InvestinginValueCreators-REQ Capital

Investing in Value Creators

Time Tested Principles for Long Term Stock Investments

apital is an asset management company based in Oslo.

e a true partnership owned by the founders of the

ny. We are long-term owners of excellent companies.

est in value-creating companies with management of the integrity. Our goal is to find the best corporate cultures

vest in them for the long term. We believe that our

ment philosophy and strategy will provide excellent long-

turns to our investors.

An investor mindset There are many ways to succeed or fail in the stock market.

This book on value creation offers one way to think about stocks as long-term investments. To benefit from the philosophy and mindset presented in this book, you as an investor need a very long investment horizon, spanning ten to 20 years or even more.

Some people prefer a short-term trading strategy in stocks.

Others prefer a fundamental approach. The goal of this book is to provide a brief and concise introduction to what determines shareholder returns over the long term.

The book presents some basic principles and fundamental reasons why some stocks perform significantly better than other stocks over the long term.

The key concept is "value creation". In the long run, the stock market is a very rational market. Shares of companies that create value over time will deliver strong share price movements. Shares of companies that destroy value will experience weak share price performance.

This book does not require lot of knowledge of accounting, finance, or valuation. It attempts to explain the key concepts of value creation and stock analysis in a way that is easy to

rience as a portfolio manager. And remember - there is

ntific formula for choosing the right long-term

ments. Hopefully this book will give you some principles to

u on your way to becoming a better investor.

tment horizon

9

kes are part of the game

16

s on what you can control

23

reation ition of value creation

26

growth and bad growth

40

EPS can mislead you

52

end discount model

57

ptional companies e types of investments

68 74

eys to unlock growth

80

decomposition

83

ptional long term investments

86

ative analysis

analysis

97

rbolic discounting

110

ive analysis gement and capital allocation

116

eholder communication

125

ure for great long term returns

131

o management on sizing

137

tions to management

140

edge as an investor

145

management

150

sition driven compounders emarks

154 161

ences

163

of stock received by the Drivers company, and changesreturns in the stock's valuation multiple. EPS growth and dividends are "fundamental" return

drivers, as these two return drivers are based on the company's fundamentals.

The change in the valuation multiple reflects changes in sentiment and is therefore an emotional return driver. I will return later to the fact that not all EPS growth is good. Growth can be bad for you as an investor if the growth does not create value. In other words: If growth does not generate a return on capital that exceeds the cost of capital, the company is destroying value.

We devote an entire chapter to this very important topic.

There are several ways a company can achieve EPS growth.

Two chapters are devoted to how a company can grow its EPS. Most companies, with the exception of very high growth companies, pay dividends. This is also an important driver of returns over time. Over the long term, i.e., several decades, the return on your stock is the sum of earnings growth and dividends.

ars. As you expand your investment horizon, try to find

hat can consistently grow earnings per share in a

le manner and pay some dividend.

Investment horizon type of research that I believe is useful for the long-term investor.

The figure below illustrates the focus that is important for the various time horizons of an investor from a quarter of a year to more than ten years. Speculators who focus on a time horizon of one year or even less do not have to worry about fundamentals or changes in fundamentals. With such a short time horizon, the only thing that matters to your return is changing sentiment, such as changing perceptions of the industry in which the company operates, political and macroeconomic sentiment, and other short-term issues. Very few people are always right with this type of speculation. You may be right the first time and believe you are a stock market genius. But the stock market will prove you wrong if you continue this type of effort.

A short-term time horizon of one year is also emotionally taxing, as you need to stay one step ahead of the game. As Gautam Baid wrote in Joys of Compounding: "If everything you do needs to work on a three-year time horizon, you are competing against a lot of people. But if you are willing to

at". your focus from a quarterly or annual horizon to a multi-

rizon increases the impact of changes in a company's

entals on your investment results. We will return to the

of fundamental return drivers at short time horizons. The

of fundamentals on your returns over the short term is

an you might think.

minant force on your returns over a three-year horizon is

tiple expansion or change in the P/E ratio. A rising P/E

very welcome, of course, and the return you get from

ltiple expansion is as real as the return from the two

multiple expansion. There is a limit to how expensive a stock can get. On a five-year view, the fundamental factors start to kick in, even though the change in the multiple is still very important. On a five-year view, the dominant force for your return is still where we are in the cycle and the medium-term industry headwind or tailwind. You may have picked the right company, but on a five-year view, the impact of industry dynamics and the macroeconomy are still important factors for the company you invested in.

As you extend your investment horizon beyond seven years, company-specific factors begin to dominate your returns. The company's reinvestment opportunities and the company's ability to deploy large amounts of capital at high rates of return become the dominant driver of returns. We will return to the very important topic of reinvestment. On a ten-year view, it's all about investing with the right management and in the right corporate cultures. In my experience, any investment over ten years is more a bet on the people running the company than anything else. Therefore, an analysis of the corporate culture and management is essential.

In the chart below, we look at the empirical data of the U.S. stock market over the last 105 years and separate the "fundamental" returns (EPS growth + dividends) from the "emotional" returns (changes in P/E ratio). On a rolling five-year horizon, the average contribution of "fundamentals" is 44% of

en with a five-year time horizon, emotional returns are

n driver for stocks.

xtend your stock investment horizon to 20 years, you

arly see that fundamentals are the dominant force in

urns. With a rolling 20-year time horizon, 72% of your

omes from the sum of earnings growth and dividends.

h as 28% of your return comes from changes in the P/

ple. So even with a 20-year investment horizon, you

in the multiple disappear. In the long run, the stock market is very rational. Over rolling 40-year investment periods, the return you earn on your stock comes solely from rational fundamental return factors.

If you look at the last 105 years in the U.S. stock market, you will see the contribution of earnings growth, dividends and multiples in the chart below. Over this very long period, the nominal annual return on U.S. equities has been 9.6% per year.

Of that 9.6%, 5.0% came from EPS growth, 4.5% from dividends, and only 0.1% from multiple expansion. No one has a 105-year time horizon for their investments, but the figure illustrates that you should focus on companies that can grow profitably and pay dividends over very long periods of time.

You can examine the impact of returns from earnings growth, dividends, and changes in the P/E multiple for different ten-year periods over the last century.

The table illustrates several points. First, the return contribution from dividends changes quite a bit over all ten-year periods, but always contributes positively to your total return. When you turn to the earnings growth column, there is greater variation in return contribution. Note, however, that earnings growth contribution is positive in all periods except the 1930s. It is very rare that you experience ten years without corporate earnings growth.

ution is positive. In other periods, it is negative. At the end

ot.com era in the late 1990s, stocks were trading at high

os. Consequently, the contribution from multiple

ion in the following ten years from 2000 to 2010 was

e 3.2% per year, which was enough to put the total return

ed for that ten-year period at -1.2% per year. Note,

er, that in all ten-year periods in the last column, only two are in the red. The conclusion for the market as a whole

he fundamental return drivers of earnings growth and

ds are almost always positive in each ten-year period. At

me time, try to avoid too high a P/E ratio, as this can

from good fundamental performance. Over a ten-year

the stock market usually generates good returns for

rs. The fundamental and emotional return factors on the

s pages can also be applied to individual companies. In

specific example shows that most of this stock's return over the last ten years is due to fundamental factors. Overall, Accenture's return is 15.7% per year, exactly equal to the sum of earnings growth and dividends of 16.2% per year.

Mistakes are part the game nvesting.

We all make a lot ofof mistakes.

Investors who

om their mistakes will be successful. If you can not see a

in the mistakes you have made as an investor, just keep

. These are some of the many mistakes I have made

e years that form the background for many of the

s in this book. too early

mon mistake I have made several times is selling stocks

o early just because the price has risen sharply in the

rm. These sales were of companies that were strong

m compounders. Very rarely was I able to get back into

ck at a higher price. The most important lesson for me

at I am very hesitant to sell shares of companies that are

ming perfectly. Sometimes the stocks of these companies

ad of the underlying performance of the companies. The

for me is not to let a temporarily high stock price scare of the company. I have come to three reasons to sell a

The first reason is that you made a mistake when you

bought the company. The company is not as strong as

should draw the consequences and sell the stock.

The second reason to sell is that you no longer trust management. Management is starting to convey a message that you do not understand. You do not like the language they use and they do not seem to be good stewards of your capital. I have made several misjudgments about management. These mistakes have led me to some principles that I need to pay attention to in order to form an opinion about management's abilities. I will discuss this in more detail later in this book. The third reason to sell a stock is due to pricing of the share which is far beyond what you think is rational. In my opinion, this is the most difficult reason to sell and therefore I am very reluctant to sell based on the pricing of the stock alone. There are always very good reasons why a stock is trading at a high multiple.

Buying too much too soon One type of mistake I have made several times is buying too much too soon. It takes time to learn about a company. And the best way to learn is by owning the stock. Sometimes just owning the stock causes you to see the company through different eyes. In my experience, do not buy the entire position at once, but start with a smaller position. After a while following the company as a shareholder, you normally grow your conviction and buy more. I prefer to average up rather than average down, which means I am happy to pay a higher price after following the company as a shareholder for a while. If the

e down, i.e., buy more shares of a company that is

ng. I prefer to buy shares in companies where

ement executes according to plan.

nalyze

of my worst investments have been in companies that I

ar too much time analyzing. The main takeaway for me

ese mistakes is to try to find companies that are easy to

and and where you do not need a lot of spreadsheets in

o form an opinion. If you feel you need to delve into the

of a company, I have often found that I bought the wrong

ny to begin with.

perience has made me much less interested in

ated business models. I like simplicity. I like to read

y or annual reports and quickly decide whether the

ny is on the right track or not. Too much information company often leads to decision fatigue. With complex

ss models, you are not able to form an opinion about the

n of the company because there are too many conflicting

about the way forward. When investing, simplicity often

t over complexity.

onfidence and underconfidence

the big challenges in investing is finding a balance

n confidence and humility. You need confidence to make

stment. At the same time, you need to be aware that you

you constantly believe that you will be wrong, you will not be able to make an investment. The stock market is a fantastic tool to make you humble. This is the reason why very experienced investors are often of the humble kind. They have made many mistakes and have learned from those mistakes.

Learn from losses To grow and develop as an investor, try to learn as much as you can from your mistakes. Over time, the mistakes you make will form a set of principles that will guide you through your investing career. You will learn the hard way where your strengths and weaknesses are as an investor. Keep learning and refining your principles. Try to write down your mistakes and record them in a journal. Over time, you will find that there are some common situations that you need to avoid just because your journal and experience show that these situations are not your strengths.

These situations should therefore be avoided. The best tool is to learn from your own mistakes. But there is also much to learn from the mistakes of others. If you are lucky enough to have a mentor or a network of investors, it can be very fruitful for your growth as an investor.

As Charlie Munger has said: “It is remarkable how much longterm advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent”.

Charmed by management Some investors avoid any interaction with management. Others

ement that is too charismatic management should be

d. It is helpful to consider how the company's employees

out the CEO sitting in front of you. Is the company a

an show" or is the CEO able to see and acknowledge

mpany's employees? What kind of culture does the CEO the company? Company culture starts at the top. It is

O's values that are transmitted down through the

ation. It's been my experience that CEOs who spend too

me talking about themselves and not the company they

e a big red flag. It takes a few management meetings to

and that you should not necessarily invest in the most

matic and outgoing CEO in town. From my experience, I

Os who are down-to-earth, pragmatic, and able to give a

sponsibility to employees. You want to invest in

nies that are led by CEOs who you think are very good

dels in the organization. If you doubt that the CEO is a

le model, you should not invest. We will cover this topic

this book.

ling to change mindset and investment philosophy

mous economist Keynes once said, "When the facts

, I change my mind." As your investment career

ses, hopefully you will learn a lot from your mistakes.

stakes you make should help make you a better investor. believe there is only one way to achieve consistent

returns in the stock market. There are many paths to

s. I believe you will become a better investor if you can

one strict investment philosophy throughout your investing career. Look at Warren Buffett. He has radically changed the way he invests throughout his career. At the beginning of his investing career, he favoured investing in value stocks. This evolved into buying high-quality companies. If you are not willing to change and evolve, you will keep looking at the same type of investments. As for your personal growth, listen to people who think completely differently than you do. It will be easier for you to recognise your blind spots as an investor and respect the fact that there are many ways to make money in the stock market.

Too much focus on numbers My personal investment journey has changed a lot over the years. Initially, I focused a lot on the quantitative aspects of potential investments. I am still very interested in the financial history of companies. At the same time, however, I have come to the conclusion that my biggest investment mistakes were due to investing in the wrong kind of management and the wrong ownership structures. My best investments have been characterized by investing in excellent management teams and right ownership structures. As a result, I have started to pay more and more attention to how management communicates and interacts with investors. I have become more and more interested in the art of evaluating management, which is not an easy task. I have become more and more interested in "owner operators" and companies that are run by management rather

he business as if it were its own. When you rent a car,

y rarely, if ever, spend time and money cleaning the car

intaining it. I try to find management teams that are

o-earth, pragmatic, and understand value creation. I have

ncluded that management teams that do not give

ce to investors and that stand by their mistakes in

nce calls are usually more interesting as investment

nities than the opposite. All of these are non-financial

s that are more difficult to assess than financial numbers.

se qualitative assessments increase the chances of

hareholder returns.

ling to sell losers

y mistake I have often made is not being able or willing to

mpanies that have not performed according to

ations. If your investment thesis changes, you should re-

e the investment. Weaker than expected fundamental

mance is always accompanied by a falling share price

emingly more attractive pricing of the stock. It is better to

ou were wrong and sell the stock than to try to find a

ason to own the stock at a lower price. I

ather average up and buy more shares at a higher price

companies where the underlying fundamental

mance is better than expected.

Focus onanwhat you decisions that go into investment.

can control

The problem with focusing on returns is that you can not control the returns. Good returns can result from both good and bad decisions. High returns can result from both skill and luck. I believe that anyone investing for the long term should focus on four controllable factors that ultimately determine returns.

These four factors are time, behavior, cost and risk. If you manage these four factors well, strong returns will come naturally. By focusing on these four factors, you as an investor become more process-oriented than outcome-oriented. I believe that a process mentality is important to be successful as a longterm investor.

Time As a private investor, you have full control over your time horizon, which means you have a big advantage over many professional investors. Many professional investors do not have the luxury of taking the long-term perspective because of many different factors. As a private investor you do not have the

often easier said than done. The market will always try to

u opportunities to make bad short-term decisions. You

empted to buy and sell stocks at the wrong time. Time is

erful company's best friend. As an investor in strong,

m value creators, time works for you, not against you.

or

y, you have control over your behavior as an investor. market will always present you with opportunities to act that hurt your returns. Greed and fear are a natural part

sting. There are many patterns of behavior that you will

ter. If you try to become aware of these behavior

s and reflect on them, you will be a better investor. Keep

al of your investment decisions. Over time, an investment

ll help you become aware of your behavior patterns.

own what you were thinking when you decided to buy or

the long run, these notes will make you more aware of

havior patterns and hopefully help you make fewer

es in the future.

n control all the costs associated with investing in stocks.

ong run, be aware of the costs that reduce your returns.

hink long-term, reduce the costs associated with

tions, and if you invest in a fund, reduce the annual

ement fees. My advice is to use only active funds that

y long-term and different from benchmarks. And make

Risk You have full control over the risk you choose to take. I devote a separate chapter at the end of the book to risk management.

