Whilst this piece is written in the context of investing in the United States, it gels nicely with Marcellus’ investment philosophy. That apart, the piece elegantly explains the benefits of “Identifying, buying and holding very good businesses over a long period of time can help deliver good returns. While there is no universal template, founder-led businesses and those generating strong returns on capital appear to have a correlation with long-term returns.”
The piece begins by explaining that the returns a stock generates for you is directly proportional to the company’s Return on Capital. This should be an obvious point but it wasn’t until Charlie Munger made it so three decades ago by saying: “It is hard for a stock to earn a much better return than the business that underlies it.” The Seeking Alpha blogger then highlights “Intuitively, this makes sense, because the cash generation that occurs from the business earning high returns on assets can be put to work to further invest in new opportunities and create additional assets that can, in turn, earn higher returns for the business.
It’s a virtuous cycle of steady and aggressive compounding at high rates of return that can contribute to long-term wealth creation. Various quantitative research studies confirm and support this idea. A study by Forbes found almost a 60% correlation between returns on invested capital and stock returns for a business.” The authors then shows a super chart from Forbes showing a R-squared of 57% (with EV on the vertical axis and ROIC on the horizontal axis).
The blog goes on to highlight that such free cash flow generating businesses find themselves in a very strong position when exigencies like Covid come to the fore: “While businesses like United Airlines (UAL) and Ford (F) have had to request government assistance or contemplate other costly strategic capital-raising initiatives, businesses like Alphabet (GOOG, GOOGL) and Facebook (FB) that have $150 billion and $50 billion in cash reserves respectively have been able to get by without needing to resort to any such measures.”
Thirdly, and perhaps most interestingly, the blog highlights research done in the US by Bain, the management consultancy, that Founder-led businesses outperform CEO-led businesses: “Research from Bain & Company suggests that the returns of publicly listed, founder-led businesses are significantly higher than those that are governed by a professional ‘corporate manager’: “Some of this is just because founders have their incentives better aligned with shareholders, with founder CEOs such as Marcos Galperin of MercadoLibre having close to 10% of his net wealth in the business.
However, it’s not just the equity alignment that is important, it’s also the vision and strategic direction that these founders bring to the business. I believe that this is particularly relevant in new markets, where value is created through the power of disruption or challenging status quo.
Founders in new markets tend to have very deep expertise in their particular industries and a vision for how those industry should be transformed and operate. MarketAxess (MKTX) founder Rick McVey noticed a pain point in the inefficiency of bond transactions, with a direct buyer-to-seller relationship not allowing for optimal bond price discovery and creating transaction inefficiency. Twilio (TWLO) founder Jeff Lawson had a vision of telecommunications being brought to the masses quickly and efficiently in a scalable way, rather than developers having to deal on a case-by-case basis with complex telecom carrier negotiation.”
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
