Return on Invested Capital - A Multi-Silo Approach

I paraphrase Sanjay Bakshi when he says, being a great operator or a great capital allocator are rare skills; being both is almost unheard of. Return on Invested Capital is the most basic value of a business' success - how much money have you made as a percentage of how much money you invested. ROIC (and it's cousin ROE) is typically used to value public companies because it is easily calculable. With a base level of capital (or equity) what are the company's earnings? The use of debt can help leverage the ROIC by using someone else's money to increase your business assuming it is cash-flow positive.

The problem with the common understanding of ROIC is it's limitation to being used to evaluate within silos, not across them. Sadly, this is a tenant of most video games (and game theory) that is often not correctly applied to real life. Save up coins or dollars or credits and the more you have, the more you can trade in for a benefit producing advantage.

For years, I have listened to Buffett speak along the lines of, "if I had a million dollar portfolio, I could easily return 50% a year". The misinterpretation of this statement is that he is implying the necessitation of stock picking. The most recent Shareholder's Letter has been widely quoted due to Buffett's lesson on his commercial real estate in New York and his farm in Nebraska. An individual with a million dollar portfolio has an advantage because of the greater market mispricings in illiquid and/or psychologically misjudged investments on a localized level. That individual does still have greater opportunities than the billionaire investor in financial markets due to size but why even bother? If one found a gas station for sale that had a ten-year track record of 50% ROIC, there is no point to even do security analysis. You can't beat that.

So where does your gas station investment leave you? After your first year, you have a 50% return (since you are such a good operator) that you must now allocate in order to obtain maximum IRR. For generalization sake, you have three options at this point:

1. Invest in something with a higher ROIC
2. Invest in something with equal ROIC
3. Invest in something with lower ROIC

While this may seem like a mundane answer to the question, the application in real life is very important to consider. Consider the scenario:

1. Invest in a better opportunity with a higher ROIC. On paper this sounds like a no-brainer but in actuality, you may find this hard to accomplish. The 50% I chose as base case was from an actual listing I was reviewing. Anything above 1 would certainly be a no-brainer (and possible when there is blood in the streets). 
2. Invest in an opportunity with the same ROIC. Naturally, your thought process would lead to more gas stations, which could increase your ROIC if efficiencies are obtained. Or invest in similar mispricing scenarios available to the smaller investor. 
3. Invest in opportunities with lower ROIC. Unfortunately, this is what the vast majority of people do. After experiencing high levels of ROIC, they protect their earnings by placing them in "safer" scenarios, which are often deemed safer by access to liquidity. This is mind numbing. You have an initial investment that with some degree of certainty, you can predict will return another 50% ROIC next year yet you decrease your IRR by investing in "safer" alternatives rather than trying to match or increase ROIC. 

Clearly, the elephant in the room is absolute return compared to ROIC. If you can get more money to your bottom line, than you should. Or should you? Should you ignore absolute return (possibly decreasing IRR for the short term), to maintain a high level of ROIC in the long run. By any reasonable argument, you should do the latter. This is the problem with size. As you get bigger, investments that maintain a high ROIC become more difficult. But there is a major difference between size of a Fortune 100 company and an individual investor. An individual investor, by definition, will never be too big for the investing universe to maintain his ROIC whereas one of the 100 largest companies in America (or the world) has almost reached the apex. Surely there will be physical limitations to the abilities of the individual investor (there can only be so many yogurt stores in one city) but reaching a point of fulfilling affluence should be easily obtainable without size limitations.

Sadly, Robert Kiyosaki's Cash Flow comes to mind but there is an important example to be made. In the game, you can invest in many different asset classes from securities to major developments. In the game, as in real life, there is a restriction on C, not on R. You only have so much capital to invest. Each step up you make in investable capital, more asset classes become available to you. For the very small investor, common stocks are probably the best opportunity for a good ROIC. As the investor grows, asset classes are unlocked. If you are able to invest in the gas station around the corner with a ten-year ROIC of 50% or a common stock with a ten-year ROIC of 50%, which is the better move? While there are many factors that could effect an individual's appetite for risk such as liquidity or capital appreciation, I would argue that circle of competence outweighs all others combined. You inherently know way more about the economics of your neighborhood than you do of a common share of a large corporation. Its a no brainer. By keeping your money that far within your circle of competence, you are able to eliminate risks inherit with public markets and the corporate governance of a public company. 