You have to decide for yourself what kind of risks you want to take. I do not believe in the standard financial textbooks that recommend that you must take a high level of risk to achieve high returns. You need to set your own risk principles that you will stick to. Avoiding permanent capital losses should be one of your goals as a long-term investor. I will come back to how I think about avoiding devastating losses.

De of value creation tal and the nition cost of capital.

To create value for

olders, the return on capital must exceed the cost of It is important to understand the theory behind value

n. to keep the theoretical aspects to a minimum and spend

me on how value creation is reflected in the market the pricing of stocks. The following figure summarises

operating profit after tax, NOPAT, and invested capital. We calculate WACC using the relative weighting of equity and debt in the company's long-term capital structure and the calculated cost of each source of capital.

Return on invested capital There are several definitions of return on invested capital, or ROIC. As an investor, you can make a variety of adjustments to the income statement to get the right cash-adjusted result you need to calculate ROIC. Some adjustments are more important than others. The goal of the adjustments is to produce a "cash result" that can be used to meet the claims from equity and debt investors. Net income at the end of the income statement (P&L) is not a good starting point for financial analysis. Net income is the result of numerous adjustments, subjective opinions, and various types of accounting treatment that are of little importance to investors. Net income may be interesting from an accounting perspective, but it is less relevant for financial analysis. I will make a few adjustments to the P&L that are easy to understand and that go a long way toward getting us to the cash earnings we are interested in. I will present a definition that is easy to calculate and that captures the essence of the ROIC calculation: ROIC = NOPAT / Invested capital ROIC measures how effectively the company is deploying the

measures what cash rate of return you got on the assets

usiness. If you own the entire company, you are

ed in the cash result that you can use to pay the

ny's two capital providers, the debt providers and the

providers. Naturally, companies with a high ROIC are

ble to create shareholder value than companies with a

IC. The better the company uses its capital, the higher

mpany's ROIC. One aspect is the level of ROIC, another

nt aspect is the durability of the high return.

oes not depend on the capital structure of the company.

al is to gain insight into the quality of the company's

onal decisions, regardless of its capital structure. ROE

on equity) depends on both the operating decisions and

ncial decisions of the company.

mpany decides to increase debt, ROE may increase even

perating side of the business does not change for the

By using ROIC, we avoid the impact that an increase in

uld have on the ROIC ratio. Before I present how to

e cash earnings, we need to look a bit at the income

ent. The point here is not to analyse the income

ent, but simply to make the reader aware that the income

ent contains both cash and non-cash costs.

mple, employee salaries are a cost that reduces both

ome and cash on hand. On the other hand, some costs,

cost on the income statement. These costs are expensed over a number of years as the asset is depreciated or amortised in stages and charged to the income statement. But the impact of research expenses on cash flow is immediate and real. This treatment causes cash flow and earnings to differ. There are many books that deal with income statement analysis. Here, we are not concerned with income statement analysis, but with the calculation of cash earnings. The NOPAT is defined as: NOPAT = EBIT - cash tax EBIT is earnings before interest and taxes. Cash tax is the tax payment you find in the cash flow statement. EBIT is the profit after deducting all the operating costs that were incurred to generate the revenue. Note that we also deduct depreciation, even though depreciation is not a cash item. The reason for this is that we need to match the denumerator (Invested Capital) when calculating ROIC. Depreciation is simply an accounting measure and an estimate of the loss in value of factories and equipment. Depreciation is not a cash cost. The reason we deduct depreciation and use EBIT rather than EBITDA as a starting point is because of the balance sheet. Each year, assets on the balance sheet are reduced by annual depreciation. Equity on the balance sheet is gradually reduced by the amount of depreciation. To remain consistent with the balance sheet, we must therefore also deduct depreciation in the numerator.

ch, we would have to add depreciation back to the

e sheet each year to achieve a match between NOPAT

ested capital. Another non-cash cost, amortization, is the

f capitalizing R&D on the balance sheet. Amortization is

ctive charge to the income statement that is non- cash.

we calculate NOPAT, we do not add amortization costs,

ough amortization is not a cash cost. The reason for this

ame as with depreciation of fixed assets. The intangible

n the balance sheet is reduced each year by the

ation cost. Cash earnings are generated from the

ons of the business, before financing costs. The cash

herefore serves the claims of both debt and equity

rs. To calculate ROIC, we need to know how much

s used to create NOPAT.

ed capital

d capital is the sum of total capital from debt and equity and is the denominator in the calculation of ROIC. You

nk of invested capital in two ways. On the one hand,

d capital is the sum of all the assets the company needs

uce results. On the other hand, you can think of invested

as the sum of equity and debt. In the following, we will

the left side of the balance sheet and calculate invested

based on the asset side.

d capital = net working capital + fixed assets + goodwill operating assets

capital, that is, how much capital the company has tied up in these three accounts. If a company has 100 million in inventories, 30 million in accounts receivable, and 20 million in accounts payable, the net working capital is 100+30-20 = 110 million. The company has 130 million committed in inventories and from money not received from customers, but has not yet paid 20 million to its suppliers. Therefore, net working capital is 110 million.

The company can improve net working capital by reducing inventory, ensuring that customers pay their invoices faster, and extending payment terms with its suppliers. Net working capital is necessary to generate cash earnings and is therefore part of the invested capital in the company. Net working capital is often calculated as a percentage of sales.

There are large differences in net working capital commitment between industries and companies. Some companies even have negative net working capital. A negative net working capital can tell us a lot about the competitive situation of the company. Negative net working capital is not normal and tells us that it is the customers and suppliers who are actually funding the company. If the customers pay their invoices before the product is delivered and/or if the suppliers are not paid soon, the net working capital position of the company can become very attractive, even negative. Fixed assets are the total of factories and production equipment, etc. on the asset side of the

ll arises when a company buys another company and

ore than the book value of the assets. Goodwill is an

hat contributes to the company's results and therefore

be part of the invested capital. Goodwill is not

ated or amortized each year like fixed assets and

ble assets. Goodwill is "tested" each year by the auditor. as the auditor believes that the goodwill amount is

t remains unchanged in the balance sheet. If you have

about whether or not to include an asset in the

ion of invested capital, you can ask yourself whether the

ontributes to generating cash flow. If the asset is

ary to generate the result, it should be included in the

d capital.

next page is an example of how ROIC is calculated. The

ny below is generating a high return on invested capital

oximately 15%, which is higher than the normal cost of The company is growing at a ROIC above the WACC.

mpany creates value as it deploys new capital at a (ROIC-WACC) spread.

f capital (WACC)

ing the cost of capital (WACC) is critical to setting the

m rate of return (hurdle rate) that management should

for new capital projects. Investments with returns above

t of capital create shareholder value, while investments

practice it is quite "fuzzy," as Warren Buffett put it: "We do not formally have discount rates. Every time I start talking about this stuff, Charlie reminds me that I have never prepared a spreadsheet. But, in effect, in my mind I do. We want to get a significantly higher return, obviously - in terms of cash produced relative to the amount we are outlaying now - for a business than we are from a government bond. That has to be the yardstick at a base. And how much more do we want? Well, if government bond rates were 2%, we are not going to buy a business to earn 3 or 3,5% expectancy over the years. We just do not want to commit our money that way. We would rater sit around and wait a little while. If they are 4,75%, you know, what do we hope to get over time? Well, we want to get a fair amount

oday?" I mean, we have never used the term. We want so that we feel very comfortable if they closed down on

ck market for a couple of years, if interest rates go up hundred basis points or 200 basis points, we are still

with what we have bought. I know it sounds kind of fuzzy, fuzzy" (Warren Buffett, 2007)

st of capital takes into account the returns required by

bt and equity investors, since cash flows are discounted

nterest is paid, i.e., cash flows to which both debt and

olders have claims. The appropriate rate for discounting

mpany's cash flow is the weighted average of the cost of

d equity. For example, assume that a company's after-

t of debt is 3 percent and its estimated cost of equity is

ent. Also, the company plans to raise capital in the

g proportions: 30 percent in the form of debt and 70 in the form of equity. We calculate the weighted

e cost of capital (WACC) of 8 percent as follows:

0,30) + (0,10 x 0,70) = 8%

portant to emphasize that the relative weighting of debt

uity is determined neither on the basis of dollars raised

irm in the past nor on the basis of the relative proportion

rs the firm intends to raise in the current year. Instead,

ropriate weightings should be based on the proportions

and equity that the firm is targeting for its capital

e over the long-term planning period. Should book

(balance sheet values) or market values be used in

values, despite their volatility, are conceptually superior because the company needs to generate competitive returns for debt and equity investors on the respective current market values to justify its valuation.

Suppose shareholders invested $5 million of initial capital in a company ten years ago. Over the ten years, the book value grew from $5 million to $7 million. However, the market value grew to $20 million over the same period. Given current market conditions, an 8 percent return is reasonable. Would current shareholders be satisfied with an 8 percent return on the $7 million book value, or would they expect to earn 8 percent on the current $20 million market value? Rational investors will base their decisions on current market value. Book value reflects historical costs, which generally have little to do with economic value, and is therefore not relevant to current investment decisions. There are entire textbooks on how to theoretically calculate the correct WACC. That is not the goal of this chapter. I will briefly introduce the concept of WACC and show how to calculate it.

I will introduce the Capital Asset Pricing Model (CAPM) to to calculate the cost of equity. When we add the cost of debt, we get the cost of capital (WACC). As a practitioner, not an academic, my experience has been that it is better to study the durability of a high return on capital than to spend too much time trying to estimate the "right" WACC. The weighted average

oviders charge interest. But equity holders also have

ssociated with financing the business. The cost to

olders reflects the risk to which the shareholders are

d. The cost of equity is therefore not as clear-cut as the

debt. The cost of equity is higher than the cost of debt

e the shareholders are entitled to the assets of the

ny after the creditors in the event of bankruptcy. If the

ny is not able to generate a return on capital above the the company's shareholders are not compensated for taken.

tically, shareholders will withdraw capital from the

ny and the share price will fall. If the company does not

return on capital above the WACC, the creditors may be

d for a while because the creditors will receive the payments. But over time, creditors will demand more

o reduce the company's financial risk. This process how the capitalist system works. Equity is invested in

ets that yield the highest return, taking risk into account.

ts pressure on management teams to optimize capital

on and find the best use of capital. Companies that do

erate sufficient return on capital are punished by falling

rices, which in turn puts pressure on management.

nies that are able to deploy capital at high returns will

capital, making these companies less subject to

older pressure.

weighted by the expected proportion of debt and equity. The formula for calculating the WACC is as follows, where Rd = cost of debt D = debt E = equity Re = cost of equity t = tax rate

The cost of debt is usually calculated using the after-tax yield on the company's long-term debt, such as a 10-year bond issued by the company. If a company pays 4% interest on long-term debt and has a 25% tax rate, the after-tax cost of debt is 3%.

Let us assume that the cost of equity is 10%. If the company plans to finance itself with 30% debt and 70% equity, the WACC is: 3% x 30% + 10% x 70% = 8%. Thus, the ROIC threshold for value creation is 8%. If the company is able to deploy new capital above 8%, it is creating value. 8% is the minimum threshold above which we should invest in the company if we want to invest in value-creating companies.

The cost of equity is calculated using the Capital Asset Pricing

ny's stock relative to risk-free investments. In theory, this

mium is calculated using the stock's beta factor. The

easures how volatile the company's stock is compared to

rall stock market. A beta of 1.5 means that if the stock

increases by 10%, the company's stock tends to

e by 15% and if the stock market decreases by 10%, the

ny's stock tends to fall 15%. The CAPM model is shown

where

ost of equity

k free interest rate

a

= risk premium

st of equity is calculated using the risk-free interest rate

ernment bonds, and adding the risk premium multiplied

beta factor. Let us assume that the long-term risk-free rate on government bonds is 4%. The beta factor is 1.5 risk premium is 4%. The cost of equity calculation is 4%

4% = 10%. We use 10% cost of equity to calculate the In summary, the definition of value creation is very The company needs to invest new capital at returns on

that are higher than the cost of capital.

actitioner, I would not spend too much time looking at the

achieve a high return over time. Investing in value creators means investing in companies with a wide margin of safety between return on capital and cost of capital and with good growth prospects.

growth and growth , weGood would like to explain whybad you should invest in

nies that grow and create value at the same time.

nies can grow but still destroy value for shareholders.

y to understanding the difference between growth and

reation are the two concepts of return on invested capital

st of capital that I just introduced.

e long term, stocks will track the value creation or

tion of the underlying business. On the left side below,

e a company that over time reinvests its profits at returns

On the right is a company that reinvests at returns on capital below the cost of capital. This company is destroying value and should not try to grow because it is investing at returns below the cost of capital. We naturally look for companies on the left.

To create value for shareholders, a company must meet two criteria: 1) The company needs a return on invested capital that is above the WACC, ROIC > WACC 2) The company needs to be able to reinvest new capital, growth > 0% The key concept of this chapter is to explain what a company needs to create value for its shareholders. If growth is zero, value creation is zero. When the (ROIC-WACC) spread is zero, value creation is zero. I will show this both conceptually and numerically.

Growth in earnings is not always good. Growth destroys value when it occurs at a negative (ROIC-WACC) spread. In other words: If a company is only able to invest new capital at a ROIC that is below the WACC, the company should instead not only distribute all profits as dividends, but also downsize its business by selling assets.

he capital at least at or above WACC. The following table

next page shows 9 results in a (ROE -cost-of-equity) and

matrix. On the upper horizontal axis is the spread

n ROE and the cost of equity. It shows a negative spread

eft when ROE is below the cost of equity, a neutral

(0) in the middle, and a positive spread on the right

OE exceeds the cost of equity. is shown on the vertical axis. Negative growth is shown

op left row, where the size of the company is shrinking.

mpany is basically selling assets. In the middle is a

state where growth is zero and no new capital is being

ted. In the bottom left row, the company is experiencing growth. The company is able to deploy new capital and

et us start with the 5 cells marked "0" in the table.

mmonality of these 5 cells is that they do not create

or shareholders. In the middle of the table, where growth

d the spread (ROE -cost of equity) is 0 (white cell), the

ny maintains its production base constant because it is

wing and is only investing to maintain existing capacity.

ng that the pricing of the stock is correct, which we will

o later, the investor receives the cost of capital return, market return. The company does not create value

ts cost of equity.

might be able to create value if it had the opportunity to grow and deploy new capital. Unfortunately, the company does not have the opportunity to grow and therefore is not able to exploit the positive (ROE -cost of equity) spread. There may be several reasons for this. The company may be the only market participant in a market that is not growing. The company clearly has a competitive advantage because the spread is positive, but without the ability to deploy new capital at the positive spread, there will be no value creation for shareholders. For the yellow company, growth is all that matters. The company is generating a positive spread (ROE - cost-of-equity) on its existing capital base, and the price of the stock already reflects this to a point where the price of the stock only offers you, the investor, the cost-of-capital return by getting into the stock. However, for this company to increase its value, it must find opportunities to reinvest.

