*** If you missed the chance to take part in the HOLT Valuation Challenge, no worries - you can still benefit. Most business students will be familiar with Buffettims i.e. Warren Buffett's philosophy of choosing a company to invest in. HOLT did a neat analysis only to prove that the investor's wisdom can indeed be empirically supported.
Leave us a comment - pick your favourite Buffettism and give us a practical rationale behind it. The HOLT team will choose the best explanation and grant you access to their investment tool for as long as you're a student! ***
• Corporate profitability is sticky. Good companies tend to remain good companies, and poor companies tend to remain stuck in the mud. Sustainable corporate turnarounds are difficult to execute, and investors should be careful about overestimating the odds of success.
• Companies in defensive industries exhibit more persistence in corporate profitability than firms in cyclical industries. The reputation of the business tends to remain intact regardless of industry. Companies with an operational edge tend to maintain it; those without it tend to repeat operational mistakes.
• Firms with excellent profitability tend to outperform those with the worst return on capital. Out-performance improves if high quality firms are purchased at a fair price. Outperformance can further improve buying quality firms at a fair price that are exhibiting positive relative momentum.
Warren Buffett’s success as a fundamental, long-term investor in top quality firms has achieved iconic status. We felt it worthwhile to test a few “Buffettisms" against HOLT’s exhaustive historical data set for empirical validation. Our results affirm what many already know to be true: the wisdom of Omaha’s sage is supported by sound empirical evidence.
Distinguishing Good Companies from Poor Companies
In order to conduct our test, a financial measure that distinguishes good from poor businesses is necessary. The metric should reverse accounting distortions and non-cash charges such as depreciation and amortization. It should remove the effects of inflation, so firms can be compared over time and across borders. It should be rooted in sound financial economics, reflecting the underlying real (inflation-adjusted) economic return to capital providers.
HOLT’s CFROI® metric meets all of these objectives2. The long-term global average CFROI for industrial and service firms is 6%; we use this as our baseline economic reference. Firms generating economic returns above 6% are value creators; firms failing this threshold are value destroyers.3
CFROI can be compared to a cost of capital, adjusted for inflation, to distinguish whether a firm is creating or destroying shareholder value. This has enormous implications for a firm’s strategy and valuation. A firm whose CFROI exceeds its cost of capital should focus on reinvestment and growth to increase shareholder value. Mature firms with a CFROI at or below the cost of capital should improve key value drivers such as operating margins and asset turns. It is not earnings growth that matters but rather the quality of earnings growth. Boards and investors who don’t appreciate the difference might reward management for growing earnings while destroying shareholder wealth. Boards and investors who don’t appreciate the difference might reward management for growing earnings while destroying shareholder wealth. In the words of Warren Buffett:
“The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.” 4
In our Industry CFROI Performance Handbook5, we investigated industry group CFROI performance back to 1985. The average firm earns a CFROI close to 6%, the 60-year average CFROI for industrial and service firms6. 25% of firms earn a CFROI above 11%; 25% earn a CFROI below 3%. These results are helpful but do not inform us about the persistence, or stickiness, of CFROI. Persistence can be evaluated by studying 5-year transition probabilities across performance levels.
A CFROI transition matrix is shown left. Q1 represents the poorest CFROI performance quartile; Q4 represents the best; Q2 and Q3 are below average (-) and above average (+) firms, respectively. If operating performance were random, all probabilities would be 25%, indicating that the starting and ending points are independent. This is not the case. A global sample reveals the best performing firms (by CFROI) have a 51% probability of remaining amongst the best performing firms. Worst performing firms have a 56% probability of remaining the poorest performers. Corporate turnarounds are difficult to enact. Warren Buffett’s observation is supported by empirical evidence. The transition matrix clearly shows that operating performance is not a random walk phenomenon and that firms tend to remain in their starting quartile. Great companies tend to remain great companies, and poor performers tend to get stuck in the mud. Another Buffett quote bears mentioning:
“The way to get a reputation for being a good businessman is to buy a good business.” 7
The chart (at right) highlights from industries with the highest CFROI persistence8 to those with the lowest (from left to right). Unsurprisingly, defensive industries occupy the left and cyclical industries the right. The correlation coefficient indicates how stable the relative ranking in firm profitability is for each industry. The CFROI persistence factor shows the how much corporate profitability tends to fade over any 4 year period. A CFROI persistence factor of one indicates no fade in CFROI; a factor of zero indicates full mean reversion.
