AN ACTIVE APPROACH TO SUSTAINABLE EQUITY RETURNS

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1 JANUARY 2015 COUNTING ON CASH AN ACTIVE APPROACH TO SUSTAINABLE EQUITY RETURNS David Dalgas Chief Investment Officer, Global Core Equity Kenneth Graversen Portfolio Manager and Senior Research Analyst, Global Core Equity Klaus Ingemann Portfolio Manager and Senior Research Analyst, Global Core Equity IN THIS PAPER: Cash is a powerful indicator for equity investors. Unlike accounting earnings, which are often misleading, cash flows provide a clear picture of a company s underlying performance. When combined with detailed fundamental research on a company and industry, cash can provide effective intelligence on a company s future growth and stock price appreciation potential. In this paper, we present case studies to show how an investment approach focused on cash flows can identify companies that generate strong and sustainable equity returns. For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.

2 CASH FLOWS POINT THE WAY For a company that is the global market leader in cosmetics, L Oréal had no way of putting any gloss on its outlook in late CEO Jean-Paul Agon announced in November that third-quarter sales would advance by only 2.3% on a like-for-like basis, far below analyst estimates. It was turning out to be the company s worst year since But viewed through another lens, investors could see a very different story. L Oréal s cash flows have remained high and stable for more than a decade even through challenging periods after the global financial crisis. Resilient cash flows, along with a broader fundamental analysis, indicated that L Oréal s underlying business remained intact and was likely to deliver solid growth and investment returns over the long term. DISPLAY 1: L ORÉAL: CFROI SIGNALS A ROBUST BUSINESS MODEL CFROI (Percent) E 2015E As of December 31, 2014 Source: Credit Suisse and AB CFROI is a trademark or registered trademark of Credit Suisse Group AG or its affiliates in the US and other countries. 2 For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.

3 L Oréal is a good example of how to select stocks using a cash-flow approach. We measure a company s cash-generating track record by looking at its cash-flow return on investment (CFROI): essentially the annual percentage rate of return produced by a company s net cash flows over time (see box CFROI: How Does It Work? on page 5 for a more detailed explanation). Over the past decade, L Oréal s CFROI has remained at or above 20% (Display 1), compared with an average of about 12% for global equities. About 40% of its business is in emerging markets, which is likely to drive future growth. And the company benefits from global brand recognition and a perception of quality that supports high pricing for its products and fuels profitability. In our view, all of these traits which underpin dependable high cash flows suggest that L Oréal should be able to withstand a bout of market turbulence and return to its path of long-term growth. We believe that using cash metrics rather than accounting earnings helps identify companies generating strong and sustainable returns. When combined with detailed research on industry and company fundamentals like revenue trends, margins, competitive positioning and balance sheet health, it helps investors obtain effective intelligence on a company s future growth and stock price appreciation potential. WHY IS CFROI IMPORTANT? CFROI might not be a standard component in an equity investor s tool kit. Yet our research shows that global stocks with high and stable CFROI have outperformed the MSCI All Country World Index and delivered stronger risk-adjusted returns over time (Display 2). We believe there are several clear benefits to putting CFROI at the heart of an investment process. + + Cash is transparent Accounting indicators of a company s performance can be misleading. For example, earnings can be inflated by accounting decisions on revenue recognition. But generally speaking, cash provides a reliable depiction of how a company is really doing. By stripping out noncash measures from a company s reports, an investor can also effectively compare companies that aren t subject to the same accounting systems, neutralizing items that may be distorted by accounting technicalities to create an apples-to-apples basis for evaluating similar companies in different jurisdictions + + Noise is reduced Cash-based metrics typically make it easier to assess the impact of short-term fluctuations in earnings caused by one-off events or seasonality in revenues + + Returns are more likely to be sustainable High and stable CFROI is usually a sign of a company that generates value consistently. In our view, companies like these typically have a strategically sound position, built, for example, on a powerful brand and a large scale in a business that is protected by a strong moat. In other words, there are high barriers to entry for competitors, so these companies have the potential to maintain superior investment returns through changing market conditions For all these reasons, historical CFROI is a good starting point. But investors also need to understand whether a company can maintain or increase its cash flows in the future and how those cash flows are valued today. That s why we also look at a company s ability to grow its assets over time, which provides a good signal of its ability to continue generating cash and creating value. DISPLAY 2: COMPANIES WITH HIGH AND STABLE RETURNS ON INVESTED CAPITAL OUTPERFORM High and Stable CFROI High CFROI Stable CFROI MSCI ACWI Annualized Returns Return/Risk Ratio % % % % 0.38 As of March 31, 2014 Past performance does not guarantee future results. CFROI based on quintiles of the highest, least volatile and the highest and least volatile stocks in a Credit Suisse universe Source: Credit Suisse, MSCI and AB For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public. COUNTING ON CASH 3