In the orange cell on the left of the table, growth is 0 and ROE is below the cost of equity. Since the company adds no new capital

it had sold some production assets that generated a

e (ROE -cost of equity) spread and paid out those assets

eholders so that the shareholders themselves could have

ted that capital above the cost of equity.

lue cell, where the spread (ROE -cost of equity) is 0 and

is negative, the company is selling assets (negative that generate the same ROE as the cost of equity. This

that investors get capital back from the company, but at

me ROE they could have invested themselves in the

(cost of equity). Thus, with this strategy, the company

ot create or destroy value.

ray cell, where growth is positive but the spread

n ROE and the cost of equity is 0, no value is created.

m is able to grow and deploy new capital, but the new

generates only the cost of equity (0 spread), meaning additional capital deployed for growth could just as

ave been paid out to shareholders. The shareholders

lves can invest at the cost of equity. us turn to the two positive cells. In the lower right-hand

you have a company that is strongly value-creating. This

ny is not only able to grow, but the growth is generating

bove the cost of equity. This company is able to use its

efficiently. It creates value because the return on

nal capital spending is higher than the cost of capital and

increase both growth and ROE to capture even more value.

The other positive cell in the upper left corner is special because this company creates value by shrinking its business and returning capital to shareholders. If a company is generating a negative spread (ROE -cost of equity), the rational strategy is to sell assets and return capital to shareholders so that shareholders can invest elsewhere at or above the cost of equity. You would assume that survival is the natural path. But to survive and create value, the company must not only increase growth, but also ROE which may prove to be a difficult path.

The last two cells are both negative - both are situations that destroy value for shareholders. On the lower left, the company is growing with a negative (ROE -cost of equity) spread. With a negative (ROE -cost-of-equity) spread, the company should not grow. It deploys capital below the cost of equity. It is a clearly negative strategy and as an investor in such a company you would either like to see the company increase the (ROE -cost of equity) spread or stop growing or even see the company shrink.

The last cell in the upper right corner is also negative. The reason is simple. The company has attractive return opportunities at a positive (ROE -cost of equity) spread, but the company has negative growth. The company sells assets that are ROE above the cost of equity and pays that capital back to

e creation. This company should spend all its time for growth opportunities where it can deploy new capital

sitive spread (ROE -cost of equity). All of the

erations in the 9 cells above can be calculated

matically. I will show this later, but first I will present a

or valuing stocks using the dividend discount model.

ollowing pages I will provide three different examples of

nies that have the following characteristics:

wth without value creation (Steady value Corp.)

wth with value destruction (Value destruction Corp.)

wth with value creation (Value increase Corp.)

wth without value creation (Steady value Corp.)

rst table below, we consider a company with sales of

lion and operating costs of 170 million, resulting in EBIT

illion or an EBIT margin of 15%. The company pays a

x rate on EBIT, resulting in a net profit of 22.5 million.

ue of this company at a cost of capital of 10% is 225

(22.5 / 0.10). Let us assume this company spends some

king capital and growth capex in order to increase the

ny's revenue by 10%. The EBIT margin of 15% remains

me and the tax rate of 25% also remains the same. We

e that a capital investment of 22.5 million leads to a 10%

to spend 22.5 million in incremental working capital and fixed capital investments to increase sales. In short, since the present value of incremental cash inflow is identical to the present value of investment or cash outflow, the value remains unchanged.

The present value of the change in profit is equal to the present value of investments to increase profit.

Another view is that profit growth of 2.3 million (from 22.5 to 24.8) earns exactly the 10% cost of capital. Therefore, the growth does not increase or decrease the value of the company.

Since the company earns only the cost of capital, it might as well use the incremental capex and pay that amount to shareholders. Shareholders could try to find investment opportunities themselves that could generate more than a 10% return on capital.

2) Growth with value destruction (Value destruction Corp.)

Example number two shows a company that has to spend a little more capital to increase sales and profits by 10%. It must spend 30 million to grow earnings with the same amount as in the first example. Since the net present value of the increase in profits ((2.3/0.10)=23) is less than the net present value of the capex needed in order to grow earnings (30), the value of the company decreases. The net present value of the increase in earnings is 23 (2.3/0.10). The capital outflow is 30 million.

30 million in incremental capex is only 7.5% (2.3 / 30).

he return on capital is less than the cost of capital of

e value of the company decreases despite a 10%

in profits. The value of the company falls from 225 to

wth with value creation (Value increase Corp.)

d example shows a company that grows earnings by

t only has to invest 10 million. Profit increases by 2.3, as

ther investment is 23% (2.3/10), well above the 10%

capital. Since the company is earning a return on capital

han 10% on the incremental capital deployed this

ny is creating value. This company not only increases

s, but also increases the value of the company from 225

5. These three examples illustrate that earnings growth

value-neutral, as well as value-reducing or value-

ing. The key is the return on the incremental capital that

oyed by the company.

EPS can mislead you mance.Why The financial press, analysts and investors spend

time focusing on the EPS figure. EPS growth is easy to

and and by applying P/E multiples to the EPS figure,

ough P/E is a function of value creation, the impression

ed that EPS and P/E are the most important metrics.

E ratio is a function of value creation. I have observed

self on several occasions when examining companies impressive track record of EPS growth where the stock

at a very low P/E multiple. In these situations, you know

ct that the return on capital is well below the cost of The market has already recognised that the company's

is not creating value, so it has set a very low multiple for Stock prices reflect value creation, not growth per se.

rs are only interested in profitable growth - growth above

t of capital.

are many important reasons why earnings fail to measure

s in the economic value of a company. Three reasons

3) The time value of money is ignored In looking at EPS growth, you are overlooking the fact that the business needs investment, both in fixed assets and working capital, to sustain growth. As a company grows, it needs to invest in more inventory. Both accounts receivable and accounts payable increase. An increase in both inventory and accounts receivable from one year to the next means that cash flow is less than the profit numbers on the income statement.

The EPS figure will overstate the actual cash flow that the company is generating. When a company grows, it needs to invest in inventory. An increase in inventory is clearly a cash cost. Goods on warehouse shelves cost money to produce, both labor and materials. But building inventory is only reported as an investment on the balance sheet, not as a cost on the income statement. Clearly, building inventory is a cash expense for the company. For companies with increasing inventories, the cost of sales will understate the cash outflow for inventory buildup.

For companies that grow and increase their receivables and inventories, you will find that profit is greater than cash flow. The third major component of working capital, payables, acts as a counterbalance. Payables are unpaid invoices for items that are already included as expenses on the income statement. So the cost of sales and the selling, general, and administrative expense accounts on the income statement overstate the cash

cognized.

that depreciate such as property, plant, and equipment,

ally recorded at cost and included in the fixed assets of the balance sheet. Accountants allocate this cost over

mated useful life of the asset through depreciation. While

ation is an expense, it does not involve an outlay of

On the other hand, the profit figure does not include

expenditures made during the year. So, to get from

s to cash flow, two adjustments are needed. First,

ation must be added back to earnings, since it is not a

xpense, and second, capital expenditures must be

ted from earnings, since capital expenditures are a cash

e.

he fundamental differences between the calculation of

ting earnings and economic value, it should come as no

e that profit growth does not necessarily lead to the

n of economic value for shareholders. Shareholder value

reases when the company earns a return on new

ments that is higher than the return investors can expect

vesting in alternative, equally risky securities. However,

s growth can be achieved not only when management

at or above the cost of capital, but also when the

ny invests below the cost of capital, thereby reducing

older value. Yet, despite these facts, most managers

e to believe that stock prices are driven by short-term

I believe one important reason for this is that market reactions to earnings announcements are often misinterpreted. If investors believe that quarterly earnings reports provide new information about a company's long-term cash flow prospects, reported earnings per share will affect market value. But the market does not respond to reported earnings per share.

Instead, the market uses unexpected changes in earnings as a useful guide to reassess a company's future cash flows, when appropriate.

A disappointing quarterly earnings announcement that is viewed as a negative change in future cash flow prospects will drive the stock price down. A positive quarterly earnings announcement, viewed as a positive change in future cash flow prospects, will drive the share price up. I have seen many examples of announced changes in accounting methods at various companies that affect reported earnings but not expected cash flows, and these changes have had very little, if any, impact on stock prices.

On several occasions, I have seen restructuring announcements in which management announced its intention to reduce its losses and divest value-impairing businesses, almost invariably accompanied by significant write-downs in current earnings and a sharp increase in share prices. I believe that in these situations, the market is not reacting to the

discount modeldiscount model (DCF) model.Dividend Valuation models like the dividend and the DCF model are great ways to learn more about the value drivers of stocks.

However, in my experience, they come with major limitations. I think you should study the models and understand the concepts of stock valuation. But my experience has always been that you should rely more on the qualitative aspects of management and culture when making an investment decision. I will introduce both models in this book, starting with the dividend discount model. The dividend discount model calculates the value of the company's equity. The DCF model calculates the value of the company, including its debt.

At the end of the DCF model, we subtract the value of the debt to calculate the equity value of the company. Both models provide the same result. I introduce the dividend discount model because it brings more clarity to the value creation concept. The purpose of introducing the model is to show that the table of value creation already presented can be calculated with a

k the dividend discount model with the concept of the P/

. In this way, I will show how market participants will stock with different ROE - and growth characteristics. As

ow, the P/E ratio contains a lot of information. Ultimately,

ins information about the expected value creation of the

ny we are analysing.

idend discount model is well known to investors. The

uses the expected dividend stream that the company will

e in the coming years and asks what price an investor is

o pay for the dividend stream today.

e the dividend discount model to show how the P/E

e reacts to different combinations of ROE and growth of a

ny. This can be a valuable tool for you as an investor, as

n gauge the market's expectations for both growth and

om a stock's current P/E ratio. The P/E multiple contains

valuable fundamental information for us as investors to

assess the expectations inherent in a stock. A company's

ome can be used to pay dividends and/or reinvest in the

ny to grow. According to traditional economic theory, a

ny that does not invest in its business cannot grow. A

ny needs reinvestment in its business to grow. The

der of the net income can be distributed to shareholders

ends. The net profit of a company belongs to the

olders of the company.

idend discount model is rarely used as a tool to convey

stock price. As I will show, you can extract these expectations from the model and be better informed about market expectations for the stock. To value a company using either the dividend discount model or the discounted cash flow (DCF) model, you must calculate the future stream of dividends or free cash flow. In the dividend discount model, we need to estimate the amount and growth of the company's dividends in the coming years. The key question is: What do you have to pay today to get a stream of dividends in the coming years? To calculate what to pay for a stream of dividends today, we need to discount the dividend stream at an appropriate discount rate.

For example, a company is expected to pay a dividend of D2 in two years. The present value of the dividend today is D2 / (1+r)^2, where r is the cost of equity. Since the dividend discount model is a model that calculates the value to equity holders we use the cost of equity rather than the cost of capital.

The simplest way to estimate the cost of equity is to look at historical nominal equity returns over very long periods of time.

One assumption underlying the dividend discount model is that dividend growth is constant. To calculate the dividend in year 2, we calculate the dividend in year 1 and multiply it by the dividend growth rate, such as D1 x (1+g). The dividend in year 3 can be calculated as D3 = D1 x (1+g)^2. The present value (P0) of the dividend in year 3, D3, can be expressed as P0 = D3 / (1+g)^3. We continue this dividend stream to infinity. To reduce

howing that the present value of this dividend stream can

essed as follows:

1 / (r-g)

mple formula contains the expected dividend in the next

1), the cost of equity (r) and the dividend growth rate (g). this chapter, when we talk about a company's

s, we will make the assumption that dividends grow at

me rate as earnings. This is a rational expectation for a

company in a mature industry.

r assumption is that the cost of equity is constant, which

plification of reality. If interest rates change and the risk

ompany changes due to changes in the balance sheet

e, you would assume that the cost of equity would also

.

ulate the correct price of a stock that pays a $1 dividend

ar and whose dividend grows at 5% per year at a 7%

equity, the net present value of the stock is 1 / (0.07 50. You are willing to pay $50 today for a dividend

that starts at $1 and grows at 5% for eternity because

portunity cost of equity is 7%.

merator in the dividend discount model, D1, is the result

e company's operating decisions, financial decisions,

and reduces the ability to pay dividends, and high capital expenditures also reduce the ability to pay dividends. In practise, a company with low investment needs trades at a higher multiple than a company with high investment needs.

We assume that the company we study has no debt, which means that there are no interest payments. We also assume that the company's net income equals "cash earnings," which means that the company has neutral net working capital and invests in the business in line with depreciation and amortisation. In other words, the profits shown can be fully distributed as cash dividends. Under the above assumptions, the only difference in the ability of two companies to pay dividends is the difference in capital requirements.

Almost every business needs to make investments to grow, but the amount of investment needed to grow can vary significantly from business to business. Every company needs to make some type of maintenance capex in order to keep production levels constant. In today's market environment, you will find many interesting companies with low investment needs. Of course, these companies usually trade at higher P/E ratios than the market. "Growth investments" are additional investments needed to grow the company. The more the company has to invest in capital expenditures, the lower its ability to pay dividends. "Reinvestment rate" is the portion of net income that the company spends on investments to grow. The remainder (1-

mpany earns $1 in profit and spends $0.3 on growth

ments (reinvestment rate of 30%), that leaves $0.7 that

distributed as dividends to shareholders. We can

e the expected growth from the $0.3 spent on growth

ments if we know the return on equity that these

ments will bring. If we assume that the company is able to

$0.3 at 20% ROE, the growth in earnings (and

ds) is 6% (30% reinvestment rate x 20% ROE on

. On the other hand, if the company spends the same

ill 30% reinvestment rate) at 10% ROE, the growth is

% (30% x 10%). So two companies with the same 30%

tment rate will have different growth paths because of

erences in ROE.

n turn this around and say that the first company that is

reinvest at 20% ROE only needs to reinvest 15% of its

s to grow as much as the second company with 3%

15%). This means that the first company has a better

d paying ability ($0.85) than the second company, but

me growth. Which of the two companies would you rather

learly, given the same price, the first company. Let us

w the market will value these two companies. Company

y has to invest 15% of earnings to grow 3%, and 85% or

s paid out in dividends. The NPV of the $0.85 dividend

growing at 3%, at a 7% cost of equity, is: $0.85 / (0.07 21.25. Since earnings are 1 and the correct price of the

Company two reinvests 30% of its profits at 10% ROE and will achieve 3% growth with this capital expenditure, the same growth as company one. But company two has only $0.7 left after capital expenditures to pay out as dividends. Therefore, the correct price of company two is 0.70 / (0.07 - 0.03) = 17.5.

Since the profit is 1 and the correct price of the stock today is 17.5, the P/E ratio of company two's stock is 17.5. In summary, these two companies have different quality characteristics.

Company one is clearly a better company than company two.

But the market has recognised this fundamental difference in reinvestment needs and reflected the fundamental quality difference in the pricing of the two different stocks. With a P/E ratio of 21.25 for company one and a P/E ratio of 17.5 for company two, the two companies are equally good investments given the pricing of the stocks.

The opportunities for you as an investor arise from two situations. The first situation is that you are able to identify changes in the fundamentals of these two companies. If you strongly believe that Company Two's ROE will increase from 10% to 20% in the coming years and the stock is valued at a P/ E ratio of 17.5, you today and wait for the market to recognise the fundamental change and re-price the stock.

The second situation is that the stock price does not reflect the underlying quality of the company for many different reasons. If

an opportunity. Situations where company one is trading

E of 12 are very rare in my experience, and there are

ery good reasons why the market values the company at

f 12. The fundamental reasons are found in the dividend

nt model.

he perception of growth opportunities has disappeared,

d for reinvestment has increased (dividend capacity

d) or the opportunity cost (cost of equity) has increased

.

he dividend discount model, we calculate the correct P/E various combinations of growth and ROE in the table

Note that the 9 cells in the next table are a mathematical

of the illustration walked through earlier.

