Up to this point we have been careful to emphasize the word “poten- tial” when referring to buy or sell opportunities. This qualification is necessary because market implied expectations of economic profit growth (even if positive) might already be reflected in share price. For example, we recognize that “good” companies that show up in Quad- rants II and IV of the company growth and value matrix (Exhibit 11.7) can have good or bad stock characteristics. To illustrate this, Exhibit 11.8 shows the “Excess Return on Invested Capital” versus the “Market Value of Invested Capital to Replacement Cost of Invested Capital”17 for a sample of companies that we track at GAM USA.
17Note that the “excess return on invested capital” is equivalent to the EVA-to- capital ratio as well as the EVA spread. Also, the use of market value-to-replacement cost of invested capital is really just a scaling on our previous usage of the NPV- to-capital ratio.
In this exhibit, the excess return on invested capital is simply the after-tax return on invested capital less the cost of capital. This is just the EVA spread that we defined before. Also, we report the market value of invested capital (or enterprise value) relative to replacement cost of capital for consistency with the traditional way of evaluating companies in profitability versus “price-to book” context. There is no slippage of economic profit focus because the market value of invested capital-to- replacement cost of invested capital ratio is directly related to the NPV- to-invested capital ratio that we explained before.18
Exhibit 11.8 shows a scatter plot of “good” companies (culled from an Exhibit 11.7 analysis) measured relative to a curve through the data points. Points in the exhibit that lie above the curve are considered to be buy opportunities, while data points that fall below the curve represent
18Recall that the enterprise value-to-capital ratio can be written as:
V/C = 1 + NPV/C
In this expression, V is enterprise value (or market value of invested capital) and C is a measure of invested capital. Hence, V/C is greater than one when NPV is posi- tive, while V/C is less than unity when NPV is negative. The market value of invested capital-to-replacement cost of invested capital is also a measure of “Tobin’s Q.”
EXHIBIT 11.8 Excess Returns Relative to Valuation
sell or short sell opportunities.19 For companies that plot above the curve, Exhibit 11.8 shows that at such excess return on invested capital positions, the companies should command a higher valuation. If correct, this upward revaluation is reflected in a rise in the Value-to-Capital ratio.
In this case, internal or warranted expectation of economic profit growth is higher than market implied EVA growth imbedded in stock price.
Specifically, while the capital market expects compression in future economic profit down to the curve (Exhibit 11.8) for any given market value-to-replacement cost of capital ratio, internal expectations of eco- nomically profitable reinvestment for combinations above the curve imply a higher valuation for a company’s stock. Astute investors can therefore expect to earn risk-adjusted returns on stocks that plot above the curve because of the fortuitously positive (and presumed consistent) economic profit position of these companies.
In contrast, companies that plot below the curve represent sell or short sell opportunities. Exhibit 11.8 suggests that these firms should command a lower relative valuation. In this case, internal expectation of economic profit growth is lower than market implied growth imbedded in current stock price. Here, the capital market incorrectly expects an upward revi- sion in economic profit to the curve for any given market value of invested capital-to-replacement cost of capital ratio. However, consistently low expectations of economically profitable reinvestment for companies that fall below the curve imply a lower valuation. Active-minded investors should look elsewhere if they are restricted to a “long only” strategy, while they should consider a “long-short” strategy if shorting is permissible.
Hence, the stocks of companies that plot above the curve (Exhibit 11.8) are viewed as buy opportunities, while stocks that plot below the curve are viewed as sell or short sell opportunities. In practice, the quan- titative insight should be tempered by qualitative considerations that impact the actual trading decision. This additional research is necessary because the data points in Exhibit 11.8 are constantly changing over time. Moreover, we now see that the economic profit approach to invest- ing—on both the long and short side—emphasizes three key elements:
expected EVA spread, capital formation, and the reconciliation of actual- versus-market-implied expectations of economic profit growth.
19The buy or sell recommendations in Exhibit 11.8 presume that we are focusing on
“good” companies that show up in Quadrants II and IV of Exhibit 7. This joining of exhibits recognizes that there are good companies with “good” or “bad” stock char- acteristics (buy or sell opportunities). Note that companies in Quadrants III and I of the company growth and value matrix (Exhibit 11.7) were previously identified as (short) sell-to-avoid opportunities, respectively—although in practice, even these sell considerations can be tempered by finer distinctions regarding fundamentals versus valuation in the event of anticipated management change or takeover.
SUMMARY
We argue in this chapter that the discovery of good companies and bad companies—buying and selling opportunities—should be grounded in the fundamentals of wealth creation. Good companies are pointing in the direction of economic profit creation while bad companies are point- ing in the direction of economic profit deterioration. Along the way, we argue that the decision to buy or short sell securities should be based on (at least) three economic profit criteria: namely, the expected EVA spread, capital formation (positive or negative), and the reconciliation of actual versus market implied expectations of economic profit growth imbedded in share price. We believe that with an EVA research plat- form, investors will have a robust framework for buying and selling securities that is consistent with economic profit and NPV principles espoused in the theory of finance.
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Long-Short Equity Portfolios