Insanity of Investment - LNKD

While I am quick to bash Facebook, Groupon, and Tesla today I will take on another of their ridiculously priced brethren, LinkedIn. LinkedIn is currently trading at a P/E of 860. 860. This is not a case of, "oh, they had a bad quarter" or "once they monetize, the earnings growth will be astronomical". This is a case of pure irrational exuberance.

Since it's IPO in 2011 where it reached, on day one, near $130 (closed around $94 for fairness sake), LNKD has returned 46% (100%) to investors. This, in the midst of one of the greatest market turnarounds in history, the SP has returned 43%. So LNKD has about matched the market return in three years (depending on how precise your market timing is). Where is the growth? Who actually is making money?

Where is the money? The money all went to the founders, angels, VCs, and investment banks in the IPO. The instant burst of liquidity (to a barely profitable company) allowed all of them to cash out for massive multiples over what the actual business is worth. Today, none of the founding five members own a reportable stake. Why anyone pays ridiculous multiples for a business that doesn't make any money is beyond comprehension.

So who is left holding the bill? The current shareholders of course. Mostly through mutual funds, which may or may not be choosing to own the stock. Many surely own it as a reflection of their "strategy", which mimics some indexable formula (Growth Stocks, Mid-Cap, Technology etc.). In order for LNKD to return to a market matching valuation (~19xE), earnings would have to increase 45x over. Immediately. Not in 5 or 10 years or a DCF would need to be applied compounding the growth astronomically bigger. How can an established company with market penetration and a monetization strategy possibly increase sales by that factor?

The growth is already in the price. It was from day one when the founders took the company public. Sure, the stock has increased since then but the economics of the business can't possibly continue the madness. When will LNKD in revert back to the mean? I have no idea but a due date lingers for this rocket ship.

Letter to Eddie Lampert (SHLD)

Edward S. Lampert

CEO and Chairman

Sears Holding Co.

What is the plan?

We, as shareholders of SHLD, are closing in on a decade since the merger of Sears and K-Mart in 2005. Over the last decade, we have watched both Sears and Kmart continue to fall from market leading positions and lose ground to traditional and online retailers alike. So I ask the question, what is the plan?

Myself, like I’m sure many other shareholders, bought into SHLD because of a belief that you, very personally, would right this ship. It was very clear for any shareholder to see that there was value to be unlocked through real estate or the brands. That is why we joined the cause. We, as shareholders, believed that you would do what was in the shareholders’ best interest.  We had faith in you. We have faith in the entity that you and Bruce control a majority stake in. What do we have to show for it?

The business is in a state of chaos. I have a Kmart and Sears within 5 minutes of my house. I have never been to either of them (in 8 years). The most recent shareholder’s letter verges on insulting due to your lack of understanding of branding and consumer behavior. The failure to invest in capital expenditures for the brick and mortar stores has forced customers to the likes of Wal-Mart and Target. If your customers don’t want to go anywhere near your physical locations, why on earth would they shop with you online given the proliferation of superior online retailers? Certainly Kmart and Sears brick and mortar stores still have markets that are captive and verge on monopolistic and therefore are able to convert customers to Shop Your Way customers but this can’t possibly be the strategic plan for the whole company, can it?

You posted on your blog at the beginning of the year about transformative companies. For ten years, SHLD has been lost in the shuffle as all of its competitors transform around it. Building an integrated online and physical platform is not transformative; it’s the norm. If you want this company to be transformative, make it disruptive. Change. Do something.

Everyday the value of the real estate portfolio becomes less valuable. The proliferation of empty commercial real estate (mall real estate especially) in America signals the exact transformative change you outline in your letter. There are hundreds of stores not making money, why are we behind the curve in making a real transformation and closing all of them immediately?

Mr. Chairman and CEO, what is the plan? The last ten years have seen remarkable opportunity costs go down the drain. How do we add value to shareholders over the next ten?

Thank You,

Jason M. Nista