E multiples in the table show us the correct valuation for

ck given growth and ROE. Let us look at the table and multiples it gives us. Notice that the P/E multiple of 10.5

t of equity) does not change as we move down the with 9.5% ROE for various growth scenarios (blue and

eas). The cost of equity is 9.5%. There is no change in

reation in this column. As long as ROE is equal to the

equity, changes in growth do not affect pricing. Similarly,

ow to the right of 0% growth (orange and yellow areas), multiple of 10.5 does not change with different spreads

cost of equity). The multiple stays at 10.5 across all

value is created. surprise because both the growth assumption (positive) and the ROE spread assumption (positive) are satisfied. For example, if Let a company us start with a the ROE lower of right 22% green is ablepart to increase of the table, growth which from corresponds 6% per year to to 8%, the lower the correct right green valuation figure of earlier. the stock Asincreases you can from 20.8 times earnings to 42.4 times earnings, more than doubling the valuation of the stock for a 2% increase in growth.

A 33% increase in the growth rate from 6% to 8% corresponds to a value increase of more than 100%. This clearly shows how important growth is for companies that generate a high return on capital. For a company earning 22% ROE, it is actually more valuable to increase growth than to try to increase ROE even more. If a company growing 6% can increase its ROE from 12%

go to the pink part of the table, where growth is negative

re is a positive spread between ROE and the cost of

If you go to the right in the pink part of the table, you will

t the P/E multiple is going down. This is because the

ny is selling assets that are generating returns well above

t of equity. These value-creating assets are distributed to

olders. Shareholders are only able to reinvest these

t the cost of capital. In the pink part of the table,

ement should focus solely on finding growth

nities. If the company is able to increase growth at a rate

n that exceeds the cost of capital, the multiple increases

e value is created.

urn our attention to the upper left and brown part of the

his company does not generate a sufficient return on

The return on equity is below the cost of capital. The

y of this company should be to increase both growth and

on equity. Let us look at the row where the growth is -4%.

ason why the P/E ratio increases from 11.1 to 11.6 when

ve from 8% return on capital to 7% return on capital is

e when the return on capital is below the cost of capital,

mpany's most value-creating strategy is to sell assets and

te the assets to shareholders so that shareholders can

the funds at or above the cost of equity. The worse the

on equity, the more assets the company should sell.

cost of capital. Therefore, it should not try to grow. As we can see from the table, the correct P/E multiple for a company with a 7% return on equity is 6.3 if the company grows at 5%, which is below the value neutral multiple of 10.5. The company destroys even more value if it tries to grow more. This is illustrated by the fact that the multiple falls from 6.3 to 4.1 when the company increases growth from 5% to 6% with a return on equity of 7%.

The conclusions from this table are many, but can be summarized as follows.

There are two criteria that must be met to create value: positive growth and a positive spread between ROE and the cost of equity. To create value, the company must generate a return on equity that exceeds the cost of equity. Second, the company must grow at high rates of return. If both the return and growth criteria are met, the company creates value for shareholders and the stock will trade at a multiple that is higher than the "value neutral" multiple. In practice, my experience has been to spend more and more time finding companies with good longterm growth opportunities and sustainable high returns on capital. It's not often that you find companies that simultaneously have good growth opportunities, increasing returns on capital, and a low entry multiple. But when you do find these opportunities, you could be on to something that is very interesting from an investor's perspective.

Exceptional f companies are very oftencompanies perfectly valued. The stock

has already discounted a lot into the share prices of

onal companies. In my experience, if you are a very

m investor, you should focus primarily on the potential

n of growth opportunities and the sustainability of returns.

of my worst investments have been in stocks with very

e multiples. Some of my best investments have been in

hat I initially thought were too expensive, but where it

out that I had greatly underestimated the growth path sustainability of the high returns.

erstand what has already been discounted in terms of

e growth and margin expansion, you can use a DCF

and reverse engineer the model. I will come back to how

at.

want to give you an alternative way to look at these

al investments. An exceptional company can easily turn

mediocre investment if you pay too much for the stock.

n easily look at an exceptional company that is able to

stock's current multiple.

You can be even more conservative and ask what kind of earnings growth is required if the company's market position and return on assets reverse to the average for the market in general. In other words, how much growth does the company need if you assume that the current high multiple will derate down to the market multiple in, say, ten years. Let us take an example.

Let us say you are satisfied with a 10 percent annual return on a stock you want to hold for the next 10 years. The ten percent annual return is your threshold, the minimum return you need to invest. If you look at the stock's price-to-earnings (P/E) ratio, it trades at a P/E ratio of 30. A P/E ratio of 30 means that the market already knows that this company is exceptional and has a bright future. What does the P/E ratio of 30 tell us in terms of growth expectations?

We assume that this exceptional company to be gradually challenged by other companies over the next decade. As a result, we expect the P/E multiple to gradually decline to a P/E multiple of 25, which is still higher than the long-term market multiple of about 17. In other words: We assume that the company will still have a competitive advantage after ten years.

The key question is: How much does the company need to grow in earnings over the next ten years to generate a 10% return on

The difference between the required 10% and 7.6% is the

swer f the change to the growth in the question multiplierisover 12%. tenThe years. company needs 12% a year over the next ten years for you to get a 10%

on se,the if you stock, buygiven a stock thatatyou a P/E assume of 25 aand derating exit the from stock 30 at to a P/E

here no dividend is no change payments. in theInmultiple. the table Sobelow, for theI show stock you to earn 10%

arnings growth a company needs to achieve in order for an investor, to earn a 10% return with various entry and

ltiples. We assume that no dividends are paid.

can see from the table, with an entry multiple of 30 and

multiple of 25, you need to achieve a fundamental

s growth of 12% to achieve a 10% annual return on the

n contrast, if you buy a stock at a P/E of 20 and assume

unreasonable assumption that the return on capital will revert to the mean, companies whose return on capital does not revert to the mean may be undervalued. Therein lies our opportunity as investors in exceptional companies. Exceptional companies are worth much more than you can imagine.

The challenge is not to determine that the history of the company you are researching is exceptional. The challenge is to have the foresight to see that the next ten years will be just as good as the last ten years, or maybe even better, and also to have an informed opinion about the company's market position after ten years. Most professional investors are incentivised on very short-term time horizons of one to three years. Very few, if any, are measured against a ten-year perspective.

Therefore, most private investors have a major competitive advantage over professional investors. Private investors can focus on the long term and take positions in stocks that professionals consider too risky from a pricing point of view. As a professional investor, you could lose your job if you pay too high a multiple, because in the short term, i.e. within one to three years, you might experience a derating of the stock that has nothing to do with the underlying fundamentals. As a private investor who is not accountable to clients or other principals, you have the advantage of having a long-term perspective.

A company's ability to reinvest profits at high rates of return

at high rates of return in the coming years, you would be

o pay a lot for that crystal ball. Below is an illustration of

ect P/E multiple for a company given different returns on

on the x-axis, an investment horizon of 20 years, and

t reinvestment rates. The market multiple is 17 times

s.

owing chart shows you what P/E multiple you could have

achieve a market return of 6% per year (P/E of 17) if the

n the x-axis remains constant and you reinvest 60% or

r 20 years.

return of 6% over the next 20 years. At the end of the 20-year time horizon, the multiple will equal the market multiple of 17. If you could buy this stock at a P/E of 52, times you would beat the market. The point here is not to pay excessive prices for stocks. As a long-term investor, the really important question is whether or not the company you are studying will be able to reinvest at high returns. For the long-term investor, whether the stock is trading at 22 times earnings or 17 times earnings is of secondary importance. You need to find companies that have: 1. A long runway of growth opportunities 2. The ability to reinvest at high returns

Three intypes of investments and investing companies that are very cheap for a

Still others have an advantage in seeking out the right

companies at the right time. It comes down to your

ment strategy, process and personal preferences. present three different types of investments and try to why the market values them at very different multiples.

rket will be willing to apply a much higher multiple to

nies that can grow with a positive spread between return

tal and cost of capital than to companies with a low

pread.

mpanies that generate returns well above the cost of

have strong barriers to entry. The different competitive

ages of these firms lead to pricing power and high returns

tal. The following figure illustrates this point. The figure

hree different types of investments. The figure shows the

and price differences between these investments.

ity, I mean the spread between the return on invested

The "transformational" companies on the lower left side of the chart are often in industries that are in decline, and the companies are in a very unattractive position today. There may also be a management problem in these companies and a strong need for change. If these types of companies continue to generate a very low return on capital (below WACC), you will never get a good return on these investments. They become a value trap. I have often underestimated the challenge of investing in these types of companies. I think you often need some sort of catalyst or significant change in industry dynamics or management for these stocks to generate good returns over time. If you discover a company in the lower left corner that can transform and become a high-return business your return on the stock will be very strong since you will benefit from both strong

middle, you will find companies that generate a return on

d capital that is more or less equal to the WACC level.

se companies, sometimes ROIC exceeds WACC and in

ears ROIC falls below WACC, depending on the cycle supply and demand for the products these companies

e. These are typical cyclical companies. The pricing of

tocks fluctuates by the amount of capital invested in the

ny. In good years, when ROIC exceeds WACC, the stock

above the invested capital. In bad years, when ROIC

ow WACC, the stock trades below the value of invested In order for the company in the middle to justify a higher

on multiple on a sustained basis, the company must

e ROIC and growth on a sustained basis, which is no

at in a cyclical industry.

pper right corner of the chart are the companies with the (ROIC-WACC) spread. These companies have strong to entry. The high spread between ROIC and WACC is

d in the pricing of the stocks. The pricing, reflected in the

enterprise value to invested capital is high. If this type of

ny is able to deploy new capital and grow at the current

read between ROIC and WACC, the pricing of the stock

ease exponentially. I illustrate this in the following figure.

horizontal axis, you see the ratio of ROIC to WACC,

s the ratio of ROE to the cost of equity when the

a ROIC for this isthat theisdifference twice as high in quality as the inWACC. terms ofOn thethe spread vertical between axis is the enterprise ROIC and WACC. value to invested capital (EV/IC) ratio, which is the ratio of market capitalization to book value when the company has no debt. When the ratio is 1, EV is equal to IC. A ratio of 2.0 means that the market is willing to value the stock at twice the capital invested in the company. In the latter case, the market clearly sees that the company is able to utilize the invested capital in a way that few other companies can, as the market is willing to pay twice the invested capital for the company.

wth" illustration. The line has a slope of 45 degrees and

nies trading on this line are correctly priced in a no

scenario. In a no growth scenario, a company that can

e a ROIC/WACC spread of 2 will be priced at 2 times

d capital.

assume a company has invested $100 million in the

ss and the company is generating 7% ROIC. The cost of

s also 7%. The value of this company under the

d discount model with 0 growth is 7/(0.07-0) = 100

So the company generates exactly the cost of capital

WACC = 1) and therefore trades with an EV/IC ratio of 1

0). If the company is able to generate 14% ROIC (still no and the cost of capital is 7%, the ROIC/WACC ratio is

4/0.07). This company is trading with an EV/IC ratio of

we include growth in combination with a positive ROIC/

spread, the slope of the line becomes exponential as

by the black line in the chart. Growth is the magic that companies with high returns to trade at high multiples. also show this using Gordon's growth formula. If the

ny achieves a ROIC of 14% and a WACC of 7%, the

WACC ratio is 2.0 (0.14/0.07). However, if the company

at 2.1% with the same ROIC/WACC spread, the

se value of the company is 290, or an EV to IC ratio of 2.0 as in the no growth example. This ratio is calculated

/(0.07-0.021).

spread of 2.0 is an EV/IC of 2.0. With growth of 2.1%, the correct market multiple for this stock is 2.9 times invested capital. The more growth the company can generate, the higher the market multiple. On the far right of the chart, a company generates a ROIC/WACC spread of 2.9, which implies a ROIC of about 20% (7%*2.9). With a growth rate of 3.9%, the market should value the stock with an EV/IC multiple of 6.5 (0.2/ (0.07-0.039)).

In summary, growth at high returns is the magic that investors need to understand. In a perfect market where all stocks are priced correctly, the important task is to anticipate changes in growth and return patterns that the market has not yet discovered. In a perfect world, the market will correctly price stocks on the black runway. High return companies with great growth prospects will be valued much higher than companies without growth.

The keys tocompany. unlockThis growth nes the growth of the can also be

sed by a simple formula:

E x Rr, where

wth in earnings

return on equity

einvestment rate (1 – dividend payout ratio)

e a company earns a net profit of $ 100 million. The

ny is able to reinvest 50% of the 100 million in growth

s with a 20% return on equity. The 50 million USD

d at 20% ROE generates 10 million additional net profit.

company's net profit grows from 100 million to 110 million

% growth rate. The remaining 50 million will be distributed

eholders in the form of dividends.

assume that this company is able to reinvest the entire

lion profit at a 20% return on equity. So the company will

y 20% and shareholders will not receive any dividends

e all the capital will be reinvested. Think of Netflix and

From a stock investing perspective, I have come to the conclusion that I should be a little cautious about extreme growth machines that reinvest every penny of profit. The reason is simple. If a company that reinvests 100% of its profits in growth starts having challenges in deploying new capital in growth projects, the stock market will be pretty brutal about it and treat the stock as "ex-growth." If you invest in companies that reinvest all net earnings in growth, you run the risk of taking on too much risk.

On the other side of the reinvestment scale, you find companies that have no reinvestment opportunities at all. These may be situations where there is no growth in the markets in which the company operates. Therefore, 0% of the net profit is reinvested and since the company does not invest, it will not grow. The entire 100 million of the net profit will be distributed as a dividend to the shareholders. Real world examples could be European banks where growth opportunities are rare and almost all of the net profit is distributed as dividends, so the dividend yield is somewhere between 4% and 6%.

If the company is not growing, paying 5% dividends, and the earnings multiple remains the same, you as a shareholder will only get the 5% from the dividend as the total return on the stock. I do not think many long-term investors are satisfied with a total return of 5% per year.

me. This provides me with decent earnings growth taking the risk of expecting too much growth from the

Very few companies are able to sustain 100%

tment rates at high returns for very long periods of time.

s a table of earnings growth rates at various

ations of return on equity and reinvestment rates. As you

e from the table, a 0% reinvestment rate results in 0%

for the company, regardless of the return on equity. The

s true for 0% ROE. At 0% ROE, it does not matter how

apital you reinvest in the business. At 0% return, your

base does not grow. The conclusion from the above that you should try to find potential investments that

long runway of growth ahead of them with a high return

ty, without paying too much for these investments.

ROE decomposition the drivers of return on equity.

Below, I'll briefly introduce you to the DuPont equation, which breaks return on equity into three parts: Profit Margin, Asset

Turnover, and Leverage. Breaking ROE down into its components will help you better understand how ROE changes over time.

The name Dupont comes from the DuPont Corporation, which began using this formula in its business in the 1920s. Three companies with similar ROE can reach the level of ROE in very different ways.

One company can have very high profit margins, another company can have low profit margins but very high sales turnover and the third company can achieve the same level of ROE by using a large amount of leverage. Return on equity is a function of profit margin times sales turnover times leverage.

