JANUARY 2015
COUNTING ON CASH
AN ACTIVE APPROACH TO SUSTAINABLE
EQUITY RETURNS
David Dalgas
Chief Investment Officer, Global Core Equity
Kenneth Graversen
Portfolio Manager and Senior Research Analyst, Global Core Equity
Klaus Ingemann
Portfolio Manager and Senior Research Analyst, Global Core Equity
IN THIS PAPER: Cash is a powerful indicator for equity investors. Unlike accounting earnings, which are
often misleading, cash flows provide a clear picture of a company’s underlying performance. When combined
with detailed fundamental research on a company and industry, cash can provide effective intelligence on
a company’s future growth and stock price appreciation potential. In this paper, we present case studies to
show how an investment approach focused on cash flows can identify companies that generate strong and
sustainable equity returns.
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
CASH FLOWS POINT THE WAY
For a company that is the global market leader in cosmetics, L’Oréal had no
way of putting any gloss on its outlook in late 2014. CEO Jean-Paul Agon
announced in November that third-quarter sales would advance by only 2.3%
on a like-for-like basis, far below analyst estimates. It was turning out to be
the company’s worst year since 2009.
But viewed through another lens, investors could see a very different story.
L’Oréal’s cash flows have remained high and stable for more than a decade—
even through challenging periods after the global financial crisis. Resilient
cash flows, along with a broader fundamental analysis, indicated that L’Oréal’s
underlying business remained intact and was likely to deliver solid growth
and investment returns over the long term.
DISPLAY 1: L’ORÉAL: CFROI SIGNALS A ROBUST BUSINESS MODEL
25
CFROI (Percent)
20
15
10
5
0
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014E 2015E
As of December 31, 2014
Source: Credit Suisse and AB
CFROI is a trademark or registered trademark of Credit Suisse Group AG or its affiliates in the US and other countries.
2
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
L’Oréal is a good example of how to select stocks using a cash-flow
approach. We measure a company’s cash-generating track record
by looking at its cash-flow return on investment (CFROI): essentially
the annual percentage rate of return produced by a company’s net
cash flows over time (see box “CFROI: How Does It Work?” on page
5 for a more detailed explanation). Over the past decade, L’Oréal’s
CFROI has remained at or above 20% (Display 1), compared with an
average of about 12% for global equities. About 40% of its business
is in emerging markets, which is likely to drive future growth. And the
company benefits from global brand recognition and a perception of
quality that supports high pricing for its products and fuels profitability. In our view, all of these traits—which underpin dependable high
cash flows—suggest that L’Oréal should be able to withstand a bout
of market turbulence and return to its path of long-term growth.
We believe that using cash metrics rather than accounting earnings
helps identify companies generating strong and sustainable returns.
When combined with detailed research on industry and company fundamentals like revenue trends, margins, competitive positioning and
balance sheet health, it helps investors obtain effective intelligence
on a company’s future growth and stock price appreciation potential.
WHY IS CFROI IMPORTANT?
CFROI might not be a standard component in an equity investor’s tool
kit. Yet our research shows that global stocks with high and stable
CFROI have outperformed the MSCI All Country World Index and
delivered stronger risk-adjusted returns over time (Display 2). We
believe there are several clear benefits to putting CFROI at the heart
of an investment process.
++ Cash is transparent—Accounting indicators of a company’s performance can be misleading. For example, earnings can be inflated
by accounting decisions on revenue recognition. But generally
speaking, cash provides a reliable depiction of how a company is
really doing. By stripping out noncash measures from a company’s
reports, an investor can also effectively compare companies
that aren’t subject to the same accounting systems, neutralizing
items that may be distorted by accounting technicalities to create
an apples-to-apples basis for evaluating similar companies in
different jurisdictions
++ Noise is reduced—Cash-based metrics typically make it easier to
assess the impact of short-term fluctuations in earnings caused by
one-off events or seasonality in revenues
++ Returns are more likely to be sustainable—High and stable
CFROI is usually a sign of a company that generates value
consistently. In our view, companies like these typically have a
strategically sound position, built, for example, on a powerful brand
and a large scale in a business that is protected by a “strong moat.”
