By Ray Chipendo, JUNE 16 (The Source) – In Warren Buffett’s biography -Snowball, the author, Alice Schroeder discusses one of Buffett’s most outstanding investment picks – Mid Continent Tab Card Company. Apart from ticking the usual investment boxes, Mid Continent possessed two exceptional attributes that excited Buffett; a high asset turnover of 7 times a year and a sky-high net profit margin of 40 percent. Combined, the two attributes would give rise to an extraordinary cash compounding machine. Not surprisingly, 18 years later, Buffett’s original investment of $1000 in the company would have been compounded into a whopping $170,000.
In our present times, it is unlikely that you and I will ever come across companies of such a pedigree – much less at an attractive price. We have to be content with lesser amazing opportunities. But suppose one is confronted with two companies- one with a high asset turnover and another one with high profit margin, how should one go about picking a winner? This predicament may sound familiar to investors who in 2010 were faced with two promising stocks, Hippo Valley – a sugar cane producer and miller, and OK – a general retailer.
In 2010 Hippo was in its own class, churning out profits at a net profit margin of 22 percent. Over the course of 5years Hippo’s net margin would have averaged 12.4 percent, not an easy feat by any count. For OK, net profit margin was a pathetic 0.7 percent in 2010. And its 5 year average barely inched 2 percent. The retailer’s price earnings ratio (P/E) was not pleasing either. In 2010, its average P/E was 38 whilst Hippo’s was a conservative 14. Considering these basic valuation ratios, one would have concluded; OK was a ‘money pit’ and Hippo, a ‘bargain’. But watch what happened in the last 4 years.
Had you invested a $100 in Hippo Valley in 2011, three years later you would have lost half of your fortune and left sitting with $50. That’s because Hippo Valley’s share price was 135c at 2011 financial year end before sinking to the current 68c in 2014. On the other hand, the same $100 invested in OK would have turned out a $240. Who could have told? Well, some were smart enough to tell. A case in point, in 2010/11 when most investors stood by, undecided about Zimbabwean stocks, Investec fund managers were busy piecing together convertible loans for the retailer. Today, those once loan-turned-shares have worked very hard for the SA based fund manager.
How well were the two sweating their assets?
In hindsight, what could have helped you pick OK and not Hippo Valley?
Mid Continent’s second attribute, asset turnover ratio could have signalled danger about investing in Hippo Valley. Simply, asset turnover is an efficiency ratio which measures how many dollars of sales are generated by a single dollar of assets. So, while a dollar of OK’s assets was yielding sales worth $5.60 a year; Hippo Valley’s dollar was producing a paltry 30c in sales. Basic arithmetic would have suggested that OK’s efficiency was a staggering 18 times more than Hippo Valley. In essence OK was sweating its assets to the core while Hippo’s assets were lazing around.
Compounding vs destruction
Even with a net profit margin 6 times larger than that of OK, Hippo Valley’s low efficiency depressed the miller‘s return on invested capital to an average 7.2 percent since 2010.
And while Hippo Valley was gobbling debt, $65m in 2014 ($20m, 2010), interest rates on outstanding loans were more than doubling, rising from an average 5 percent in 2010 to 12 percent in 2013. With a 7.2 percent return on invested capital, Hippo Valley’s cost of debt of 12 percent was eating into the value of the business. In fact, with each dollar secured in loans, Hippo Valley was losing about 5 cents.
During the same 5 year period, OK’s average return on invested capital had averaged 17.5 percent, thanks to its super-efficient assets. Unlike Hippo Valley, OK had succeeded in reducing its outstanding loans from $7m in 2010 to $4m in 2014. With each dollar of re-invested profits or capital raised, OK’s 17.5 percent return would more than cover for the cost of capital thus creating value for shareholders.
Missed boat or gravy train?
So, if you missed OK’s excellent run in the last 3 years you must be wondering; does the company still have any steam left? At a P/E value of 22 and Price/Sales at 0.44 – the highest in 5 years, OK may no longer be as attractive as it used to be. But, one would ask if this is not the same narrative that most investors used to stay away from OK 4 years ago when its P/E value was 38 – and ended up missing one of the best rallies. True to an extent, but an investor who feels they have missed the boat should be cautioned against hurriedly jumping back at a time the boat cruise is turning into a gravy train ride.
In an environment where growth is very uncertain, one safe way of testing if the current price is reasonable is by performing a reverse discounted cash flow valuation (DCF). The model calculates what growth rate the market is applying to the current stock price. Using cost of capital of 9.6 percent and perpetual growth of 2 percent a year reveals that at the current price of 18.5c, the market is expecting OK’s free cash flows to grow at 13 percent. In light of rising unemployment and an economic growth rate downgraded by World Bank to 2 percent, it is difficult to see how a retailer could grow at such levels. In fact, between 2010 and 2013, OK revenues were growing at 37 percent a year, yet the last financial year end’s growth rate plunged to a mere 1 percent. Is it not interesting that the market would expect a 13 percent growth rate on a company that has just posted a 1 percent growth in a worsening environment? It appears OK may have run its course already. At this current price, a little sitting and waiting for the price to swing down may be the best option.
In the last four years Hippo Valley has spent more than $56m mainly expanding and maintaining its plant and equipment. Management reckons its extensive mill refurbishment programme is responsible for enhancing sugar extraction rates from 67 percent in 2010 to 87 percent in 2014. That’s a 20 percent improvement. Management could argue that the benefits of this costly expenditure may start to bear results from this year. Completion of this programme and subsequent slowdown in capital expenditure will surely increase asset turnover thereby enhancing returns to shareholders.
At the price of 68c, Hippo Valley is trading at a P/E value of 14.6 – quite a conservative multiple for a company that has been profitable since 2009. Compared to OK, Hippo’s share of exports (sales to Europe accounted for 65 percent of the industry’s sales) is likely to insulate the company from any slackening local demand. But more interestingly, Government has in the last few months introduced tariffs which will make Hippo’s sugar significantly cheaper than imports.
Using similar assumptions (a weighted average cost of capital of 9.8 percent and a perpetual growth rate of 2 percent) a reverse DCF at Hippo’s current price (68c) suggests that the market is expecting the sugar producer to grow at a rate of 0.6 percent.
Four years later, the investor must be sitting with a worse dilemma than the 2010 one. To OK or to do Sugar? As the economy squeezes your wallet you may stop eating cornflakes from OK – but will you stop putting sugar in your tea? Hardly! To close the debate, I think I would sleep better with an investment priced on the expectation of a 0.6 percent growth rate than 13 percent- more so when the economy is said to grow at 2 percent. By the way, who once said – anything can be a good investment as long as the price is right?
Ray Chipendo is the Research Lead at Emergent Research. He is contactable on firstname.lastname@example.org, @ray_chipendo