By Andrew Manton and Matthias Knerr
With an investment universe that has over 3,000 companies, international investors need a method that takes advantage of modern day efficiencies to help find worthy stocks.
Corporate managers and executives are often heard discussing their theories on maximizing “shareholder value.” While this may be interpreted differently, it is the basis for an important question all managers should be asking: How do we create value for shareholders?
The “competitive corporate lifecycle” is one concept asset managers and financial advisors can use when assessing what actions should be taken to create value. This concept captures the relationship between competitive forces and a firm’s economic performance and valuation over time.
By focusing in on a company’s economic returns and its reinvestment rate, more accurate assumptions can be made about the future generation of cash flows—the basis for a company’s stock price.
Lifecycle Classification Process
Unlike widely used sector and regional classification approaches, which are simplistic and readily available, the lifecycle methodology first requires a unique classification system that can measure a company’s ability to redeploy capital and grow cash flows—a much more useful starting point in fundamental analysis. The system consists of five categories, which our team has defined as: Innovation, Expansion, Deceleration, Maturity and Distress.
Innovation: Highest investment phase. Low returns reflect early stage of development.
Expansion: Invest aggressively for growth. Returns are high and rising, creating significant shareholder value.
Deceleration: Opportunities are scarcer. Capital is deployed to maintain returns. Create shareholder value by using asset base to generate cash flows and compound returns.
Maturity: Competition erodes returns. Limited investment is required. These are typically large, stable companies.
Distress: Returns must improve before investing. A management change is often required.
How It Works
As an example of how the classifications work, consider the following two case studies.
Distress Companies: Usually mature companies which, for various reasons, are no longer able to achieve sufficient returns on their capital and have a low probability of outperforming their peers. They therefore demand a greater amount of analysis, but are capable of rebounding and re-entering a healthier lifecycle phase if the proper adjustments are made.
French auto part supplier Valeo SA (FR:FP) was classified as distressed in 2009, when it had 10 different divisions. There was very little synergistic value to its structure and, as a result, very low operating margins. A new CEO and a restructuring resulted in only four operating divisions, with strict performance and manufacturing goals. Over the next several years margins increased substantially, revenue growth exceeded the overall auto market, and the stock rose approximately 900 percent. Valeo successfully shed its distressed classification, and is now in the expansion phase of the lifecycle.
Expansion Companies: These are the fastest growing businesses in the investment universe, earn a return above their cost of capital, and have the greatest probability of outperformance over the long term.
As the world’s largest dedicated semiconductor foundry, Taiwan Semiconductor Manufacturing Corp. is a prototypical “expansion” company. Semiconductor manufacturing is a capital-intensive business, requiring large-scale production capacity and long investment lead times. Given its unrivalled scale, TSMC has the resources to invest and innovate in leading technology, while providing smaller customers with high-quality manufacturing at the lowest available price.
Although initially established to support the growth in the PC market, TSMC’s business expanded further with the adoption of mobile technology, something expected to continue with the exponential increase in the number of internet-enabled devices. The high barriers to entry in this fast-growing industry, coupled with skillful management, have allowed TSM to deliver an annual stock price increase of nearly 25 percent over the past 5 years.
How It’s Measured
Using a lifecycle approach, it is critical for investors to focus on companies whose management is increasing the return on investment within their company, where:
ROI = Profit/Assets
The lifecycle classification system is also based on ROI. Because of optimal investment choices, a firm’s assets and growth options change in predictable ways.
The growth rate of assets used to produce their goods or services and the resulting growth in profits are what drive a company’s expected stock returns. Therefore, the lifecycle classification phase focuses on these two important metrics.
In the numerator, a company’s gross cash flows are a much more accurate proxy for comparing a company’s economic profits. By adding back minority interest, taxes, payments to debt holders, research and development expenses, rental expenses, and special items to net income, the team arrives at a more universal figure.
In the denominator, a company’s book assets are distorted by depreciation, off balance sheet financing such as leases, and time-value adjustments not made to assets such as plant and land.
To get a more accurate picture of a firm’s overall assets used for investment, accumulated depreciation is added back to book assets, gross plant and land book values are adjusted for inflation, and leases and R&Ds are capitalized.
A shorthand equation for the measure used is instead:
ROI = Profits Assets → CFROI = Gross Cash Flows Gross Investment
Once a company’s gross cash flows and gross investment figures are found and the CFROI is calculated, the final step is to compare these figures across the universe.
The Global Equity Screen
Once every company in the universe is formally categorized within a lifecycle stage, the team can then apply a proprietary screen.
Unlike some of the more basic screening processes where companies are sorted and eliminated according to basic fundamental metrics (sequential screening), our international investment team applies a more rigorous system that takes full advantage of the unique qualities in each stage of the lifecycle spectrum and applies criteria to the entire investment universe at once.
There are many idiosyncrasies to global equity investing and sorting companies by sector or region is often not a helpful first step in the investment process. Adopting a lifecycle-based process, which classifies the global universe into a construct that both identifies a company’s historic ability to create value and its universally common geographically can be a more effective and productive starting point.
Andrew Manton and Matthias Knerr are Portfolio Managers for the Shelton International Select Equity strategy at Shelton Capital Management, a registered investment adviser with offices in Greenwich, Denver and San Francisco.