Wonderful Company at a Fair Price
Buffett believes that time is on the side of great businesses and in one of his most famous quotes advises investors to prefer buying quality companies over companies trading at discounts:
“It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” 9
We ran a number of backtests to assess this advice. Using a sample of global firms10, we examined whether high quality firms, as indicated by CFROI, outperform low CFROI firms. Indeed, the highest quintile (top 20%) CFROI firms earned an average annual return of 10.5% versus 8.8% for the universe compared to lowest quintile firms which earned 4.4% and displayed higher tracking error, e.g., besides underperforming the market, they are riskier relative to the market. We next tested whether investing in high quality companies at a fair price improved performance. We defined “fair price” as the top half in value11 attractiveness to avoid over-emphasizing any value effects. Annual outperformance for high quality companies at a fair price increases from 1.7% to 3.3%. Clearly, valuation plays a critical role for improving investment performance. Not surprisingly, value’s importance increases as quality declines and adds 5.4% to the annual performance of the lowest quality firms. An investment strategy of buying wonderful companies at a fair price has empirical grounding. It works even better if you can buy them at an attractive price.
In summary, corporate profitability is sticky, turn-arounds difficult to enact, and Buffett’s insight is well-grounded in advising that poor culture often wins in battles against brilliant management. Applying these principles as an investment strategy shows evidence of superior returns over time.
1 This document is a summary version of “Was Warren Buffett Right: Do Wonderful Companies Remain Wonderful?” For access to the original article, please ask your HOLT representative.
2 Holland, David and Tom Larsen. Beyond Earnings: A User’s Guide to Excess Return Models and the HOLT CFROI® Framework. John Wiley & Sons, 2008. Print.
3 For the Financials industry, we measure the real return on equity, CFROE®, which averages 7.5% over the long-term. Regulated Utilities tend to have a lower economic return due to government oversight and stable cash flow generation. The mean-reverting CFROI is 3.5% for regulated Utilities, whereas unregulated Utilities are assumed to trend toward a 6% CFROI.
4 Connors, Richard J. Warren Buffett on Business: Principles from the Sage of Omaha, page 100. John Wiley & Sons, 2010. Print.
5 Matthews, Bryant and David Holland (2012). “Global Industry CFROI Performance Handbook.” Credit Suisse HOLT. Available upon request.
6 Credit Suisse HOLT research dating back to 1950. Available upon request.
7 BRK Annual Meeting 2003 Tilson Notes. http://www.buffettfaq.com/
8 CFROI persistence is measured as the strength of association between CFROI(t) and CFROI(t-4), and is the beta coefficient (slope) in the equation E(Y | X=x) = x′β+ε, where x′ is the vector CFROI(t-4). In this equation, β indicates the average degree of persistence in CFROI over a lagged 4-year period. β =1 indicates that CFROI does not fade and β =0 indicates full reversion to the mean.
The correlation coefficient ρ is the Pearson product moment coefficient and indicates relative ranking over a 5-year period. ρ=0 indicates random ranking and ρ=1 indicates that rank order remains constant.
Price volatility is the annualized median 36-month standard deviation of price returns for all firms within an industry group.
9 Connors, Richard J. Warren Buffett on Business: Principles from the Sage of Omaha, page 142. John Wiley & Sons, 2010. Print.
