November 9, 2019
When searching for high quality growth investments, Fairlight prioritises finding businesses with high returns on capital, evaluating the sustainability of the excess economic returns and only then considering price. This approach is informed by the notion that over the long term the returns achieved on any stock will approach the return on capital earned by the business over the holding period. Put simply; if a business can sustain a 20% return on capital for 20 years, it will be the exponential growth in earnings and dividends cashed that determine the lion’s share of investor returns, not any linear change in the P/E multiple.
A historical perspective
This relationship can be illustrated using a current Fairlight portfolio holding; ANSYS, Inc. Ten years ago the business could be purchased for $41 per share on a P/E multiple of 23x. Today, it trades at $216 after a 45% increase in the P/E multiple to 33x, with investors who held for the entire journey enjoying a 16% p.a return. However, despite the multiple expansion, it was the compounding impact of 14% p.a EPS growth that was responsible for ~80% of an investor’s total return. In fact, an investor could have paid 60x earnings, almost 3x the original multiple, and still earned an acceptable 10% p.a total return whilst enduring a precipitous drop in the multiple on their investment from the theoretical 60x to today’s 33x. Such is the power of a high quality business compounding over a long period of time.
CROCI reveals value-creating businesses
When assessing returns on capital, Fairlight utilises the Cash Return on Capital Invested (CROCI) framework. This measure considers the impact of capital structure, depreciation schedules, operating leases, goodwill and intangibles, providing an untarnished view of cash dollars of profit earned in relation to cash dollars spent to set up and operate the business. If a business generates a CROCI below its cost of capital, it implicitly follows that shareholder value is being destroyed. Although this relationship can be obscured by short term volatility in share prices, our view is that the underlying economic realities inevitably prove themselves over time. Fairlight is not looking to participate in any short term market re-rating of a value-destructive business and as a result the portfolio is filled with businesses earning returns well in excess of their cost of capital (see Figure 1).
Easy in hindsight, hard in reality
Although it is easy to reflect historically to identify businesses that have maintained value creating CROCI levels and double-digit EPS growth, finding those who can continue to sustain excess returns going forward proves to be a more difficult endeavour. Fairlight relies on two strategies we believe tilt the probabilities in our favour:
1. Assessing competitive advantage
The nature of markets is that any business generating enviable returns will quickly attract determined competition, and so as times passes the CROCI for most businesses reliably approaches the cost of capital. Fairlight looks for businesses with strong, sustainable competitive advantages that minimise the ability of competition to enter and erode returns. Businesses in the Fairlight portfolio share one or many of the following characteristics; first mover advantage/network effects, brand strength, R&D or innovation dominance via scale, long-tenured customer relationships, recurring revenues and/or a large required upfront capital investment.
2. Margin of safety
Despite the ability of a high quality business to outrun price paid to a degree via compounding, discipline on valuation remains an important risk management tool. Investing with a margin of safety provides a degree of cushioning, should we misappraise the quality of the business or the sustainability of its returns.
The Fairlight View
When investing for the long term, we believe the multiple paid for a business will be far less significant on ultimate returns than the quality of the business and the underlying returns on capital. When assessing an investment, the first and most important analysis we consider is determining the quality of the business. Second, to determine the sustainability of the returns going forward by assessing competitive advantages. And lastly, to build in a margin of safety via price to protect capital when mistakes are made.