You can increase your ROE by increasing margins, increasing sales turnover and increasing leverage.

w well the company can control its costs. ROE will go up

n goes up. A higher margin brings more money to the

line and increases ROE. This does not mean you should

ok for companies with high margins. Thin margins can be

good if the company manages to have high sales

r. Examples of companies with high margins are luxury

s or railroads. But these high margin companies usually

wer sales turnover either high inventory or a large asset

urnover, or the ratio of sales to total assets, measures

iciently a company uses its assets to generate sales.

nies with low profit margins tend to have high asset

r. When sales turnover increases, ROE increases. Some

ompanies may have very low profit margins, but are able

sales many times over during a year compared to total

, this can lead to a high ROE despite low profit margins.

al leverage, or the ratio of total assets to average

older equity, refers to the amount of debt a company finance its operations. The difference between total

financial leverage leads to an increase in ROE. Since ROE is calculated by the ratio of net profit to average shareholders equity, we can increase net profit by taking on more debt.

An example of highly leveraged industries is banks. Banks can have as little as 10% equity on their balance sheet. If you use 90% liabilities (debt), as many banks do, you can achieve a high ROE. Of course, when you take on more debt, the risk of the company increases. As you can see from the formula above, you can cancel out the components in the numerator and denominator and get ROE = net profit / average shareholder equity.

long term investments nExceptional your total stock returns.

"100-baggers" is a term often describe stocks that return 100 times your investment

ng periods of time.

nvestments are rare, of course, but they share some

nt common characteristics. There are several articles

ver the topic of 100-baggers. I strongly recommend two

on the subject; Christopher Mayer's 2018 book "100-

s" and the original 1962 version by Thomas Phelps.

books are excellent sources of information for your

for outstanding investments and are also very inspiring.

presents both concepts and case studies. try to summarize some of Mayer's discoveries, but to get

insight, you should read his book.

cus here on the two important features of the 100-

s; strong and profitable earnings growth combined with

e expansion. Typically, you need these two engines to

0,000 into $1 million. It is possible to introduce a process

This chapter is not about finding the next small oil exploration company that suddenly drills a hole in the ground and discovers one of the largest oil deposits the world has ever seen. It's not about a new mining company that happens to be at the right drilling site with the right metal ore at the right time. It's not about finding the next pharmaceutical company that discovers a revolutionary way to treat cancer. Even though these companies can return 100 times your money, these investments are not easy to repeat. They are lottery tickets and difficult to build a process around.

Both Phelps and Mayer exclude these types of speculative investments from their studies. Both Phelps and Mayer come up (randomly) with a sample of 365 stocks that they study over several decades to find common characteristics of the "100baggers" 100-baggers take time to bear fruit, and few investors have the patience and courage to join the joyride. Because it really is a joyride.

100-baggers are no walk in the park from an emotional point of view. As I show below using Amazon, which has returned more than 1200 times the original investment since going public in the late 1990s, you would have to endure multiple drawdowns of more than 50%-70% on this stock. How would you feel about a 70% loss? Would you be tempted to sell the stock? Most likely.

100-baggers need conviction and the ability to hold and hold

ould be tempted to sell the stocks after a 5 or 10 fold

ur profit would be outstanding and greed would test you

he shares.

ok at Amazon's total return chart since its IPO. Since its

s a publicly traded company, it has increased 1200-fold.

al multibagger. But also look at the dramatic declines. times the stock has fallen 50% to 70%. It takes a lot of

on not to sell in these stressful times.

various time horizons. A stock that earns a 16.6% annual return will reach 100-bagger status after 30 years. In other words, it takes a lot of patience and high returns over a long period of time to reach 100-bagger status. Few companies will be able to achieve such high returns over long periods of time. It requires a high reinvestment rate combined with a high return on invested capital. From the investor's perspective, this requires an unusual amount of conviction and patience.

Using the concepts presented below from Mayer's book, you could develop a process to find 100-baggers. To discover a potential 100-bagger, look for the following five common elements: -Small in size -High quality -Growth in earnings -Long runway of growth -Low starting multiple

status started with investments under $ 300 million in

capitalization. Those are pretty small companies. The

path is longer for small companies. Small companies less attention from analysts. Professional investors often

arket capitalization limitations and cannot invest in these

nies. Since many institutional investors cannot invest in

ompanies, you may be lucky to find

nies with low multiples. As we will show, one of the

ents for a 100-bagger is a low starting multiple.

ore, as a small private investor, you have an advantage. to management is often easier with small companies

nagement's influence on the business is much greater

th large companies. With small businesses, you are

to a much high degree on management. Small

nies are often run by the founder, who still owns a large

he company. If you invest with a CEO with skin in the

imself, the odds are in your favor. Management

ion is paramount in small businesses, and the

ation of small businesses often turns out to be an

ation of management's abilities both as operators and as

al allocators. In small companies, confidence in

ement is more important than in larger companies. We

rn to the evaluation of management.

unger the company, the more the investment process

es an art of evaluating management and less of a

. Earnings growth tends to be stronger in small

a risk-adjusted basis. But you should not expect smooth sailing with small companies as a long-term investor. There will be massive setbacks and your conviction will be tested several times. Because small companies often tend to offer only one product or service, they may be riskier investments. Small businesses tend to dominate a niche. They rely on management and the company's niche position. Small businesses are often more vulnerable than large businesses. A change in management could significantly impact the business. The quality of the business may not yet be evident in the financial statements. It takes foresight and imagination to find these investments early. Therefore, you need to be independentminded in these potential investments and structure your investments differently than most other investors. You do not always have to be a contrarian investor and only buy the stocks that have fallen completely out of favor. But it often means you need to look at companies in a different way than most other investors. You often need to stand out from the crowd and look at companies in a different light. Who would have thought

Amazon would dominate U.S. retail space when it was a small bookstore on the Internet in the early days? Amazon is a player in a very large retail market. IMCD is the dominant distributor of specialty chemicals. A small company increases the chances of increasing earnings in the coming decades.

High quality For potential 100-baggers, you can not just focus on EPS. As

ready explored, profit growth can be good and bad,

ing on the return on invested capital and the cost of

Munger, Warren Buffett's partner at Berkshire Hathaway,

d: "If a business earns 18% on capital over 20 or 30

even if you pay an expensive looking price, you'll end up

ne result".

sumption behind this quote is based on the assumption company will be able to reinvest all or most of its capital

to the business at an 18% return on investment. These

unders recycle profits back into the company at high return over very long periods of time. The quality of a

ny is its ability to produce products or provide services

nerate a high return on invested capital. Since earnings

depends on both return on invested capital and

tment rate, you need both to contribute to earnings If your return on invested capital is very high, but there

y few reinvestment opportunities, the business will not

st enough. You need both a high return on invested

and high reinvestment opportunities. You do not find the

gger by looking at the companies with the most

us dividend payments.

desire to grow in all dimensions. Growth in sales, growth in margins, growth in return on investment, and growth in the multiple. As Phelps concluded, these growth companies often approach their end markets with new methods for solving problems. Many of them turned out to disrupt their end markets.

Below is an illustration of what happens with two different companies growing at 20% and 10% annually for 10 years. The table illustrates the end result if you buy the first company at 20 times earnings per share and the second company at 10 times earnings per share and the first company derates 50% of its value in the final year. You still end up with a better result with company A than with company B. One conclusion is that you should not always be scared away from quality stocks that trade at high multiples. In the long run, they can be the better investments, even if they have a significant derating. As Phelps said, "Good stocks are seldom without friends." The goal is to find high-quality, low-risk growth in companies that are able to reinvest nearly all of their capital back into the business at high rates of return. But as we have already explored, growth has to be "good" - meaning that companies are reinvesting new capital at a ROIC above WACC. Printing lots of stock to grow, or sacrificing ROIC to grow, may not be the right way to grow. 100-baggers become an exercise in studying growth and how growth occurs, why it occurs, and what must be in place for growth to last. Persistence, by

unway of growth

eve 100-bagger status, the company must maintain

and return on investment for decades. Having the

on to hold the stock for such a long period of time is a

ge for anyone. The biggest challenge may be your own

o sit still both during periods of weak growth, which can

ars, and your own ability to not sell the stock after a sharp

price. When the stock has returned 5 or 10 times your

vestment, you will be tempted to sell. The best strategy

nvestor is to buy the stock and forget about it.

ice

allenge for investors is to buy companies with good

prospects and high return on capital at low prices. The

market is quite efficient and obvious 100-bagger

ates are already trading at very high multiples. As Mayer

rrectly writes in his book, "You can't just willy-nilly buy

growth stocks and expect to come up with 100-baggers."

ren Buffett has said, "For the investor, a too- high

se price for the stock of an excellent company can undo

cts of a subsequent decade of favorable business

pment" What situations create attractive entry points in

f a low earnings multiple? There may be several reasons

u can buy a high-quality growth company at a low price.

p company with a high return on capital indicates to you market believes there is very little, perhaps even

To buy at a low multiple, you need to take a differentiated view of the company's prospects. If the market tells you that the company you are looking at has no growth opportunities, but you clearly see several growth drivers that could spur growth, there may be an opportunity for you to get in on the stock at an attractive valuation level. A high level of debt and/or potential liquidity issues at the company could also provide you with an attractive entry point. Of course, this situation can present major challenges for you as an investor if the company is unable to

g in these stressed liquidity situations. The payoff might

e in terms of potential share appreciation, but if the

ny fails to solve the situation, you could experience

dilution if the company needs to issue more shares. A

e can also be offered in very illiquid stocks. These are

mall companies where the founders and insiders own

hares. Since liquidity is low, investors provide a liquidity

nt on the stock, which may be appropriate given the

size of the company. As the company grows and

es larger, liquidity often improves and as market

zation increases, institutional investors may buy the

which in turn increases the multiple. In summary, finding

ggers is more art than science. Finding one of these 100-

s could save your entire investment career. You need to small companies with a high return on invested capital.

companies need high reinvestment opportunities to

a very long runway of growth. You need to study the

ement and ownership structure and try to get into these

at a time when they are trading at favorable multiples.

rhaps the biggest obstacle with potential 100-baggers is

wn mental capacity to hold these stocks for decades.

will be many opportunities to sell these stocks out of both

d greed.

stocks. There are entireDCF-analysis books on how to build DCF models. The goal of this chapter is to cover the essential aspects of the DCF model and to provide the reader with a tool for valuing stocks.

The chapter also aims to provide insight into the various advantages and disadvantages of the DCF model. A great book that go into the details on many of the concepts presented below is written by Alfred Rappaport and is called “Creating Shareholder Value: A Guide For Managers And Investors”. I highly recommend the book for those interested in DCF analysis.

The value of a company is the present value of all future free cash flows generated by the company. By estimating the free cash flow for future years and discounting it at the cost of capital, we determine the present value of the company. The long-term discounted cash flow model reflects the way the market values stocks, bonds, and real estate. The value of an asset that generates cash flow for the owner is the present value of all future cash flows from the asset.

sh flows and adding the terminal value, we implicitly make

ery important assumptions. We will return to these

ptions.

put of a DCF model is only as good as the quality of the

s input. Working with the assumptions of the DCF model will

u a better understanding of the business. These insights could

more valuable than the final output of the model itself. show, we can use the DCF model and the current stock price

ulate the implicit assumptions that the stock market has made

he company's key value drivers. In other words, we can work

rds from the current market price of the stock and find out

e stock price is telling us about the fundamental expectations

ded in the stock. This could prove to be valuable information

nvestor. As Professor Michael Mauboussin - co-author of

g Shareholder Value and author of Expectation Investing -

DCF to understand the expectations embedded in a price and

sess reasonableness. Recognize that the single point of price

nts a distribution of outcomes"

are six value drivers that constitute the input of a DCF model".

nputs are:

e growth

margin

-Capex requirements -Cost of capital The following figure illustrates these six value drivers. The top line is the company's revenue figure and requires no further explanation. The EBIT figure we use in the DCF model requires some explanation. We arrive at EBIT and the EBIT margin by subtracting not only cost of sales and administrative expenses from sales, but also depreciation and amortization, even though depreciation and amortization are non-cash items.

The reason I use EBIT instead of EBITDA is that the capex calculation further down the model is based only on "growth" capex, or capex that exceeds depreciation. Growth capex is what the company needs to spend to grow sales, not just to

ion. Therefore, we use EBIT instead of EBITDA in the

words, we could have used EBITDA in the DCF model,

n we would have had to include all capital expenditures,

g maintenance capital expenditures, further down the

So, if we add depreciation and amortization to operating to convert it into a cash flow number, and add the same

ation and amortization to incremental fixed capital

itures to convert them into total capital expenditures, the

ow from operations would be the same. rate used in the model is the cash tax paid from the

ng cash flow statement divided by the operating profit When it comes to investments that drive revenue these investments are divided into two forms of growth

ments. A company must invest in working capital and fixed

n order to grow. Incremental working capital investment

et amount of investment in accounts receivable,

ry, and accounts payable. I take the sum of total net

g capital over the last ten years and divide that sum by

ease in sales over the same period. In this way, I get an

e of how much net working capital the company needs to

o increase sales. We do the same for fixed investments and equipment. We examine the sum of all capital

itures minus depreciation and divide that sum by the

e in sales over the same 10-year period. In other words,

The sum of the percentage of incremental net working capital and the percentage of incremental growth investment is the "cost of growth" to the company. In the DCF model, these costs are deducted when estimating the free cash flow of the company. The last value driver, the cost of capital, has already been presented.

Residual value Before we look at the DCF model, we need to introduce residual value. Residual value is often the largest part of a company's value. For most companies, only a small portion of the value can reasonably be attributed to the estimated cash flow over the next five or ten years. Value-creating strategies are those that produce excess returns over those demanded by capital markets and thereby generate positive net present value.

This goal of value creation is achieved by companies that can raise funds in capital markets at competitive rates from capital markets and then invest those funds to exploit imperfections in product markets. These imperfections arise from a type of competitive advantage. The challenge for the investor is to assess how long the competitive advantage will last. Very few companies are able to suspend the laws of gravity or the decline in return on capital over time. When companies earn a return on capital that exceeds the cost of capital, competitors will do everything they can to enter the attractive market and

rpetuity method of estimating residual value is based on

ompetitive dynamics. It is essentially based on the

ption that a company that is able to generate returns

ts cost of capital will eventually attract competitors.

titor entry will push returns to the minimum of the

able rate or cost of capital.

rpetuity method assumes that, after the forecast period,

mpany will earn on average,the cost of capital for new

ments. Another way to express this idea is to say that

e forecast period, on average, the firm will invest in

investment is assumed to have fallen to the cost of capital. In order for the company to create more value, it must defend its return on invested capital (ROIC), which is represented by the dashed line. For each year it can defend its ROIC, it creates more value as long as it is able to deploy new capital at high returns. Once the rate of return has been driven down to the cost of capital rate, changes in future cash flows no longer change the value of the firm.

Therefore, these future cash flows can be treated as if they were a "perpetuity" or an infinite stream of identical cash flows.

The cash flow could grow, but it is assumed that the cash flows do not generate a return above the cost of capital. Thus, no value is created. Growth is neutral with respect to value creation. The present value of a perpetuity is simply the value of the expected annual cash flow divided by the rate of return. The present value of the perpetuity is thus calculated by dividing the operating cash flow before new investments by the cost of capital.

