An Introduction to Defensive Value Investing
We think investors persistently undervalue companies with genuine predictability.Nick Train
When I invest in a company my hope is that it can continue to grow far into the future, and while the future is always unknowable to some extent, we can at least try to glimpse into the future by looking at the past.
We began this process last month by calculating a company’s Growth Rate, based on the assumption that companies which have grown in the past are more likely to grow in the future.
That may be largely true, but in many cases it won’t be. To improve the odds that my investments will indeed grow consistently in the future, I look for past growth which is not only inflation-beating, but which is also high quality. And for me, high quality growth is both consistent and sustainable.
Measuring growth consistency
One way to measure growth consistency is to measure how frequently a particular factor increases over set period of time. We can easily apply that thinking to the factors we’ve already looked at, namely revenues, capital employed and dividends per share.
In my experience though, capital employed tends to increase quite consistently for most companies, or at least for growing companies, so there isn’t much difference from one company to the next.
A better way to separate out companies with consistent growth from those with inconsistent (or nonexistent) growth is to look at how often their earnings increase. Earnings are quite volatile for most companies, so if a business has inconsistent growth then it will definitely show up in its earnings.
That’s all there is to measuring growth consistency, so here’s a quick recap:
Steps to calculate growth consistency
As you might expect, I have some rules of thumb which help me avoid companies with relatively inconsistent growth:
Growth consistency rules of thumb
As with most things, these rules of thumb may require some judgement. I might still invest in a company where earnings go down as often as they go up, as long as there is a clear upward trend over time.
However, I’m unlikely to invest in a company if its earnings have declined for five or six years in a row.
Let’s work through a quick example of how to calculate growth consistency, after which we’ll take a look at growth sustainability.
Ted Baker’s consistent growth
We looked at Ted Baker’s consistent track record of dividend payments in week 1, so let’s expand on that and look at the company’s consistent growth across revenues, earnings and dividends.
|Year||Revenue PS||Earnings PS||Dividend PS|
Table 3.1: Ted Baker’s results for the ten years to 2018
If you look at Ted Baker’s 2018 results compared to its 2009 results, it’s easy to see that the company has grown. The data also gives the impression that Ted has grown consistently, but how consistently?
Let’s find out.
Calculating Ted Baker’s growth consistency
As you can see, Ted Baker’s growth consistency score to 2018 was an almost perfect 26 out of 27.
Only one EPS decline from 2011 to 2012 kept the company from having the maximum possible growth consistency, which is very impressive. This of course means that Ted Baker easily passes my growth consistency rule of thumb.
Next we’ll take a look at growth sustainability, because fast, consistent growth which is unsustainable is a disaster waiting to happen.
Measuring growth sustainability
Over the long-term, dividend growth is unsustainable without earnings growth, earnings growth is unsustainable without revenue growth and revenue growth is unsustainable without capital employed growth.
In practice this means companies can only produce long-term sustainable growth if they employ more capital to fund more factories, warehouses, vehicles, machines, robots, offices, computers and an endless array of other capital assets. Or to put it another way, if you’re looking for sustainable dividend growth, you should start by looking for sustainable capital employed growth.
What is sustainable capital employed growth?
Capital employed consists of equity capital, debt capital and leased capital, and these differ in terms of their risk profile and their sustainability. In other words, some forms of capital growth are better than others.
The easiest way for a company to grow capital employed is to grow its debt capital or leased capital. You simply take on more debt or lease obligations and, hey presto, you have access to another retail store or factory. Any idiot can do that.
However, growing capital employed primarily through increased debt and lease obligations can be risky. Those funding sources come with inflexible interest and rent costs, and if earnings growth doesn’t keep pace with interest and rent increases then eventually some sort of crisis is inevitable.
That leaves equity capital growth. This is typically the most sustainable form of capital growth because equity funding doesn’t come with fixed expense obligations. Of course, shareholders expect a return on their equity, but unlike debt interest or rent, those returns don’t have to be paid out in cash on a regular basis (management can choose to cut or suspend the dividend, although it may cost them their job).
We can break equity growth down into two parts:
- Equity growth from rights issues
- Equity growth from retained earnings
Rights issues occur when management ask shareholders for more money, in exchange for newly issued shares. Rights issues are often used to fund long-term investments where the returns on those investments are uncertain, with a prime example being acquisitions.
