Good companies can be bad investments

Conversely, bad companies can also be good investments. Here's some advice on how to be smart about it.
By Guest |  31-03-17 | 
 
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Professor Aswath Damodaran believes that there are a lot more bad companies with bad managers than good companies with good ones in the public market place. In this post, he draws a distinction between good companies and good investments, arguing that a good company can often be a bad investment and a bad company can just as easily be a good investment. And, that not all good companies are well managed and that many bad companies have competent management. The following post is an excerpt from his blog

Investment advice often blurs the line between good companies, good management and good investments, using the argument that for a company to be a "good" company, it has to have good management, and if a company has good management, it should be a good investment. That is not true. To see why, we have to be explicit about what makes for a good company, how we determine that it has good management and finally, the ingredients for a good investment.

Good and bad companies

There are various criteria that get used to determine whether a company is a good one, but every one of them comes with a catch.

You could start with profitability, arguing that a company that generates more in profits is better than one that generates less, but that statement may not be true if the company is capital intensive (and the profits generated are small relative to the capital invested) and/or a risky business, where you need to make a higher return to just break even.

You could look at growth, but growth can be good, bad or neutral for value and a company can have high growth, while destroying value.

The best measure of corporate quality, for me, is a high excess return, i.e., a return on capital that is vastly higher than its cost of capital, though I have noted my caveats about how return on capital is measured.

Reproducing my cross sectional distribution of excess returns across all global companies in January 2017, here is what I get:

GlobalExcessReturnPicture

To the extent that you want the capital that you have invested in companies to generate excess returns, you could argue that the good companies in this graph as the value creators and the bad ones are the value destroyers. At least in 2017, there were a lot more value destroyers (19,960) than value creators (10,947) listed globally!

Good and bad management

If a company generates returns greater (less) than its opportunity cost (cost of capital), can we safely conclude that it is a well (badly) managed company?  Not really! The “goodness” or “badness” of a company might just reflect the ageing of the company, its endowed barriers to entry or macro factors (exchange rate movements, country risk or commodity price volatility).

The essence of good management is being realistic about where a company is in the life cycle and adapting decision making to reflect reality.

If the value of a business is determined by its investment decisions (where it invests scarce resources), financing decisions (the amount and type of debt utilized) and dividend decisions (how much cash to return and in what form to the owners of the business), good management will try to optimize these decisions at their company. For a young growth company, this will translate into making investments that deliver growth and not over using debt or paying much in dividends. As the company matures, good management will shift to playing defense, protecting brand name and franchise value from competitive assault, using more debt and returning more cash to stockholders.

At a declining company, the essence of “good” management is to not just avoid taking more investments in a bad business, but to extricate the company from its existing investments and to return cash to the business owners. My way of capturing the quality of a management is to value a company twice, once with the management in place (status quo) and once with new (and "optimal" management).

management quality

I term the difference between the optimal value and the status quo value the “value of control” but I would argue it is also just as much a measure of management quality, with the value of control shrinking towards zero for “good” managers and increasing for bad ones.

Good and bad investments

Now that we have working definitions of good companies and good managers, let’s think about good investments. For a company to be a good investment, you have to bring price into consideration. After all, the greatest company in the world with superb managers can be a bad investment, if it is priced too high. Conversely, the worst company in the world with inept management may be a good investment is the price is low enough. In investing therefore, the comparison is between the value that you attach to a company, given its fundamentals and the price at which it trades.

Price vs value good companies

As you can see at the bottom, investing becomes a search for mismatches, where the market's assessment of a company (and it's management) quality is out of sync with reality.

Screening for mismatches

If you take the last section to heart, you can see why picking stocks to invest in by looking at only one side of the price/value divide can lead you astray. Thus, if your investment strategy is to buy low PE stocks, you may end up with stocks that look cheap but are not good investments, if these are companies that deserve to be cheap (because they have made awful investments, borrowed too much money or adopted cash return policies that destroy value). Conversely, if your investment strategy is focused on finding good companies (strong moats, low risk), you can easily end up with bad investments, if the price already more than reflects these good qualities.

In effect, to be a successful investor, you have to find market mismatches, a very good company in terms of business and management that is being priced as a bad company will be your “buy”. With that mission in hand, let’s consider how you can use multiples in screening, using the PE ratio to illustrate the process. To start, here is what we will do. Starting with a very basic dividend discount model, you can back out the fundamentals drivers of the PE ratio:

PE fundamentals

This equation links PE to three variables, growth, risk (through the cost of equity) and the quality of growth (in the payout ratio or return on equity). Plugging in values for these variables into this equation, you will quickly find that companies that have low growth, high risk and abysmally low returns on equity should trade at low PE ratios and those with higher growth, lower risk and sold returns on equity, should trade at high PE ratios. If you are looking to screen for good investments, you therefore need to find stocks with low PE, high growth, a low cost of equity and a high return on equity.

Using this approach, I list multiples and the screening mismatches that characterize cheap and expensive companies.

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If you are wondering about the contrast between equity risk and operating risk, the answer is simple. Operating risk reflects the risk of the businesses that you operate in, whereas equity risk reflects operating risk magnified by financial leverage; the former is measured with the cost of capital whereas the latter is captured in the cost of equity. With payout, my definition is broader than the conventional dividend-based one; I would include stock buybacks in my computation of cash returned, thus bringing a company like Apple to a high payout ratio.

The bottom line 

Separating good companies from bad ones is easy, determining whether companies are well or badly managed is slightly more complicated but defining which companies are good investments is the biggest challenge.

Good companies bring strong competitive advantages to a growing market and their results (high margins, high returns on capital) reflect these advantages. In well managed companies, the investing, financing and dividend decisions reflect what will maximize value for the company, thus allowing for the possibility that you can have good companies that are sub-optimally managed and bad companies that are well managed. Good investments require that you be able to buy at a price that is less than the value of the company, given its business and management.

Thus, you can have good companies become bad investments, if they trade at too high a price, and bad companies become good investments, at a low enough price. Given a choice, I would like to buy great companies with great managers at a great price, but greatness on all fronts is hard to find. So. I’ll settle for a more pragmatic end game. At the right price, I will buy a company in a bad business, run by indifferent managers. At the wrong price, I will avoid even superstar companies.

At the risk of over simplifying, here is my buy/sell template:

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Aravind Sankeerth
Apr 2 2017 01:16 PM
This feels a bit too academic and proof like rather than realistic. Any one who spends a decade in the market probably knows the cycles and how the winds blow from exceptionally high quality at the 1st to dogs and cats at the fag end.
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