Charlie Munger once said: Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 30 years and you hold it for those 30 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 30 years, even if you pay an expensive looking price, you'll end up with a fine result.”
This analysis looks at the drivers of economic earnings: Return on invested capital (ROIC), Net operating profit after tax (NOPAT) margin, invested capital (IC) turns, and weighted average cost of capital (WACC) for the S&P 500 and each of its sectors, their values below are averages to 30 June 2021 for the last 12 years (from 01 July 2009) as taken from New Constructs and Stern School of Business. 10 years performance is to 31 August 2023, as taken from the iShares.com website. I am aware that the periods do not coincide, but we also look at how the drivers for economic earnings could be used to forecast future investment returns.
For people not familiar with ROIC decomposition, this could be calculated as NOPAT multiplied by IC Turns. It helps to figure out where the high (or low) return on capital invested comes from: a high margin or a high turn of capital. For example, you could see that although net margins for Consumer Staples are relatively low, they manage to have a high turnover, and still achieve a good ROIC. As an example: Costco’s business with very low margins, but very high turnover.
In short, it could be observed that sectors with high ROIC have high investment returns, and those with low ROIC have low investment returns, exactly as Charlie Munger explained above, many years ago. The other thing that counts for performance is if you buy the stocks cheap or expensive. For example, you could argue that Technology was quite cheap 10 years ago. Even if it was trading at double the shares prices in 2013, the return would have been above 12.50%, in line with the market. Separately, for financials, even if their ROIC was a lot lower after the Global Financial Crisis (GFC), their return was higher than the ROIC, given that 10 years ago financials were very, very cheap (9.85% per annum return versus 6.90% ROIC). However, being cheap was not enough to beat the S&P 500 and the financial sector still underperformed.
Telecom was probably the worst sector to be in, due to people cutting the cord (Comcast), and very low ROIC for the big three (Verizon, T-Mobile, and AT&T). For example, in its search to boost its ROIC, AT&T made some dreadful acquisitions, loosing tens of billions in the last few years when it divested them at high discounts.
After the GFC, U.S. banks and insurers (over 90% of financial sector) were subject to higher regulation and required to hold more capital. As a result, their Return on Tangible equity dropped significantly. Even if they were cheap 10 years ago, the sector did not beat the S&P 500.
There is also well-established research by Fama and French explaining that companies affected by regulation, do not show outperformance, which explains the low ROIC for the utility and energy sectors, and some other infrastructure companies: railways, toll roads, and airports. This seems the be something that started to affect the banks too. In Europe, there seem to be now a different type of Government interference, higher taxation of profits for utility and energy companies (when these companies managed to get higher profits), and even higher taxation for banks (Italy). This usually manifests in the utility and energy sectors.
Sectors with low ROIC and heavily leveraged would have another issue due to the recent increase in interest rates. It is known some sectors carry a lot of debt: real estate, telecom, basic materials, energy, and utilities, even some industrials and healthcare businesses. The last thing these businesses would need is a cost of their debt above their ROIC, as this would mean paying more in interest then they make in net earnings when using that borrowed capital. This type of leverage leads to bankruptcy, and even if these businesses may escape bankruptcy, their investors would not get a good investment return in the future.
We prefer to invest in businesses and sectors with a lower level of debt, preferably no debt at all. Having no debt allows a company a lot of freedom in case competition tries to enter their field. As a result, a defensive strategy is a lot easier to implement, when compared with a company which is very leveraged.
In short, technology, consumer staples, consumer discretionary, healthcare sectors, and part of the industrial sector show higher ROIC and outperform the other sectors. There is the risk that Governments would try to regulate the healthcare sector, with a view to reduce the prices for treatments. The temptation is huge, although the result would be a reduction of investment in the sector, leading to less progress in this field.
One explanation is that repeat business, usually from consumers, sustains a higher rate of return. For comparison, capital goods companies sell to businesses, which employ staff specialised in acquisitions, whose main job is to drive down the cost of purchase and lengthen the payment term. These are also cyclical; companies could postpone buying until economic growth resumes.
As we explained before, it is not enough for companies to earn a high rate of return. These companies must also be able to reinvest a portion of their net profits back into the business at similar ROIC rates. Over time this will deliver very high investment returns for the investors.
Stronger portfolio design leads to better outcomes for investors. At N2 Asset Management Limited we have kept the same principles, thinking, and structure that made our investment proposition so successful in the past.
IMPORTANT NOTE: Past performance is not a guide for future returns. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.