In their attempt to buy stocks cheap, investors often fall into what are popularly called “Value Traps” – a seemingly good business at cheap valuations becomes cheaper and cheaper as the business destroys value. The folks at Eagle Point Capital provide us a framework to spot such traps and avoid them. They call it the Cash In, Cash Out framework:
“We are trying to answer a simple two-part question: how much cash does the business reinvest and what are the returns on the reinvested cash? We prefer to work from cash flow statements, as normally cash doesn’t lie and it is much more difficult to manipulate than GAAP earnings or balance sheet figures. Just don’t forget to consider stock compensation, which is a very real expense.
I like to look at ten year increments and add up how much cash came into a business from all sources – operating cash flow, debt issuance, and share issuance – versus how much cash left the business via debt repayments, share repurchases, and dividends. Add the two together and you get the dollar amount of cash retained (from all sources) over that time period.
Next, we look at the cumulative profits over the same time period to get an idea what the reinvestment rate is as a percentage of total operating profits. Finally, by looking at the change in operating profits (often this requires some normalization) over the time period and dividing by total retained profits we can assess incremental returns on retained capital (incremental ROIC or I-ROIC). If profits grew by $1B and it took $5B of retained capital to generate that extra $1B, I-ROIC is 20% ($1B/$5B). Reinvestment rate and I-ROIC, in conjunction with shareholder yield, tell me roughly how the business has compounded in value on a per share basis.”
They then give examples of three companies which proved to be value traps in this framework:
“Ford has the pleasure of operating in a brutally competitive and commoditized industry subject to constant technological change and heavy capex requirements. The business is thrown curveball after curveball. Over the past decade the business has reinvested more than all of its profits at a modestly negative return. This is the definition of treading water. Thanks to the use of debt the stock has generated a 4% yield meaning the business (not shareholders, though) eked out a small annual return.
Verizon is puzzling to me as I would expect it to be a better business given it operates in a lightly regulated oligopoly with hard to replicate assets. Alas. The company soaked up 90% of earnings over the last ten years and barely grew for a measly 1% compounding rate. A generous debt-fueled dividend payout took business returns to an underwhelming 6%. While the yield seems attractive, a high dividend payout cannot go on forever if it’s driven by increasing levels of debt.
Macy’s has been a disaster. Left behind by better positioned specialty retailers and ecommerce businesses, Macy’s reinvested a third of profits at highly negative rates and has become far less valuable over the past decade, as you can see.
Old Dominion, on the other hand, is a beast. The company competes in a tough industry (trucking) but has out maneuvered the competition, invested in hard to replicate trucking terminals, and executed exceptionally well. Overall the business has reinvested almost 60% of earnings at around 30% incremental returns for an exceptional ~17% annual compounding rate, which becomes close to 20% with shareholder yield included.”
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