10 Backtest sample includes firms with market capitalization greater than 2 billion USD, scaled through time. Sector-relative scoring was applied to minimize industry bias. The sample was tested over the past 20 years from 1993 using quarterly and annual rebalancing. Similar results were recorded. Our results below are based on quarterly rebalancing.
11 We defined value as a sector-relative combination of HOLT Percent-to-Best (50%), HOLT Economic P/E (30%), HOLT Price to Book Ratio (10%) and Dividend Yield (10%).
Disclosure and Notice
Global Market Commentary Disclaimer *12
References to Credit Suisse include all of the subsidiaries and affiliates of Credit Suisse AG operating under its investment banking division. For more information on our structure, please follow the attached link: https://www.credit-suisse.com/who_we_are/en/what_we_do.jsp
This material has been prepared by individual traders or sales personnel of Credit Suisse and not by Credit Suisse's research department. It is intended only to provide observations and views of these traders or sales personnel, which may be different from, or inconsistent with, the observations and views of Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions of Credit Suisse. Observations and views expressed herein may be changed by the trader or sales personnel at any time without notice. Credit Suisse accepts no liability for loss arising from the use of this material.
This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view of a particular market. It is not investment research, or a research recommendation, as it does not constitute substantive research or analysis. The information provided is not intended to provide a sufficient basis on which to make an investment decision and is not a personal recommendation. While it has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, each of the trader or sales personnel and Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or changes in market factors.
This material is provided for informational purposes and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. It is directed exclusively at Credit Suisse's market professional and institutional investor clients (e.g. QIBs) as defined by the rules of the relevant regulatory authority, and must not be forwarded or shared with retail customers or the public. It is not intended for private customers and such persons should not rely on this material. Moreover, any investment or service to which this material may relate will not be made available by Credit Suisse to such private customers.
This material may have previously been communicated to the Credit Suisse trading desk or other Credit Suisse clients. You should assume that the trading desk makes markets and/or currently maintains positions in any of the securities mentioned above. Credit Suisse may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. Information provided on any trades executed with Credit Suisse will not constitute an official confirmation of the trade details, and all preliminary trade report information is subject to our formal written confirmation.
FOR IMPORTANT DISCLOSURES on companies covered in Credit Suisse Investment Banking Division research reports, please see www.credit-suisse.com/researchdisclosures. To obtain a copy of the most recent Credit Suisse research on any company mentioned please contact your sales representative or go to http://www.credit-suisse.com/researchandanalytics.
Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. Backtested, hypothetical or simulated performance results have inherent limitations. Simulated results are achieved by the retroactive application of a backtested model itself designed with the benefit of hindsight. The backtesting of performance differs from the actual account performance because the investment strategy may be adjusted at any time, for any reason and can continue to be changed until desired or better performance results are achieved. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor a guarantee of future returns. Actual results will vary from the analysis.
Investment principal on securities can be eroded depending on sale price or market price. In addition, there are securities on which investment principal may be eroded due to changes in redemption amounts. Care is required when investing in such instruments.
The HOLT methodology does not assign ratings or a target price to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations, collectively called the HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates) are systematically translated into a number of default variables and incorporated into the algorithms available in the HOLT valuation model. The source financial statement, pricing, and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm performance. These adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The default scenario that is produced by the HOLT valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variables may also be adjusted to produce alternative warranted prices, any of which could occur. The warranted price is an algorithmic output applied systematically across all companies based on historical levels and volatility of returns. Additional information about the HOLT methodology is available on request CFROI, CFROE, HOLT, HOLT Lens, HOLTfolio, HOLTSelect, HS60, HS40, ValueSearch, AggreGator, Signal Flag, Forecaster, “Clarity is Confidence” and “Powered by HOLT” are trademarks or registered trademarks of Credit Suisse Group AG or its affiliates in the United States and other countries.
HOLT is a corporate performance and valuation advisory service of Credit Suisse.
© 2013 Credit Suisse Group AG and its subsidiaries and affiliates. All rights reserved.