David Einhorn and Return on Equity

Here 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.]

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Francis Chou’s Best Bargains

Last night I was going through some of Francis Chou’s annual letters to his Associates Fund holders. Chou manages investment funds for Chou Associates Management Inc., and his Associates Fund has compounded annual returns of 15.4% over the last fifteen years, compared to 10.5% for the S&P 500.

In his 2001 annual report, Chou highlights the criteria that he has used to find his best bargains:

“Over time I have sifted through thousands of bargains which have come in different shapes and flavours such as discount to net-net working capital, discount to book value and low P/E ratio. When all is said and done, those which continue to give me the greatest satisfaction are the ones which display the following characteristics:

1) Above-average to excellent companies as measured by high ROE in excess of 15% sustained over 10 years or more.

2) Companies run by skillful managers as measured by good controls maintained on receivables, inventory and fixed assets.

3) Prudent deployment of capital as measured by a company’s capital expenditures, judicious acquisitions, and timely buybacks of its depressed shares.

4) A stock price which is far lower than what a knowledgeable and rational buyer would pay.

BMTC Group met the above criteria in spades. And when companies such as this one are found, the only rational thing to do is buy as much of the stock as the legal limit allows. In these instances it’s not always necessary to be extra careful about the buy price as long as this price falls within a single digit P/E ratio. Even on the sell side, there isn’t a pressing need to time the sale as the stock price nears its intrinsic value – the reason being that the company’s intrinsic value is growing in excess of 15%.”

Chou’s specificity here and his example of BMTC Group are very useful for the aspiring investor. Most simply, Chou needs to see sustained profitability, skillful management, prudent capital allocation, and a fair price. And when he finds it, Chou buys with conviction.