The Reinvestment Illusion

A business’s ability to reinvest is critical to the long-term performance of a stock — Without reinvestment, returns cannot compound — Quality businesses have high return reinvestment opportunities.

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THE REINVESTMENT ILLUSION (Reinvestment Part II)

A business’s ability to reinvest capital is critical to the long-term performance of a stock. Without high return reinvestment opportunities, a business cannot be considered high quality. Too often, investors believe a business to be high quality, but base this conclusion exclusively on outdated historical information.

The ROIC Illusion

Warren Buffett has been professing the benefits of “high returns on capital” for decades. Metrics such as ROIC and ROE have come to define the term “Quality” for many stock pickers. But these metrics can be an illusion.

Return metrics calculated using a business’s balance sheet reflect historical performance. High ROE means a company has been successful in the past. Looking forward, if a business cannot continue to invest at historical levels of profitability, the fundamentals of the business will erode.

More interesting than ROIC, but still not perfect, would be marginal ROIC, the return on the last dollar of capital reinvested. Although this data is rarely clean enough for analysts to draw clear conclusions, theoretically, investors should look for businesses with stable or growing marginal ROIC. This would ensure than the business’s profitability metrics would persist in the future.

But even calculating marginal ROIC only captures historical investments. To be forward-looking, investors need to speak with management to understand the potential returns earned by each incremental dollar of spending.

The Conundrum

Management teams know the difficulty in finding high return reinvestment opportunities. But when opportunities are lacking, management teams rarely admit it. In the absence of attractive opportunities, management teams often take a "reinvest and hope" approach.

To be fair, the public equity markets often force management’s hand. Admitting a lack of reinvestment opportunity is often deeply disappointing to public market investors. Few businesses with an admitted lack of reinvestment opportunity maintain a premium valuation. So capital is reinvested.

Management reinvests capital on the shareholders behalf, hoping for worthwhile returns. Capital spending, mergers and acquisitions, and growing cost bases are all avenues for reinvestment dollars. PP&E and goodwill write-offs, restructuring charges, and desperate divestitures are ways in which a management team is shown to have reinvested poorly.

Even businesses that appear to be disciplined in their capital allocation often fail on the reinvestment front: investing at or above a WACC is not a high bar when interest rates are low. Yet management teams continue to plow capital into projects that offer WACC-level returns, often single digit.

Value Reinvestment

Value investors face a challenge in that many value businesses have few reinvestment opportunities. In slow growing markets, there is only so much needed capacity. Even if a business has capital to invest, there may not be a profitable way to deploy it.

Most value stocks pay dividends, effectively admitting an excess of capital and little reinvestment opportunity. For the most hated value stocks, share buybacks can create a synthetic reinvestment opportunity, but only for businesses trading at truly desolate valuations.

Too often equity analysts get excited about buybacks that may only yield investors 4-6% returns on their capital, typically below a business’s ROIC for high quality businesses. While the market cheers buybacks, this is poor marginal reinvestment.

Acknowledging the Illusion

High quality businesses are not defined by yesterday’s return metrics. Moats, network effects, culture, customer captivity, and/or economies of scale are irrelevant in the absence of high return investment opportunities.

Once a business runs out of profitable reinvestment opportunities, excess capital must be returned to shareholders. If it is not, the profitability of the business will erode as these low return opportunities are pursued.

High quality businesses acknowledge the illusion, allowing for prudent capital allocation. After all, not every dollar of capital must be reinvested. Most businesses can thrive with a combination of shareholder returns, via dividends or buybacks, while still reinvesting a portion of retained earnings at attractive rates.

Truly High Quality Businesses

This acknowledgement creates an environment supportive of proper capital allocation. High quality businesses have shattered the illusion of reinvestment and are clear-eyed in their decision making. Money is not blindly allocated to yesterday’s high return investments without a careful review of future potential. Long-term opportunities are nurtured, despite public market pressures, if they offer the opportunity for productive reinvestment.

Reinvestment opportunities determine a business’s future. Understanding the critical nature of reinvestment, and its importance to the underlying quality of a business, hones an equity analyst’s focus and provides insight into a business’s future potential.