In other words, there are high barriers to entry for competitors,
so these companies have the potential to maintain superior
investment returns through changing market conditions
For all these reasons, historical CFROI is a good starting point. But
investors also need to understand whether a company can maintain
or increase its cash flows in the future—and how those cash flows
are valued today. That’s why we also look at a company’s ability to
grow its assets over time, which provides a good signal of its ability to
continue generating cash and creating value.
DISPLAY 2: COMPANIES WITH HIGH AND STABLE RETURNS ON
INVESTED CAPITAL OUTPERFORM
Annualized Returns
1989–2014
High and
Stable CFROI
11.5%
High CFROI
11.1%
0.78
0.67
0.67
9.7%
Stable CFROI
MSCI ACWI
Return/Risk Ratio
1989–2014
5.9%
0.38
As of March 31, 2014
Past performance does not guarantee future results.
CFROI based on quintiles of the highest, least volatile and the highest and least
volatile stocks in a Credit Suisse universe
Source: Credit Suisse, MSCI and AB
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
COUNTING ON CASH 3
Historical cash flows must
always be put into context
to project future returns.
PROJECTING THE FUTURE: SUSTAINING CASH FLOWS
Moody’s is a great illustration of how to apply this approach. Following
the financial crisis, many questions were raised about the company’s
future. The rating agency had been subject to intense market
pressures, as the disappearance of structured finance and shrinking
corporate balance sheets undermined demand for its services. For
many investors, Moody’s looked vulnerable to the unpredictable
changes that were sweeping through the industry; its dominant
position in a durable business with few competitors appeared to be
in jeopardy.
Cash-flow returns suggested otherwise. Yes, the company’s CFROI
had fallen sharply from about 70% before the financial crisis. Yet the
market appeared to be expecting it to tumble below 10%, based on
the depressed valuation of its shares at the time. In fact, it stabilized
in 2009 at about 30%, which indicated that its cash returns were
strong and stable (Display 3). But the real question was whether
Moody’s could sustain high levels of cash return in a changing
market environment.
Upon closer scrutiny, our research concluded that Moody’s enjoyed
a very stable market share in a concentrated industry. This was
likely to help it maintain its pricing power and support its long-term
growth—even amid an industry shake-up. At the time, we expected
a slow but steady global economic recovery to fuel an increase in
financing needs. Disintermediation in the financial industry was
prompting banks to move more assets off their balance sheets,
allowing investors to buy them directly. And companies were also
refinancing huge amounts of debt to take advantage of historically
low interest rates. All of these trends looked likely to increase
demand for Moody’s ratings services.
But there were legitimate concerns. Regulatory and legal risks were
seen as a significant threat to the company’s traditional business,
so an authoritative forecast on these issues was essential. After
concluding that the regulatory threat to Moody’s business model was
much less significant than markets believed, coupled with its strong
cash-flow history, it was possible to take a long-term position in the
company with conviction.
The Moody’s case is a good reminder that historical cash flows must
always be put into context in order to translate past performance into
future returns. It’s also important to understand whether companies
are likely to use their cash flows to benefit shareholders—or whether
they might waste them.
USES AND ABUSES OF CASH
Some companies may also be complacent. In 2009, we took a look
at Sankyo, a manufacturer of pachinko machines. This recreational
arcade game is so popular in Japan—during good times and
bad—that it was an incredible cash cow for the company. At the time,
more than half of Sankyo’s market capitalization was in cash. It was
an enticing opportunity.
DISPLAY 3: MOODY’S: STABLE MARKET SHARE AND HIGH BARRIERS TO ENTRY
Supplier power nonexistent
CFROI (Percent)
90
60
Barriers to entry
very high
30
0
04 05 06 07 08 09 10
11
12
13 14E 15E
Competition
not
price based
Direct financing
taking share
from banks/
intermediators
Buyer power low due to regulatory requirements
As of December 31, 2014
Source: Credit Suisse; Michael Porter, Competitive Strategy (New York, 1980); and AB
4
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
Yet CFROI couldn’t tell us what Sankyo was doing with all that cash.
If a company with a lot of cash doesn’t invest in expansion, increase
its dividends or buy back shares, then it isn’t creating much value for
its investors. In this case, after further investigation, we concluded
that Sankyo’s conservative management was unlikely to change; it
seemed to prefer to keep its cash locked up in its coffers rather than
put it to use on behalf of its shareholders.
