn and Return on Equity

  1. Great post!!!

  2. I excerpted this at my blog (and added a comment or two of my own) because I fully agree with Hopton above. Excellent work.

  3. Thanks for the encouragement Daniel and Hopton. I found Einhorn’s analysis really helpful myself, particularly when thinking about turnarounds–those bloated companies with high book values that have a really good non-capital-intensive business in there (I think, for example, of eBay’s auction site and Paypal as the gems, and the numerous other acquisitions, especially Skype, as bloating the book value and lowering their ROE).

  4. I like Einhorn’s focus on weakening capital allocation discipline. It’s like the inside of the business rots out out while the ROIC remains excellent.

    This is the reason why I haven’t purchased EBAY… I can’t get past the company being run for management (aka stock options), which signals a risk of poor capital allocation going forward. The poor acquisitions track record is an example.

    Devote a post to Ebay’s management compensation…

  5. In principle, I don’t mind stock option compensation so long as they only vest at some distant point in time. I do not want management focused on the share price, and certainly do not want them crafting strategies aimed primarily at boosting near-term share price. It is hard enough to make reasonable long-term capital allocation decisions, and any hindrance to those decisions needs to be removed.

    Of course, you seem more worried about the amount of compensation than the means. I don’t have a lot of data points on this, but my current position is that eBay’s management is overpaid relative to its recent performance, and its competitors’ pay. In the proxy you cite, eBay uses Adobe, Amazon, Google, Intuit, Microsoft, Visa et al. as relevant peers for setting its compensation. Also, the metrics that eBay uses are revenues, operating margins, and return on invested capital–the right metrics, in my lights, those which management has some control over.

    If I devote some time to this, I’ll write up a longer post on their compensation. Thanks for the idea.

  6. Pingback: Buffett’s Berkshire letter for 1977 « Wide Moat Investing

  7. From your post: “Joel Greenblatt’s Magic Formula screens for companies with the highest ROE and lowest earnings multiples (i.e., P/E).”

    This statement is not accurate. Greenblatt’s Magic Formula screens for companies with high ROIC, not ROE. The former adjusts for leverage, ROE does not. Secondly, the Formula does not use stock price. Instead, it uses Enterprise Value, which, again, adjusts for debt.

    Screening for ROE and P/E would skew the results, yielding companies with higher leverage.

  8. You’re right FC–that was a sloppy mistake. Thanks.

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