This can be sensible because it matches uncertain returns from the investment or acquisition with a funding source (equity) that has extremely flexible repayment terms (dividends are optional and equity funding is perpetual, i.e. it never has to be repaid).
Although using rights issues to fuel growth isn’t necessarily a problem, it can be if the amounts raised are very large. If a rights issue is used to fund a very large acquisition, the time and effort required to integrate the acquired company can be a serious disruption to the task of winning customers and fighting competitors.
A lower risk way for management to raise additional equity funding from shareholders is to simply retain earnings instead of paying them out as a dividend.
In most cases, growth driven by retained earnings doesn’t cause much operational strain because retained earnings are usually fairly small relative to existing capital. Another positive aspect of retained earnings is that, like equity raised through a rights issue, they don’t come with immediate cash costs like interest or rent.
This combination of a less disruptive growth rate and extremely flexible repayment terms is why retaining earnings is usually the most sustainable way to drive capital employed growth.
Calculating a sustainable growth rate
If retained earnings are the most sustainable driver of growth, we can use the rate of retained earnings to calculate a company’s sustainable growth rate. Here’s how it works:
Imagine we have a company with £100 million of equity capital, £50 million of debt capital and £50 million of leased capital. Total capital employed is therefore £200 million.
Over the next year the company produces £20 million of earnings and pays a £10 million dividend, so it retains £10 million of earnings.
That £10 million is added to the company’s existing £100 million of equity, leaving year-end equity at £110 million, an increase of 10%.
With a 10% increase in equity capital, the company has the funds to invest in more assets which should drive earnings growth. Management decide that with the increased earnings potential, taking on a proportional amount of additional debt and lease obligations is prudent.
A proportional increase means that management will increase debt and lease obligations by 10%, which is in line with the increase in equity. That would leave the degree of financial leverage (i.e. the ratio of debts and leases to shareholder equity) unchanged. And since equity, debt and leases are all growing at the same rate, total capital employed will grow at the same rate as equity.
This gives us the sustainable growth rate:
sustainable growth rate = retained earnings / equity * 100%
In other words, if a company produces a return on equity of 10% then 10% is its maximum sustainable growth rate, and the more it pays out as a dividend the lower its sustainable growth rate will be. To grow faster than this the company must either raise additional equity through rights issues or increase its financial leverage, both of which also increase risk.
This gives us a simple rule of thumb:
Growth sustainability rule of thumb
One problem with the sustainable growth rate is that it’s based on the assumption that existing debts and leases are sustainable, and that proportional increases in those financial obligations will also be sustainable.
That is quite a large assumption, so I prefer to use a more cautious version of the sustainable growth rate which I call the self-funded growth rate.
Calculating a sustainable self-funded growth rate
The self-funded growth rate is basically the same as the sustainable growth rate. The only difference is that instead of assuming debt and lease obligations can grow sustainably in proportion with equity, we assume that truly sustainable growth is funded purely by retained earnings.
This isn’t necessarily true, but it does give us a very conservative view of how a company should ideally fund its growth.
The calculation for the self-funded growth rate is:
self-funded growth rate = retained earnings / capital employed * 100%
In other words, if a company produces a net return on lease-adjusted capital employed of 10%, then 10% would be the maximum self-funded growth rate. As before, to achieve that growth rate the company would have to retain all earnings and pay no dividend at all.
If you see a company where capital employed growth consistently exceeds the self-funded growth rate, that growth has been at least partly driven by increasing external funds, primarily debts, leases and rights issues.
In many cases that will be quite reasonable. Most growing companies will be growing their earnings and so will be capable of increasing their debt and lease burdens, at least to some extent. However, if there is a very large gap between a company’s actual capital employed growth over several years and its self-funded growth rate, then that could be storing up problems for the future.
Let’s have another look at Ted Baker where we can see how these ideas play out in the real world.
Ted Baker’s sustainable and self-funded growth rates
As we’ve already seen, Ted Baker produced impressively rapid and consistent growth over the period from 2009 to 2018. Now we’ll check to see how sustainable that growth really is.