The perpetuity calculation is based on the cash flow before new investments, since we do not need to consider the additional investments in fixed and working capital during the period after the forecast period. Growth investments only earns the cost of capital in the post-forecast period. Although investment in expansion projects in the post-forecast period may help increase future cash inflows, any increase in cash inflows will be

he value of the firm, in order to calculate the residual

you need only consider the capital expenditures required

tain existing capacity, which are covered by

ation.

rpetuity method assumes that the cost of maintaining capacity is approximately equal to the cost of

ation. It is important to remember that the perpetuity of estimating residual value is not based on the

ption that all future cash flows will actually be identical. It

reflects the fact that the cash flows resulting from future

ments will not affect the value of the company because

l return on those investments is equal to the cost of

m continues to grow after the end of the forecast period,

ns exactly its cost of capital, we can calculate the value

rm at that point-that is, its residual value, as if cash flows

ed constant. This simplifies the calculation considerably

es the same answer that would be obtained if we were to

nt the individual cash flows instead. The company's

ng profit margin that results in the company earning

its cost of capital is what is known as the company's

ld margin. The threshold margin represents the

m operating profit margin that a company must achieve

period in order to maintain shareholder value in that

The determination of the threshold margin is therefore a

The following are the assumptions of the DCF model. The starting point is a revenue of 100 and a revenue growth assumption of 5% per year. The EBIT margin is expected to be 7% over the forecast period of ten years. Capital expenditures required for sales growth are set at 20%, which means that the company must invest 20% of sales growth in growth or expansion projects each year. These investments are above the level of depreciation and amortization. The DCF model shown on the next page is based on the value drivers described above.

Using the inputs, we will show how the value of the company can be calculated. The marginal working capital capex is 10%, which means that 10% of sales growth must be set aside as net working capital. The cash tax rate is set at 25% and the cost of capital is 10%. The company has 10 million in cash and 20 million in debt, resulting in total assets of 30 million. The

g capital investment and cash tax from EBIT. We assume company needs to reinvest depreciation and

ation expenses to keep production levels constant. In

n, the company must make growth investments in both

ssets and working capital in order to increase sales.

he free cash flow line we calculate the NPV for each free

ow number. The cells highlighted in green are annotated

present value of 4.0 is 3.6 (4/1.1). We calculate the net value for each FCF number. Thus, the net present value

.2 million FCF in year ten is 2.4 million, or 6.2/(1.1^10).

count the 6.2 million at the 10% cost of capital for ten

o arrive at the present value of 2.4 million. Below the net value of free cash flow, we calculate the cumulative

of all these net present values. The 7.1 million in the year is the sum of 3.6 of the net present value of free

ow in the first year and 3.5 million of the net present

f free cash flow in the second year. Thus, the value of

llion in year ten is the present value of all free cash flows

e forecast period. If the value of the company after year

e 0, the value of the company would be 29.9 million plus

h position minus the debt position. But the value of the

ny after year ten is clearly not 0. We need to calculate

minal value, i.e., the present value of the cash flows after

n and into perpetuity. I calculate the net present value of

dual each year. It is important to note that we do not consider growth investments when calculating the

ment after year 10 is equal to the cost of capital. Another

ook at it is to assume that growth is 0. Therefore, we do

d to consider growth investment. To calculate the value of the terminal value in year ten of 33 million, we

ermine the free cash flow before growth investment. The

sh flow before growth investments is 6.2 million, i.e., the

year ten plus the two investment components of 1.6

and 0.78 million. This results in a free cash flow before

investments of 6.2 + 1.6 + 0.78 = 8.58. The present

f this "capex-adjusted FCF" in year ten is 8.58 / 0.10 =

llion. We calculate the present value of 85.8 million as

1.1^10) = 33.0 million. The current value of all future

ows after year ten is 33.0 million.

an 50% of the value of the company is the result of cash

at occur after the tenth year. Only 29.9 million of the

an be derived from free cash flows in the forecast period.

m of 29.9 million and 33.0 million gives the present value

ash flows of the company of 62.8 million (rounding error).

rmine the enterprise value of the company, we take 62.8

and add the company's cash of 10 million. The

se value is 72.8 million. If we subtract the company's

20 million, we get the equity value of 52.8 million.

preadsheet, I have also calculated the NOPAT for each

hich is EBIT - Cash Tax. Below the NOPAT, I have

ed the total assets. In year 1, total assets is the sum of

see from the last line, the ROIC for the company is 18%. This company is clearly creating value as it is able to grow with a return of 18% on invested capital. This value creation can be calculated by measuring the annual increase in value, also known as shareholder value added. Shareholder value added is the increase in the cumulative net present value of both FCF and residual per year. In the yellow cell of 10.4 million, I calculated the sum of all shareholder value added in the period.

We can turn this calculation around and ask ourselves at what Ebit margin the value added would be zero. In other words: What EBIT margin would result in a shareholder value of zero and a ROIC of 10%, which is the cost of capital. We can solve the DCF model backwards by setting the sum of the shareholder value added (of 10.4 million) to 0, using the "goal seek" function in Excel, and find out what kind of EBIT margin we get. The answer to this question is 3.6%. Assuming an EBIT margin of 3.6% leads to a Shareholder Value Added of 0, a ROIC of 10% and an equity value of 17 million. The best way to understand how a DCF model works is to build one and see the different results you get by adjusting the various inputs.

This will give you the insight that a DCF model is only as good as the input and that the model is very sensitive to small changes in expected margins and cost of capital. The best part about working with the DCF model is that the model makes you aware of the value drivers behind each business. My advice is to spend less time on the output of the model and more time on the sensitivity of the output due to changes in input variables.

Hyperbolic discounting ential discounting".

This discounting method is the

d method for discounting cash flows. In business

, you will probably only learn about the exponential

nting model. But what does this way of discounting cash

ean and is it the right way of discounting cash flows?

ditional way of discounting, exponential discounting, is

sensitive, meaning that you have the same relative in the discount factor as time goes by. This is the rational

ook at economics. Consequently, cash flows that are in the future are not worth much under exponential

nting in terms of present value.

ssical view of economics assumes that people discount a

eward by a fixed percentage for each unit of time they wait. If the discount rate is 10% per year, a person

like $100 now and $110 a year from now equally. The

erson should also like $100 in one year and 110 USD in

ars equally. Under exponential discounting, the amount

discount a future reward depends only on the length of

The formula for calculating the present value of a cash flow using the exponential function is as follows: PV = Cash flowt / (1+r)^t where PV= present value r = discount rate t = time Behavioral studies of humans and animals show that we do not behave as traditional economic theory says we should. We are not rational. Humans seem to exhibit inconsistencies in their decisions over time. Our way of discounting as humans is time dependent.

In other words, we use different discount rates depending on how long it takes to receive a payoff. Hyperbolic discounting refers to the tendency of humans to prefer a smaller reward soon over a larger reward later. Let me explain with some examples.

In the first example, you can choose to receive $ 100 today or $110 a year from now. In experiments, people strongly tend to choose $100 today to get the instant gratification.

e year longer to receive $110. Since instant gratification

ot occur anyway, we act more rationally and think that we

t another year until year 11 because we are already

y prepared to wait a long time. The challenge in example

ere you have decided to wait 11 years, is that when you

ch year ten, you would rather get the instant gratification than wait another year. In other words, people avoid

more the closer the time of waiting gets.

hort run, people are irrational, but in the longer run, they the rational option. People make choices that reflect

olic discounting to a much greater degree than

ntial discounting. The basis for the hyperbolic

nting model is human behavior. The pattern that emerges

e way people choose with increasing time follows what is

a hyperbola. Humans do not appear to use a constant

nt rate, as exponential discounting purports to do. In

mics, hyperbolic discounting is a time-inconsistent model

ounting that more closely approximates the way people

hoices in reality.

perbolic model discounts more than the exponential

at the beginning and less than the exponential model for

ng term events. Hyperbolic discounting states that

nt rates are greater in the short run than in the long run.

ore, with hyperbolic discounting, valuations fall very

the discounting formula looks different than exponential discounting. Below is an example of what it might look like.

The key is that the discount rate now varies with time.

PV = Cash Flow / (1+r x t)^(B/A) where PV = present value r = discount rate t = time B and A are greater than 0 Hyperbolic discounting in finance What does hyperbolic discounting mean for valuation and cash flow modeling? In the hyperbolic formula, the present value of short-term cash flows is lower than in the exponential model, but the present value of longer-term cash flows is higher than in the exponential model. Consequently, for long-term cash flow forecasts, the present value under the hyperbolic assumption is higher than under the exponential assumption.

There are several types of mathematical expressions for the hyperbolic formula. I will not go into the mathematical expressions, but will use the hyperbolic function formula above with an example of a 20-year cash flow. Below, we see that the discount factor for the hyperbolic function is lower in the early years than for the exponential function. In the long run, the hyperbolic function provides higher present values than the

ption.

esent value of cash flows resulting from the exponential

n and the hyperbolic assumption is as follows: The

g present value of all cash flows under exponential

nting is 851. The present value of all cash flows under

olic discounting is 951.

under exponential discounting. The difference is even much greater if we include the present value of the terminal value. I am not advocating that you should flip all your DCF models and start using hyperbolic discounting. The reason I find the topic interesting is that hyperbolic discounting could be one of the many reasons that very strong companies with very predictable cash flows far into the future are valued much higher than other companies in the stock market. It could be that market participants value these stocks by discounting their cash flows using a discounting mechanism that is closer to the hyperbolic discounting method than the exponential discounting method.

andto capital allocation r,Management you trust your money the top people in the company investing in. You trust them to make the right decisions

ur money on your behalf. Finding the right top

ement is perha perhaps more of an art than a science.

Buffett put it this way: "It is almost impossible to overpay

ruly extraordinary CEO... but the species is rare."

apter draws on my own experience and a brilliant book

subject of exceptional CEOs called "The Outsiders" by N. Thorndike. I highly recommend reading the book. It

ke you a better investor. I have personally applied many

rinciples listed below in my search for exceptional CEOs.

the CEOs I have invested in and believe to be in line with

ciples listed below is Mark Leonard of the Canadian

e company Constellation Software. I recommend reading

eonard's annual letters.

ht truly exceptional CEOs in Thorndike's book share

haracteristics. What makes them extraordinary is the fact

y have led their respective companies for decades, not

have run have proven to become 100-bagger investments. But aside from Warren Buffett, who is one of the eight CEOs in this book, these individuals are less well known to the public. They have many things in common.

As an example, Henry Singelton, who founded Teledyne in the early 1960s, returned 20.4% on the Teledyne stock during his 30-year tenure as CEO. He may be one of the best CEOs in

American corporate history, but he is less well known than Warren Buffett. $1 invested in Teledyne when Singelton took the helm became $180 at the end of 30 years. The same dollar invested in the S&P index returned $15, and the same dollar invested in Teledyne's "peer" companies, mostly conglomerates, returned $27. So, all in all, an exceptional performance.

hlight the key similarities among the eight CEOs in

ke's book and why it is important to look for these traits

s. What is the correct way to measure the success of a

t's not the size of the company or the number of

ees or the number of headlines in the business press.

e of the CEO is to manage two resources - people and

- in a way that gets the most out of them.

as shareholders, the most important criterion for judging

is the total shareholder return over very long periods of

d the comparison of this shareholder return with the

market return and the return of a relevant peer group. If

nagement has been in place for many years and has

ed total shareholder returns that far exceed the market

nd peer group, you know the top management team has

omething right and maximized value per share.

ing for commonalities between exceptional CEOs is not

eresting, but could also increase the chances of finding

ceptional investments where the right kind of top

ement is in play. It's easy to be intrigued by an outgoing

culate CEO who constantly shows up at equity

nces and trade shows and speaks with great conviction

trategies and market opportunities. Busy CEOs who are

ntly talking to journalists and analysts seem to be the

r most CEOs. Wall Street loves these CEOs.

Wall Street as a distraction. For them, customers and employees are their top priority. If the customers and employees are happy, so are the shareholders. These outstanding CEOs take a long-term view and let their performance speak for itself.

Of course, they know that as a publicly traded company, they are exposed to a lot of short-term noise, but they choose not to pay attention to it. They build dominant companies with enduring cultures. They own a portion of the companies themselves.

Thorndike draws on Jack Welch as an example of a charismatic and outgoing CEO, long considered the perfect blueprint for a good CEO. Welch was CEO of GE from 1981 to 2001 and achieved a 20.9% CAGR on the stock during his tenure. That's an impressive return by any measure, even in one of the longest bull markets in history. But the truly exceptional CEOs in

Thorndike's book have achieved even higher returns over longer periods.

The extraordinary CEOs in "The Outsiders" differed from ordinary CEOs in three distinct ways: 1) They were very strong capital allocators 2) They ran very decentralized organizations 3) They were independent, humble and family oriented.

The truly exceptional CEOs do most things differently than their

e superior performance unless you do something

t". Capital Allocation The truly exceptional CEOs chose

allocation as their most important job.

CEOs were investors rather than managers. Every CEO

oolbox when it comes to capital allocation. As shown

there are 3 sources of cash and 5 ways a CEO can

t. The exceptional CEOs were masters at using the right

of capital at the right time and spending the capital

t produced the best returns for shareholders.

enior corporate executives are promoted to CEO

e they have developed strong production or marketing

ver many years in a company. Others are promoted to

ecause they are the best at navigating corporate politics.

have sole responsibility for the capital allocation of the

ny and a lot of value can be created or destructed by

allocation. Capital allocation is a skill set that's needed.

t many people have that kind of experience before

ng CEO. the CEOs in Thorndike's book made large stock

ks during their time as CEOs. Sometimes the best

ment opportunity is their own stock. These were not

y stock buyback programs like you see at most

nies. Most of them made large tender offers when the

rice was attractive, and used the stock as currency in

ions when the stock was highly valued. Many bought

buyback programs for a set amount and run them over several years. That's not the way the Outsiders operated. These CEOs very rarely paid dividends, even at times when dividends were popular with investors. They were trying to maximize cash flow per share, not earnings per share.

Many of these very successful CEOs made many acquisitions during their tenure as CEOs. The acquisitions were often made through direct contact with the sellers. By avoiding auctions, they were able to secure assets at attractive prices. They demonstrated patience and acted with occasional courage.

Warren Buffett has stated that a CEO who was responsible for a company's capital allocation for ten years and retained 10% of

The total retained earnings of 159.4 represents 68% of

assets of 235.8 after ten years.

organizations. They were not afraid of pushing responsibility downward in the organization. Staff functions were reduced to a minimum and top management's primary focus was capital allocation. They were masters of delegation. Their decentralized approach allowed them to unleash a lot of entrepreneurial energy in the organization. It's also a good way to keep costs down.

They avoided bureaucracy by paying for performance. They often combined this decentralized approach with good incentive systems that focused on maximizing cash flow per share. One criticism that many of these types of companies have is that managers who perform well are handsomely rewarded. They all set up small local branches, realizing that headquarters did not have the answers to customers' problems. These CEOs hired the best people and left those people alone. They had a deep understanding of human behavior and motivation.

These extraordinary CEOs had no time for investor relations.

They offered no guidance to Wall Street. They owned the company and acted as owners, not agents. Henry Singelton owned 13% of the company. Warren Buffett owns about 30% of Berkshire Hathaway. Personalities These CEOs were devoted to their families and often left their jobs to attend school events.