Some companies have the opposite problem—too little cash
and too much investment. When a company pumps money into
ambitious projects that aren’t likely to deliver reasonable rates
of return on capital, they’re destroying shareholder value. CFROI
can help investors avoid the stocks of companies that appear to
be on an unsustainable spending spree, like Sainsbury’s, the UK
supermarket chain.
Sainsbury’s has low returns and a growing asset base—not an
attractive combination. In 2014, the company’s CFROI was less than
3%. Yet Sainsbury’s invested £888 million in its retail operations in
the fiscal year ending March 2014—including £418 million to develop
new stores—destroying shareholder value in the process. In our view,
the company’s aggressive focus on top-line revenue growth—despite
relatively low profitability—raised the acute risk of subpar investment
returns in the coming years. CFROI helped us decide to steer clear.
Contrast these stories with Check Point Software Technologies. The
Israel-based company is a world leader in Internet security software,
and its CFROI was around 20% in late 2014. In fact, the company
was hoarding its cash, and its CFROI would have been significantly
higher if it had paid out all the excess cash from its balance sheet.
Its solid cash flows pointed to a defensible business model. On
further analysis, we found that Check Point’s leading position in the
Internet security industry is protected by a wide moat for several
reasons: It offers a broad range of products in an industry characterized by a sticky customer base. Its high pricing is supported by
CFROI: HOW DOES IT WORK?
In an industry littered with acronyms, CFROI might seem to be
just another piece of confusing jargon. But in fact, the metric
is designed to help investors obtain a much clearer view of a
company’s underlying economics.
The idea is actually quite simple. Many items on corporate
financial statements reflect subjective judgments. For
example, reported depreciation costs and accrued revenues
are notoriously open to accounting manipulation. That can
make it hard to compare one company to another—even in a
similar industry or region. So investors need to convert the
information in reported financial statements into something
more objective. That measure is cash.
Company executives will find this familiar. Before starting
a new project, a company will normally forecast both the
cash the project will consume and the cash flows it will
generate over its lifetime. The internal rate of return (IRR) is
the annual percentage return provided by the sum of these
cash flows: technically, the discount rate that causes the net
present value of the project to be zero. When compared to a
company’s cost of capital, this helps determine whether the
venture makes economic sense. CFROI does the same thing
for a whole company. Credit Suisse’s HOLT model calculates
the IRR from the cash returns that have been generated by a
company’s assets over time. This is the company’s CFROI.
For financial firms, we need to use a somewhat different
approach: cash-flow return on equity, or CFROE. Since banks
and insurers rely on leveraged equity to generate growth,
the return calculation must account for the use of debt and
the capital structure funding mix. Other adjustments are
applied to reflect accounting differences between financial
companies and industrial groups.
Ultimately, though, the goal is the same: to make meaningful
comparisons across a portfolio, market or universe of stocks,
in order to allow an investor to determine the cash returns a
company has generated over time.
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
COUNTING ON CASH 5
Strong CFROI and an
attractive valuation is a
winning formula.
to deliver results. Instead, we believe that identifying companies
with strong and stable CFROI that are also trading at an attractive
valuation is a winning formula.
DISPLAY 4: CHECK POINT: CONSISTENTLY EXCEEDING
INDUSTRY PROFITABILITY
Adjusted Operating Margins (Percent)
80
Check Point
60
US Software Companies (Average)
40
95
97
99
01
03
05
07
09
11
13
Through December 31, 2013
Source: Credit Suisse HOLT, company reports and AB
the increasing threat of sophisticated cyber attacks, which compels
companies to spare no expense for top-notch security. Competition
is relatively benign. And the company’s effective use of resellers has
allowed it to maintain especially high operating margins of about 55%
(Display 4).
But what would the company do with all the cash on its balance
sheet? If it continued to do nothing, the investment case would be
weak. Then in 2012, Check Point launched a $1 billion share buyback
program. So its cash position and management’s new willingness
to reward shareholders created a compelling investment case in a
company with a strong market position and a proven business model.