Table 3.1 contained the company’s earnings and dividends per share, so to calculate the sustainable and self-funded growth rates we’ll also need equity per share and capital employed per share.
|Year||Equity PS||Capital employed PS|
Table 3.2: Ted Baker’s equity and capital employed, 2009 – 2018
Using the figures from Tables 3.1 and 3.2, Ted Baker’s annualised Growth Rate for the 2009-2018 period comes out as 17.1%, with annualised revenue growth of 16.7%, dividend growth of 16.8% and capital employed growth of 17.9%, all on a per share basis. That is very rapid growth indeed.
Over the same ten year period, Ted produced average earnings of 66.4p and paid average dividends of 34.0p. This gave the company average retained earnings of 32.4p. Ted also had average equity per share of 285.1p.
We can use this information to calculate the company’s sustainable growth rate:
Calculating Ted Baker’s sustainable growth rate
With an actual capital employed growth rate of 17.9% and a sustainable growth rate of 11.4%, it’s clear that Ted Baker’s debt and leased capital must have increased faster than equity capital.
The implication is that Ted’s historic capital employed growth rate of 17.9% will not be sustainable in the longer-term, because eventually its debt and/or lease burden will become intolerable. And with such a large gap between actual and sustainable growth rates, there is a real risk that Ted’s rapid growth is putting a considerable strain on the company’s operations.
Let’s see how Ted’s actual growth compares to the more conservative self-funded growth rate.
Calculating Ted Baker’s self-funded growth rate
As a clothing retailer, Ted Baker makes use of a considerable amount of leased capital, primarily in the form of rented stores. These lease liabilities, along with the company’s growing debt pile, give Ted an average capital employed figure which is almost three-times its average equity.
This has a noticeably negative impact on its self-funded growth rate, which falls to 4.1% compared to a sustainable growth rate of 11.4%.
This self-funded growth rate says that if Ted Baker were to fund its growth purely from retained earnings and without increasing its debt or lease liabilities, then it would be able to sustain a growth rate of no more than 4.1%.
That’s a very long way short of the company’s actual 17.1% Growth Rate, which highlights just how much the company has depended on higher risk external funding to fuel its rapid growth.
But as I’ve said before, not all external funding is bad, and some use of external funding is quite sensible for most companies. So while fully self-funded growth may be the ideal, what we should really be interested in is the degree to which external funding from debt, leases or rights issues has been used to drive growth.
We can measure this with the growth funding ratio.
The growth funding ratio
One way to measure the degree of external growth funding is to compare the amount of additional external funding taken on to the total amount of earnings produced over a period of time.
The higher the ratio of external growth funding to earnings, the less sustainable the company’s growth has been.
Here’s the calculation:
Calculating the growth funding ratio
A negative growth funding ratio means that all of the companies growth either was or could have been funded by retained earnings. A positive growth funding ratio means that retained earnings alone where not enough to drive the companies actual growth, so additional external funds were required.
As with most ratios, the growth funding ratio provides a more meaningful result when it’s taken over a five or ten year period, so let’s calculate a ten-year growth funding ratio for Ted Baker.
Ted Baker’s growth funding ratio for 2009-2018
To calculate Ted’s growth funding ratio we’ll need its earnings, dividends and capital employed for the period, all of which we already have in Tables 3.1 and 3.2.
Calculating Ted Baker’s 10-year growth funding ratio
Ted’s growth funding ratio is over 100%. In plain English that means it raised more external funds to drive growth than it make in profit over those ten years.
That’s a lot of additional funding and it shows up in the company’s financial statements. They show that Ted’s debts went from zero to £129 million between 2009 and 2018 while lease liabilities went from £100 million to £276 million.
In late 2019 and early 2020, Ted Baker surprised investors with a string of profit warnings, a dividend cut and then a full dividend suspension.
Tough trading conditions were blamed, but I think the company’s aggressive use of external funds to drive growth far above its self-fundable and sustainable growth rates was the underlying root cause.
Rapid growth requires lots of new stores, new staff, new supply chain partners, new customers, new processes, new management and so on, and all of these have to go through a long and expensive experience curve before they can operate anywhere near optimally. Combine all this newness with rapidly increasing debt and lease obligations and it’s no wonder Ted Baker eventually ran into serious problems.