They did not attend equity conferences. They set their own agendas. They were not the rock stars of the business world, but people who operated in the background. They were not out for fame. All of these CEOs were new to the industries and

h and did not rely on external advisors.

ese eight CEOs were new to the CEO role. That may be

he reasons they were successful. They looked at the

nies and industries they were in with new eyes. They

ery rational and used new perspectives that led to great

mance. These CEOs were generalists. Most CEOs are

e to resist the "teenage pressure" to be like everyone

he Outsiders" did not care about conventional wisdom.

ere committed to rationality and eluded the peer

e of the corporate world. The bottom line is that there is

learn from exceptional CEOs who perform well over

ecades. As investors, we can use these blueprints of

s to look for investments. If we can find investments with

egrity top executives who care primarily about capital

on, that organize in a decentralized way and share many

ersonality traits mentioned above, we may have found

ing to hold onto for years to come.

shareholder Shareholder letters do not give communication you much insight into the

company or management's thinking. But the best shareholder letters do give you, the investor, good insight.

The best letters share many similar characteristics. I will discuss what these similarities are and how we can use this information to increase the odds of finding outstanding corporate cultures and great leaders. We can use shareholder letters as screening for potential investments.

The insights below are both based on own experience from reading shareholder letters and I also mention some key highlights from a great book by Lawrence A.Cunningham called “Dear Shareholder”. I highly recommend reading his book on this theme. The best shareholder letters give you insights into a range of issues that are important to investors. Warren Buffett, the CEO of Berkshire Hathaway, often comes to mind when people talk about outstanding shareholder letters. But Buffett is just one of many CEOs who can paint a picture of corporate culture that gives investors great insight.

ation of share ownership, compensation structures that

y aligned with long-term shareholder interests, focus on

and principles all build trust. In the best letters CEOs talk

about failed investments and lack of product success.

escribe failures with some sort of pride and show the

o think through challenges.

e

st shareholder letters are able to provide good insight

porate culture over many years. Over time the culture of

mpany will attract the right kind of employees. It is the

with investors. Companies get the kind of shareholders

serve. If the company describes a culture of taking the

ew and not focusing on quarterly guidance, the company

act investors who believe in those aspects. If the

ny spends a lot of time talking about short-term results

arterly forecasts, it attracts speculators who are much

hort-term oriented. The best letters are not written by an

r relations department, but by the CEO. They are

al. You very quickly see that the letter is written by the

hey do not try to cover up and hide challenges. They are

and convey a message based on trust.

ermism

st shareholder letters provide a long-term vision. The

who write these letters do not provide earnings forecasts

e the shareholder letter often as the only way to

aim for low turnover in the stock, which is a sign that many longterm shareholders are on board. The shareholder structure, over time, becomes a competitive advantage for these companies over time. The best letters often take time to explain the history of the company. As a long term investor it is important to understand where the company comes from in order to understand the present situation. They do not focus on the stock price. As Jeff Bezos has said: "We don't celebrate a 10% increase in the stock price like we celebrate excellent customer experience. We aren't 10% smarter when that happens and conversely aren't 10% dumber when the stock goes the other way. We want to be weighed, and we're always working to build a heavier company" Incentive structure The best shareholder letters are written by CEOs who are owners and act like owners. Many of these companies often have a dual share structure where the original founders or the CEO control the voting shares of the company. Since trust has been built over many years, often decades, these companies often trade at a premium to the market. Investors trust the dual shareholder structure and see that it creates long term value.

The dual structure helps to secure a long term mindset. These companies are big fans of insider stock ownership among all employees and often supplement employee 401(k) plans with company stock. The vesting periods for stocks often lasts many

These principles serve both to build the company's

and to manage investor expectations. You often observe business principles are repeated in every shareholder

usiness principles are the way a company operates.

ship principles are often about how people in the

ny interact with each other, and they focus on processes

han goals. These CEOs know what they have influence

d what they do not have influence over. By making the

process-oriented, they increase the chances of

ng their goals.

cultures

st shareholder letters are able to convey a message of

nd conservative cultures. They are able to balance

vatism and boldness at the same time. CEOs themselves example by not spending money on expensive hotels or

ickets in front of the curtain. Employees adapt to the

mentality and self select into these cultures. Employees

and that you should spend the corporate funds in the

onservative manner at you

your own money. Promoting insiders The best

older letters clearly lay out the company's succession

herefore, there are no surprises for employees or

olders when the CEO decides to leave the company.

s are often promoted to CEO, which means much less

cultural change and strategy shift. Many of these

nies are still run by the founder, even after 20-30 years.

Capital allocation The best shareholder letters emphasise the important aspect of capital allocation. The letters explain how the company will allocate capital and what its priorities will be in terms of dividends, share buybacks, investments, acquisitions, and leverage. They tend to have their own principles in terms of capital allocation. Some of the CEOs have very clear ideas about dividends and share buybacks. Most CEOs who write great shareholder letters are aware of the fact that if you have high returns on capital, you need to reinvest in the company.

You clearly see in the best letters that the CEO has some very strong preferences in terms of how to allocate capital. In order to allocate capital you need to generate capital. Therefore cash generation is of paramount importance to these CEOs. Shareholder-friendly KPIs The best shareholder letters describe how shareholders should evaluate the company's performance. The best shareholder letters include different types of performance measures, but the common thread is some type of economic value added (EVA) or economic profit. Long term investors care about value creation and not just growth in earnings per share. The best companies are able to present a value creating measurement system that is consistent over years. Perhaps the most important aspect is that the measure presented by the CEO does not change from year to

why the metric is used and continue to use across time.

tation of financials

st shareholder communication often discuss accounting limitations of accounting in measuring true economic

hey often tend to explain to investors the subjective

of accounting and its drawbacks. These letters take time

ain to investors what they should look for in financial

ents. They attempt to guide investors. For example, in

st letter on Google's IPO, Larry Page and Sergey Brin

We won't 'smooth' quarterly or annual results: If

s figures are lumpy when they reach headquarters, they

umpy when they reach you."

mary, the best shareholder communication stand out

dinary investor communication. The best annual reports

ed on trust and go to great lengths to attract the right

olders. They have a long-term focus and often cover the

opics such as ownership, principles, capital allocation

w best to value the company.

A culture for great longThere term research and even harder to quantify. arereturns many studies,

articles, or books on the relationship between corporate culture and economic performance.

Corporate culture can have a significant impact on a company's long-term economic performance. What contributes to a strong corporate culture and what is the relationship between culture and performance? Corporate culture is the personality of a company. It refers to how employees behave within a work environment and how they relate to and engage with the organization. In strong cultures, there is often a good match between employees' personal goals and the company's goals.

Companies with a strong culture are usually perceived by outsiders as having a certain "style" or way of doing things. The roots often run deep and are unlikely to change when a new CEO enters a company with a strong culture. In these cultures, new leaders are just as likely to be corrected by subordinates as by their bosses. In the book "Corporate Culture and Performance" by Kotter and Heskett, the authors find that

eadership at all levels, perform significantly better than

nies that lack these qualities.Kotter and Heskett find that

te culture is a strong predictor of financial performance.

g 200 companies over an eleven-year period, they found

mpanies with strong cultural characteristics, adaptability,

dership increased sales by an average of 682% versus

n the control group, increased net income by 756%

1% in the control group, and increased their stock price

% versus 74% in the control group. So, the weak

mers are not focusing enough on customers, employees

eholders.

otter and Heskett find is that these underperformers

mostly on themselves which is the root to the

erformance.

g culture enables a company to act quickly and in a

ated manner. Strong cultures often have deeply rooted

that are difficult to change and are shared by employees.

shared values are invisible, of course, but the culture

hrough the company's behavior at all levels. Culture is

d in the way people act. Strong cultures teach new

rs how to behave and reward those who fit in. In

ations with a strong culture, there is agreement on goals.

ms like strong cultures provide structure without too much

bureaucracy. In strong cultures, there is also continuity in

As the company grows and hires more employees, it is more difficult to get to know everyone on a personal level. However, if there is a strong company culture based on a vision and clearly stated goals, then every employee knows exactly what they are supposed to be working towards. In this way, the culture helps drive the company forward without forcing leaders to micromanage everyone. A strong founder mentality is important in establishing the company culture in the first place.

But a strong culture is not enough to achieve long-term economic outperformance. You can have both a strong culture and weak economic performance. Strong cultures can easily become arrogant, inward-looking, politicized, and bureaucratic.

A strong culture can cause intelligent people to walk in tandem without much thought. In an arrogant culture, there is little room for criticism because everything seems to be going well. When you combine this attitude with big takeovers that often lead to dilute the culture, you have all the ingredients for a cultural collapse. Willingness to change There is no "right" culture for all industries and companies. Culture must be aligned with context or strategy. A culture is only good if it fits the company's longterm strategy. The better it fits, the better the performance.

The corporate culture of a retailer should be different from the corporate culture of a bank. The customer expectations of these companies are very different and should be served accordingly.

A strong culture is not enough. A culture must be adaptable to

and not very creative. In less adaptive cultures, the norm

anagers behave cautiously and politically correct. There

k of leadership throughout the management hierarchy. In

aptive cultures, managers seem to care more about their

reers or perks than about the company. Strong cultures

apt to change tend to have visionary leadership at all

other hand, adaptive cultures seem to emerge around a

umber of people, sometimes just one person.

ingness to change is evident in the fact that leaders in

e companies frequently talk and write about the need for

. Leaders of high-performing companies get their

ers to embrace a timeless philosophy or set of values

phasise customers, employees, shareholders,

hip, as well as the need to adapt. As companies grow

d more formal systems, the leaders of high-performing

nies ensure that these systems reinforce the insight that is needed.

s poisons strong cultures

eds of a dysfunctional culture are planted whenever the

ny is doing well. A dysfunctional culture develops slowly

period of years. Because culture change is a lengthy

s, it is often invisible to the people in the company. While need to foster pride in employees, they also need to be

nt of others' arrogance and their own. They must create

employees. Arrogance is the beginning of suffering in corporate cultures. You could say that success poisons the culture.

The path to dysfunctional cultures is often the same. As organizations grow larger, day-to-day operations become more complex. To address internal organizational challenges, leaders hire, develop, and promote qualified managers who are not necessarily leaders. Managers are promoted to take care of structures, systems, budgets and controls. They focus less on vision, strategy, culture and inspiration. Who gets promoted says more about real values than any mission statement or credo. Over time, these administrators become top leaders.

These top leaders pay attention to stability and order rather than dynamic change.

Changing problem cultures is so difficult that it is almost impossible. But a few companies manage to change and the main reason is leadership at the top. The reason it is difficult to change a dysfunctional culture is because of the existing power structures in most companies. People are taught to care more about their type of work, their department, certain products or themselves. The existing power structure usually resists change that could threaten privilege. In trying to change a dysfunctional culture, the new CEO must present a new vision and be able to convince key groups in the company to commit to change.

Change must come from the very top. The few who succeed in changing dysfunctional cultures often create an atmosphere of

ng a dysfunctional culture is that the CEO must look for

ut sustainable successes to communicate to the

ation that change is happening. Strong and enduring

s are created by employees in organizations that share

f the same values. Strong cultures care about

ers, employees and shareholders. Very few companies

ll three stakeholders. For a strong culture to last, it must

egically and be able to change incrementally over time.

ship is also an important component of a strong and

g culture.

Position sizing (Charlie Munger) Professional investors often need to comply with diversification rules. I think the more experience you have as an investor, the more focused you tend to become in terms of the number of investments. Personally, I think about 20-25 investments is the right kind of portfolio diversification for private investors.

However, there are investors with much more experience who are very happy with just a handful of investments. Others may have a different opinion and feel that you need to diversify across much more than 20 stocks. I find it difficult to put more than 20% of the portfolio into a single stock. The simple reason is that you can never be sure when investing. The company and the stock may meet all the criteria: A strong market position, the right management, good growth opportunities, a strong balance sheet and attractive pricing of the stock.

But even if all the stars align and everything looks perfect from an investor's perspective, you can be wrong. And if you are

er hand, you want to gain a lot if you are right, which

arge positions. As Philip A. Fisher in "Common Stocks

common Profits" said:

dividuals, any holding of over twenty different stocks is a

financial incompetence”

sonal experience is that the largest positions in the

o should have the lowest fundamental risk, not the return potential. The largest positions in your portfolio

help reduce risk in the portfolio, not increase overall risk.

pinion, the largest positions should have the lowest

lity of permanent capital loss combined with above

e return potential. My experience has led me to not buy

re position at once.

y buy a few percentage points of the portfolio as an initial

n. Then I follow the fundamental performance of the

ny over a few quarters. Hopefully, when my confidence

es, I am very happy to average up in the positions rising stock prices. I find it better to buy at higher levels

know the company is moving in the right fundamental

n.

posite is to buy more of a falling stock when the

ing fundamentals of the company are weakening. I like

age up when management exceeds my expectations. To

As Ian Cassel, the founder of Microcap Club, has stated: "Every position should have the potential to move your whole portfolio if they work big. You need to win big when you are right. But no position should be big enough to take you out of the game if you are wrong."

Every investor has a different mindset when it comes to position sizing. Depending on your risk tolerance, you should find your own preference. The best way to determine position size is to learn from experience. There is no right or wrong way to diversify, even though financial theory says that most of the unsystematic risk reduced with 20-25 stocks. Work on finding your own style and risk tolerance.

Questions to management ny. In today's world, where quarterly results are posted

and conference calls are webcast for all participants it is

e for private investors to ask management questions. You

have to be a major shareholder to ask questions to

ement.

estions below are open-ended questions that, in my

nce, are the best way to ask questions to management.

swers you get from these questions are reflections, not

ple "yes" or "no" answers. Rather than asking about financial goals, it's better to ask how the company plans

eve those goals. Good questions are essential to getting

nswers.

meeting management in person, it can be beneficial to

bout how you will introduce yourself and get management and let their guard down. The more targeted your

ns, the more targeted the responses will be. When you

hat you are listening to management, it is easier for

ement to respond to the questions. Instead of jumping

incorporate valuable comments from management. You should try to avoid leading questions, as they do not give you insight.

Let management do the talking - do not interrupt.

Question 1) When you talk to investors and analysts. What do you think are the biggest misconceptions they have about the company? This question often gets management to think outside the box and hopefully highlights some of the issues that management feels are not getting enough attention. The answer you receive might cause you to look at the company in a different way.

Management might point out that a specific part of the company is getting too little attention or, conversely, that a small issue is getting too much attention.

Question 2) In your years with the company, what were the biggest mistakes made by management? This question reveals more about the attitude of admitting mistakes. Management might say that there have been no mistakes over the years, which of course is not a very trustworthy answer. If management points out some of the mistakes they have made over the years, the answers will give clues to some follow-up questions about how management has handled the mistakes and what they have learned from them.

This question also reveals whether management is open and willing to admit mistakes. Admitting mistakes is a very positive characteristic of a good management team.

? This open-ended question asks management to talk

he biggest developments in the company over the years.

opefully give you more insight into how the culture and

s have changed. This question will allow you to ask follow-up questions about the changes in the company

w the company got to where it is today.

on 4)

e your greatest role models in the business world and

his question may shed light on which other companies

ement believes are worth considering as investors. It

lso reveal some of management's values and priorities.

on 5)

of your competitors, suppliers and customers really stand

m the crowd in terms of execution and professionalism?

ust another way of phrasing question 4. It's always

ing to hear what management has to say about these

olders.

on 6)

pe of issues keep you awake at night?

lly this question gives you some insight into the biggest

to the company. It will also provide you with several

nities for follow-up questions on the issues uncovered.

would have to happen for your results to drop 30% to 50% in the next year? It's a question that might surprise management.