VALUATION MATTERS
Valuation is also vital. Purchasing a company with strong potential
future cash flows and asset growth at an unattractive price is unlikely
6
Our valuation approach also focuses on cash. We use an economic
value added (EVA) model based on our own detailed forecasts of
future cash flows, using differentiated research to understand
industry dynamics and other factors affecting a company’s future
cash generation. We apply a discount rate based on historical real
equity returns adjusted for company-specific factors, such as its level
of debt. Then, we compare the EVA—a company’s intrinsic value—to
the company’s current market value. A difference signals that a stock
may be trading at a discount or a premium to its long-term intrinsic
value: we look to invest in companies where our research suggests a
discount of at least 20%.
BEWARE OF BLIND SPOTS
Like any financial metric, historical CFROI isn’t perfect. Investors who
rely on it for a cash-flow analysis must be aware of the blind spots.
++ Restructuring—This is often the result of a crisis. A company
that’s in the process of being turned around might not appear on
the CFROI radar, because it had weak cash flows in crisis years.
But a successful restructuring could push returns higher
++ External effects—Companies exposed to influences beyond
their control might display swings in their cash flows. For example,
fluctuations in commodity prices can undermine the reliability of
cash flows from oil producers, airlines and nonregulated utilities
++ Disruptive forces—Radical change is a fact of life in many
industries today. Some companies that look stable from a historical
perspective may discover that their moats are shrinking because
of new technology. Think about traditional retailers, which had
stable cash flows in the past but might face huge challenges from
new rivals as consumer sales increasingly shift to online markets
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
DISPLAY 5: CFROI FAVORS ASSET-LIGHT SECTORS
DISPLAY 6: FUNDAMENTAL ANALYSIS VERIFIES
SUSTAINABILITY OF CASH-FLOW SIGNALS
Average Monthly CFROI, 2007–2014 (Percent)
Consumer Staples
Information Technology
Healthcare
Industrials
Consumer Discretionary
Financials
Materials
Telecom
Energy
Utilities
4.4
14.5
11.9
11.5
10.9
8.6
8.1
7.3
19.5
18.7
Average
From November 30, 2007, through December 31, 2014
Source: Credit Suisse, MSCI and AB
MANAGING PORTFOLIO RISK
CFROI is a tool for bottom-up stock pickers. Yet some sectors are
likely to look consistently more attractive than others on a cash-flow
basis (Display 5).
Companies with asset-light business models, for example, tend to
have much higher returns. Examples include technology companies
and nonbank financial firms. Consumer-oriented companies that can
generate higher margins also rank high in CFROI. Companies like
these can be expected to feature prominently in a portfolio based on
cash-flow returns.
Industries that are more reliant on assets and more susceptible
to cyclical trends tend to be less attractive on a cash-flow basis.
In the capital-equipment sector, many companies are very asset
intensive and are also exposed to cyclical market trends. Telecom
operators are similarly unattractive; running a phone network is a
very asset-intensive business that often generates subpar returns
and disappointing revenue growth. A naïve, high CFROI portfolio
would probably be biased toward sectors with high cash-flow
returns. However, with an active approach, promising investment
opportunities can be found from time to time in sectors and industries
that tend to rank lower in terms of cash-flow returns.
Analysis
Thesis
+ CFROI
+ Industry
Dynamics
+ Key Value
Drivers
+ Capital
Discipline
+ Financial
Model
Insight
and
Judgment
+ Intrinsic
Model
+ Worst-Case
Scenario
+ Minimum
20% Upside
Source: AB
Of course, it’s important to understand the risks that a portfolio of
companies with high and stable CFROI may be exposed to. Unintended
exposures—such as country and sector weights, growth or value
biases, or macroeconomic exposures—frequently shift and must be
actively managed. Our approach is to carefully minimize such exposures and maximize the effect of stock selection. In our view, this is one
of the best ways to create a portfolio with powerful long-term return
potential and consistent results through market and economic cycles.
By counting on cash, investors can gain the conviction to overcome
short-term pressures. Our research suggests that CFROI has a
reliable track record of pointing to companies with strong business
models that have what it takes to withstand challenges and deliver
results. To be effective, a cash-flow analysis must be coupled
with a rigorous view of valuation based on a thorough analysis of
a company’s business model, financial position and competitive
environment (Display 6). And because CFROI is not widely used as
a central component of stock selection, we believe that putting it
at the center of an investment process can lead to a portfolio with
differentiated positions and low correlations with other comparable
equity strategies.
For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.
COUNTING ON CASH 7
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