To use a driving analogy, growing too fast like driving too fast. It doesn’t matter how safe the car is. Even the sturdiest Volvo will crash and burn if it’s being driven far too fast down a bumpy, twisty road late at night.
In my experience, a growth funding ratio of 100% or more is very likely to cause operational problems at some point. Most companies find it impossible to absorb that sort of growth strain without producing cracks which will eventually cause the company to crumble.
When I’m investing in a company I’m quite comfortable seeing some degree of external growth funding, but if the growth funding ratio gets anywhere near 100% then I’ll just skip over the company and look elsewhere.
Here’s my associated rule of thumb:
Growth funding rule of thumb
Turning growth consistency and sustainability into Growth Quality
To fit this ratio into the Growth Quality metric in place of the existing “number of years the dividend was covered” component, it would be useful to express it as a range from zero to ten, just like the number of years of dividend cover.
First off, it seems sensible that a company with fully self-funded growth should have the maximum score of 10.
As for a score of zero, I looked at a range of companies and, in the end, Ted Baker’s funding deficit of -1,000% seemed to be a good example of imprudently rapid growth. So a company will have a “self-funded growth rating” of zero if its funding gap to earnings ratio is -1,000% or less. In other words, if it used more than ten-times as much external funding as its average earnings.
In between these two extremes, a company with a funding deficit to earnings ratio of -100% will score 9, -200% will score 8 and so on down to -1000% or less scoring zero.
With this change in place, Growth Quality will now be negatively affected by growth that is simply too fast for the company to self fund. I think this is an important improvement over the old model, which implied that more growth was always better, regardless of the stress put on the balance sheet.
Dividend cover is still taken into account
If you’re worried about the removal of the dividend cover component of Growth Quality then you may be glad to know that dividend cover is a key aspect of self funded growth. If the dividend isn’t covered in a given year then the retained earnings figure is negative, which will in most cases require an increase in external funding to replace the capital outflow. That will show up as a weaker self-funded growth rating.
Growth Sustainability rule of thumb
Calculating Growth Quality
say something about bringing growth consistency and growth sustainability together to make the Growth Quality score.
To calculate Growth Quality we need a company’s capital employed, revenues, earnings and dividends per share going back over the last ten years. By this stage in our analysis we should already have all these figures to hand.
Once we have the data, we can take the following steps to calculate Growth Quality:
Don’t worry if that looks complicated as we’ll be working through an example shortly. And also don’t forget there are links to spreadsheets which can do the calculations for you on the Free Resources page.
Once again I have a rule of thumb for growth quality, which should help to rule out companies whose growth is too volatile for a relatively defensive portfolio.
Growth Quality rule of thumb
Let’s have a look at how the Growth Quality score works in the real world with an example.
Burberry’s Growth Quality
I’ll use Burberry because it’s a good example of a company with high Growth Quality. Table 2.1 shows Burberry’s revenue, earnings and dividends per share up to its 2018 annual results.
Table 2.1: Burberry’s ten-year results to 2018
I don’t think it’s very easy to get a feel for the quality of Burberry’s growth just by looking at a table of numbers like this. Everything seems to be going up steadily, but earnings were negative in 2009, so there are definitely some issues lurking in the data. This confusion is precisely the sort of problem the growth quality score is designed to solve, or at least reduce.
By converting all those revenue, earnings and dividend figures into a single Growth Quality number it becomes much easier to understand how consistent Burberry has been; that in turn makes it much easier to compare Burberry to other companies.
I’ll calculate Burberry’s Growth Quality score step by step to show you how it works:
Calculating Burberry’s Growth Quality
86.5% is a very high Growth Quality score. It reflects the fact that Burberry has produced some of the most consistent and broad-based growth of any FTSE 100 company.
Also, note that Growth Quality as a number is divided by 37 to turn it into a percentage. 37 is the maximum possible score (nine increases each of revenues, earnings and dividends per share, plus dividends covered ten times), so a company with a Growth Quality number of 37 would have a growth quality score of 100%.
Next week I’ll outline how I look for companies with above average profitability, because high profitability is one of the best indicators of a company with strong competitive advantages.
Here’s a summary of the growth rules we’ve covered this week.
Growth Quality rules of thumb