The surprise factor is one to watch. Of course, the answer is also interesting and provides insight into the biggest risk factors facing the company.

Question 8) Why should top candidates work for your company? This question might give you some insight into the culture of the company and why management considers it a good place to work. Hopefully, the answer will give you insight into priorities and what the company has to offer its employees.

Question 9) How would you describe the corporate culture and the changes in culture? It is always interesting to hear management describe the corporate culture and values in the company. It's also interesting to hear how the culture has changed over the years.

The change in culture reflects the changes in the company's priorities over the years.

Question 10) What's the one thing your competitors have a hard time copying?

The answer to this question can reveal some interesting facts.

Does the company focus on products, processes or people?

on? Why do you have a fixed dividend payout? It's

good to hear what management has to say about capital

on. Does management understand the basic principles

e creation? If management and the board have

hed fixed dividend payout schedules and/or buyback

mmes, why?

on 12)

ll you achieve your growth targets? Most companies

et growth and profitability targets. The targets are not the

mportant thing you want to hear, but it is always

ing to learn how management plans to achieve them.

on 14)

CEO. Why did you take this job? An open question that

ead to some interesting answers about culture and

ion.

on 15)

makes your company one of the best in your sector? A

ly worded question like this can lead to a more open

ion later, as you highlight the fact that the company has

good job in building its current market position. It is

nt to ask good questions to get good answers from

ement. The above questions can help you on your way to conversation with management.

an investor.

Your edge as an investor

The first is in how you handle information and what kind of information you filter. The other advantage is the time horizon you have over other investors.

1) Information treatment advantage 2) Time horizon advantage The days when you as an investor had an information advantage over other investors have been over for decades.

Today, information about companies is instantly available and everyone gets the same information at the same time. You do not have to be in the financial centres of the world to get fast information. On the contrary, it can even be beneficial to be far away from the noise of the financial centres. If you are less exposed to the noise of the markets, you might have an advantage in terms of processing and filtering information.

tion from irrelevant information. This filtering is easier if

ow some basic investment principles and have a long-

vestment horizon. Then you will know what to pay

n to and what not to waste time on. The treatment of

tion has to do with what type of information you consider

t to your investment. This filtering process can be a little

in your early years as an investor. You may think that all

rmation thrown at you is relevant. You may be afraid of important information about your investment. But as the

o by, you will get better at filtering out and looking for the

ormation.

will always be information that conflicts with your

ment. But unless that information is very relevant to your

ment thesis, do not spend too much time on it.

ought a stock on the basis that the company will be a

cquirer of small competitors over many years, you will be

terested in information about the acquisition pipeline and

w than a small drop in EBIT margin or a quarterly EPS-

ll you want to know is whether or not the company is in the right direction in terms of the parameters you were relevant when you bought the stock. If you bought on the basis that the organic growth opportunities were

silient, you should spend time on your investment thesis

ontinue to find that the company is unable to deliver revenue growth. Earnings growth may be good due to

should watch this KPI closely.

Over the years, I have come to spend less time on analyst reports and more time on company reports. You should be aware that the information you read in an analyst report has already been filtered by the analyst. Therefore, I find it more valuable to read the company reports directly than to get the information from an analyst. I therefore spend most of my time reading transcripts of conference calls and the reports published by the company itself. I find that this gives me more direct knowledge about the company in question.

2) Time horizon advantage Most money in the stock markets is managed by professional investors who work with very short time horizons of one to three years. I believe that this presents an opportunity for private investors who are willing to buy companies with a multi-year perspective.

In the short term of one to three years, the market is very efficient in valuing companies correctly. In my experience, the market is not very efficient at valuing individual companies over a multi-year time horizon due to the short-term incentives of asset managers. Most quality companies with strong and robust growth prospects and high returns on capital trade at earnings multiples between 20 and 40 times. The reason very high quality companies do not trade at higher multiples, in my

ers lose their jobs if they pay too high a multiple on a

nd the stock suddenly derates over the next one to three am not advocating that you should pay any price for a

ality company. I just think most investors have trouble

anding what a long-term horizon implies for quality

nies in terms of stock pricing.

some perspective on pricing, I think it helps to go back in

and ask yourself the following question: What could you

aid in terms of P/E-multiple,for this company 15 or 20

go to get the market return over the same period? For

ality companies, you will be surprised by the answer to

estion. Let us take a practical example. What do you

ou could have paid for the consulting firm Accenture 15

go and still got the market return of about 8% annual for 15 years? The answer to that question is 124 times

s, or a P/E ratio of 124. Today, Accenture is valued at 20

arnings. The answer of 124 tells us that Accenture's

s growth during those years was well above the market

of 8%. If growth is higher than the market return for many

hen a very high starting multiple is justified.

were visionary and could see what Google could become

s ago, you could afford to pay 1250 times earnings for and still get the market return over the

eriod. Google has grown much faster than the market

e last 15 years. The two examples of "justified" pricing of

ure and Google are, of course, influenced by the fact that

course, is to form an opinion about which companies have the ability today to grow much faster than the market over the next 15 years. That's much harder to answer than looking at history.

But the answers to the above questions lead us to focus on the really important aspects of investing. We should try to find companies that are able to reinvest large amounts of capital at high returns on capital over a long period of time. If we can find these three characteristics with a high degree of certainty, the pricing of the stock will be less relevant in the long run.

Risk trated portfolio, youmanagement need to avoid "melt downs" in your

o - stocks that drop 90% and stay low. How should we

ch risk control to avoid permanent capital losses in our

oldings?

ng single-exposure risk

st basic approach to risk control, in my opinion, is the

g. I try to avoid companies that sell a single product or to a single customer in a single market. Focusing on a

product, a single customer, and a single market creates a

sk for the company.

re sitting on a chair with three legs and one of the legs is you will fall off the chair. The same is true for

ments in companies. In all businesses, at all times, there

ues that cause problems. If you sell only one product or and something goes wrong with that product, you have a

m. If you sell your product to only one customer and that

er wants to look elsewhere, you have a problem.

companies that sell many different or unrelated products to many different types of customers in many different markets. By investing in companies that reduce individual risks, you are less affected in situations where products, customers and markets fail.

Personally, this type of risk control has led me to invest in many "conglomerates" or "investment companies." These are companies that make many different products and sell those products to many different companies in many different markets. On the surface, these companies could be considered unfocused. I have found that these "multi-exposure" companies, run by management with strong capital allocation skills, are attractive from a risk control standpoint.

Careful with cyclical exposure Companies that sell commodity products are much more susceptible to adverse setbacks than companies that control their own destiny. For the investor, there is a double challenge with companies that are highly cyclical. First, the investor must figure out the timing of the underlying cyclical exposure and the supply/demand situation for the product or service in question.

This in itself is a challenging task.

Second, the investor must find the right timing for the stock price. When the stock price is depressed in cyclical companies, there is always a very good reason. Arguments such as "this

companies and especially in companies that sell pure

dity products.

ng too much debt

ebt can boost returns, and in strong markets, debt is

hought of. How much debt to use depends on the

n. For cyclical companies, I think you should always

ompanies with debt. With cyclical companies, there is a

endency for end markets to perform negatively just

ebt levels are at their worst. Therefore, cyclical

nies should not have debt.

t in favor of building a portfolio of companies exclusively debt. For companies with a strong market positions and

eturn on capital, taking on debt makes a lot of sense to

e returns. For non-cyclical companies and asset-light

ss models with strong cash flows I can get comfortable

o 2 times net debt to EBITDA. Avoiding too high

ory risk As mentioned above, if you invest in companies

y one market position, you are taking on more regulatory

hen you invest in companies with a dominant market

n, you are always exposed to regulatory risk. It is a

ge to balance the opportunities of these strong market

ns against the risk of regulatory changes.

concluded not to invest heavily in companies that have a

gree of regulatory risk. Avoiding management that you

structures that you can trust.

If you have doubts about the integrity of management, you should not invest. As I mentioned in previous chapters, investing in the right people will both increase returns and keep risks low.

Acquistion compounders tions comes to thedriven same conclusion: acquisitions do not

shareholder value. Researchers typically aggregate their

o a single average to generalize, which can obscure

nt findings between different M&A strategies.

all research examines large public transactions. Such

ndermine rather than enhance long-term shareholder

Large public deals tend to be hit or miss and often fail

e the synergies are smaller and more complicated to

e than expected, because cultural integration is difficult,

use they are poorly executed. A study by McKinsey of

cquisition companies takes a more nuanced view of

ions and value creation by dividing M&A into two distinct

ies.

dy concludes that large transformative (public) deals shareholder value and reduce annual excess annual

by an average of 1.7%. In large deals, industry structure,

s the reduction of excess capacity in the industry, tends to

arger role in the potential success of the deal than the

focus is inward during the often lengthy integration process, causing critical product or upgrade cycles to be missed. In contrast, the most interesting part of the study is the analysis of companies that take a "programmatic" approach to dealmaking.

Mergers and acquisitions are a core element of the strategy of such companies, resulting in many small (private) deals, with companies in this category achieving an average increase in annual excess return of 2.8%. Companies using this strategy make many acquisitions, which together represent a significant level of investment and create substantial shareholder value over time. It has been shown that executing a program with many acquisitions requires certain corporate capabilities.

McKinsey notes that the more small deals a company does, the more likely it is to generate excess returns. Running a large deal program requires certain corporate capabilities, such as systematic deal sourcing. A key advantage of many small deals is that the risk of cultural conflict is minimized.

“The data suggest that a growth strategy built around a series of small deals can actually be less risky than avoiding M&A altogether” (McKinsey) Acquisition-driven compounders A key lesson learned over the years is that an investment philosophy of investing in value creators fits well with investing

ng small private companies. In many ways, this strategy

o be viewed as an arbitrage between private and public

nies, where the public company buys small private

nies at multiples far below the multiple at which the public

ny itself trades.

any years, often decades, the publicly traded serial

res establish relationships with private sellers. The

on driven companies provide a "permanent home" for

ate sellers, to use a quote by the famous investor Buffett.

quisition driven companies offer the private sellers full

my, access to capital, and growth opportunities. For the

sellers, there are often a lot of non-financial arguments

heir business to the publicly traded companies that

e the serial acquisition strategy. Many of these private want to continue to own up to 20% of the company -

ith a buy-out mechanism after 5-8 years. The publicly

companies provide strong incentives for the founder to

e to grow profitably. In addition, and importantly for many

companies, sellers are guaranteed that the local

arters will not be moved to another part of the country.

often feel a commitment to the local society and

ees, who are offered the opportunity to remain with the

ny after the transaction.

pockets and can offer higher prices. But in many cases, capitalism does not always work by the textbook, and many private sellers choose these publicly traded companies as buyers. They choose the right owners for the long haul. As part of the holding company, you are offered full freedom. Capital is offered and best practices for creating shareholder value are part of the package. The publicly traded companies are able to acquire private companies at much lower multiples than the multiples they themselves trade at. In many ways, an acquisition-driven compounding strategy means that hundreds and hundreds of private companies are held under the umbrella of publicly traded companies.

Two types of acquisition-driven business models I like to divide acquisition-driven compounders into two types of business models; call them Specialists and Generalists depending on the business model. Both models make a large number of acquisitions each year.

Specialists are niche players that only operate in one single segment of the market. They are highly specialized in what they do. Over many years, these Specialists have gained an expertise in a particular market segment. This may be a particular type of software company or an industrial niche such as scientific instruments. These companies usually operate only in just one geography and become a leader in that market.

Typical considerations before investing in these specialists are

r form the basis for consolidation opportunities in the years. The fact that it is a specialist in a particular

nt could potentially bring with it some regulatory risk,

we also need to consider before investing in these

nies.

neralists have a 180-degree opportunity set in terms of

ion opportunities. In many ways, they are portfolio

ers with very diversified portfolios of different companies.

wn companies that serve completely different end

s, customers and products. Consequently, these

ists have "unlimited" growth opportunities in terms of

w. Typical considerations before investing in Generalists

r internal M&A capabilities and how they organize

lves. Some of these holding companies own more than

ed

companies, and we often see the holding company

e itself with divisional CEOs in order to keep track of the

ing holdings. Market share is usually less relevant

e the holding companies do not consolidate a particular

nt. Therefore, regulatory risk is not relevant.

rea of acquisition-driven business models, you will also

ny companies that you should not touch. These

nies share some common characteristics. The

ion-driven business models you should be careful

g in make heavy use of equity to fund acquisitions.

You want growth at a high incremental return on capital. A pattern of falling return on capital is a sign that the company is paying too much for acquisitions. You want companies that generally do not expect synergies from acquisitions. You want companies with an owner operator and a lot of skin in the game.

With these companies, management tends not to guide the market on short-term earnings expectations. You should avoid companies that play the earnings expectations game, where companies play with sell-side analysts and "beat" consensus expectations by a penny each quarter due to earnings (mis)management. The companies you should favor are those with a high return on capital.

Turnarounds rarely turn around. You should prefer "programmatic" serial acquirers where the acquisition candidates are small and private companies. Be wary of companies that do few and large deals. The companies you should look for have their own "M&A department," often consisting of top management and some additional resources.

They do not use "M&A consultants." They often source their deals from local management of previously acquired companies and from long-standing relationships with brokers.

You should favor family-owned or publicly traded companies over purely institutionally owned companies. The characteristics of attractive and unattractive acquisition-driven compounders

o be argued that it has lower risk than a purely organic

strategy. There is a lot of value to be gained by investing

e acquisition-driven compounders. It is a strategy that fits

h investing in value creators.

stock market.

The value creation principles presented are a guide to investing that will stand the test of time. The entire capitalist system is based on the fact that companies that create value thrive and companies that destroy shareholder value die out. The book has tried to explain, without too much detail, what value creation is and why it is important to shareholders.

The book has also tried to give insight into how stocks are priced and how pricing depends on value creation. The stock market is very efficient, especially in pricing individual stocks in the short term. In the longer term, i.e. over several years or even decades, market participants find it difficult to correctly value strong compounders. Therein lies one of the many opportunities for you as an investor.

The opportunity for the long-term investor is to take a closer look and understand what great reinvestment opportunities at high returns can mean for your stock returns. At the end of the book,

as helped you gain some new perspectives on long-term

g in value creators.

2) The Joys of Compounding: The Passionate Pursuit of Lifelong Learning. Gautam Baid 3) The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. William Thorndike 4) 100 Baggers: Stocks That Return 100-to-1 and How to Find

Them. Christopher W. Mayer 5) Creating Shareholder Value: A Guide For Managers And Investors. Alfred Rappaport 6) Expectations Investing: Reading Stock Prices for Better Returns. Alfred Rappaport, Michael J. Maubossin 7) Corporate culture and performance. John P. Kotter, James L. Heskett 8) McKinsey&Company: Taking a Longer-term look at M&A value creation. January 1st 2012. 1000 nonbanking companies from 1999-2010

.

s of valuing stocks: nd the DCF model.

k focuses on al allocation. ents all boil down to introduce some the search for s and corporate