4 Historical cash flows must always be put into context to project future returns. PROJECTING THE FUTURE: SUSTAINING CASH FLOWS Moody s is a great illustration of how to apply this approach. Following the financial crisis, many questions were raised about the company s future. The rating agency had been subject to intense market pressures, as the disappearance of structured finance and shrinking corporate balance sheets undermined demand for its services. For many investors, Moody s looked vulnerable to the unpredictable changes that were sweeping through the industry; its dominant position in a durable business with few competitors appeared to be in jeopardy. Cash-flow returns suggested otherwise. Yes, the company s CFROI had fallen sharply from about 70% before the financial crisis. Yet the market appeared to be expecting it to tumble below 10%, based on the depressed valuation of its shares at the time. In fact, it stabilized in 2009 at about 30%, which indicated that its cash returns were strong and stable (Display 3). But the real question was whether Moody s could sustain high levels of cash return in a changing market environment. Upon closer scrutiny, our research concluded that Moody s enjoyed a very stable market share in a concentrated industry. This was likely to help it maintain its pricing power and support its long-term growth even amid an industry shake-up. At the time, we expected a slow but steady global economic recovery to fuel an increase in financing needs. Disintermediation in the financial industry was prompting banks to move more assets off their balance sheets, allowing investors to buy them directly. And companies were also refinancing huge amounts of debt to take advantage of historically low interest rates. All of these trends looked likely to increase demand for Moody s ratings services. But there were legitimate concerns. Regulatory and legal risks were seen as a significant threat to the company s traditional business, so an authoritative forecast on these issues was essential. After concluding that the regulatory threat to Moody s business model was much less significant than markets believed, coupled with its strong cash-flow history, it was possible to take a long-term position in the company with conviction. The Moody s case is a good reminder that historical cash flows must always be put into context in order to translate past performance into future returns. It s also important to understand whether companies are likely to use their cash flows to benefit shareholders or whether they might waste them. USES AND ABUSES OF CASH Some companies may also be complacent. In 2009, we took a look at Sankyo, a manufacturer of pachinko machines. This recreational arcade game is so popular in Japan during good times and bad that it was an incredible cash cow for the company. At the time, more than half of Sankyo s market capitalization was in cash. It was an enticing opportunity. DISPLAY 3: MOODY S: STABLE MARKET SHARE AND HIGH BARRIERS TO ENTRY 90 Supplier power nonexistent CFROI (Percent) Barriers to entry very high Competition not price based Direct financing taking share from banks/ intermediators E 15E Buyer power low due to regulatory requirements As of December 31, 2014 Source: Credit Suisse; Michael Porter, Competitive Strategy (New York, 1980); and AB 4 For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.

5 Yet CFROI couldn t tell us what Sankyo was doing with all that cash. If a company with a lot of cash doesn t invest in expansion, increase its dividends or buy back shares, then it isn t creating much value for its investors. In this case, after further investigation, we concluded that Sankyo s conservative management was unlikely to change; it seemed to prefer to keep its cash locked up in its coffers rather than put it to use on behalf of its shareholders. Some companies have the opposite problem too little cash and too much investment. When a company pumps money into ambitious projects that aren t likely to deliver reasonable rates of return on capital, they re destroying shareholder value. CFROI can help investors avoid the stocks of companies that appear to be on an unsustainable spending spree, like Sainsbury s, the UK supermarket chain. Sainsbury s has low returns and a growing asset base not an attractive combination. In 2014, the company s CFROI was less than 3%. Yet Sainsbury s invested 888 million in its retail operations in the fiscal year ending March 2014 including 418 million to develop new stores destroying shareholder value in the process. In our view, the company s aggressive focus on top-line revenue growth despite relatively low profitability raised the acute risk of subpar investment returns in the coming years. CFROI helped us decide to steer clear. Contrast these stories with Check Point Software Technologies. The Israel-based company is a world leader in Internet security software, and its CFROI was around 20% in late In fact, the company was hoarding its cash, and its CFROI would have been significantly higher if it had paid out all the excess cash from its balance sheet. Its solid cash flows pointed to a defensible business model. On further analysis, we found that Check Point s leading position in the Internet security industry is protected by a wide moat for several reasons: It offers a broad range of products in an industry characterized by a sticky customer base. Its high pricing is supported by CFROI: HOW DOES IT WORK? In an industry littered with acronyms, CFROI might seem to be just another piece of confusing jargon. But in fact, the metric is designed to help investors obtain a much clearer view of a company s underlying economics. The idea is actually quite simple. Many items on corporate financial statements reflect subjective judgments. For example, reported depreciation costs and accrued revenues are notoriously open to accounting manipulation. That can make it hard to compare one company to another even in a similar industry or region. So investors need to convert the information in reported financial statements into something more objective. That measure is cash. Company executives will find this familiar. Before starting a new project, a company will normally forecast both the cash the project will consume and the cash flows it will generate over its lifetime. The internal rate of return (IRR) is the annual percentage return provided by the sum of these cash flows: technically, the discount rate that causes the net present value of the project to be zero. When compared to a company s cost of capital, this helps determine whether the venture makes economic sense. CFROI does the same thing for a whole company. Credit Suisse s HOLT model calculates the IRR from the cash returns that have been generated by a company s assets over time. This is the company s CFROI. For financial firms, we need to use a somewhat different approach: cash-flow return on equity, or CFROE. Since banks and insurers rely on leveraged equity to generate growth, the return calculation must account for the use of debt and the capital structure funding mix. Other adjustments are applied to reflect accounting differences between financial companies and industrial groups. Ultimately, though, the goal is the same: to make meaningful comparisons across a portfolio, market or universe of stocks, in order to allow an investor to determine the cash returns a company has generated over time. For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public. COUNTING ON CASH 5

6 Strong CFROI and an attractive valuation is a winning formula. DISPLAY 4: CHECK POINT: CONSISTENTLY EXCEEDING INDUSTRY PROFITABILITY Adjusted Operating Margins (Percent) Check Point the increasing threat of sophisticated cyber attacks, which compels companies to spare no expense for top-notch security. Competition is relatively benign. And the company s effective use of resellers has allowed it to maintain especially high operating margins of about 55% (Display 4). But what would the company do with all the cash on its balance sheet? If it continued to do nothing, the investment case would be weak. Then in 2012, Check Point launched a $1 billion share buyback program. So its cash position and management s new willingness to reward shareholders created a compelling investment case in a company with a strong market position and a proven business model. VALUATION MATTERS Valuation is also vital. Purchasing a company with strong potential future cash flows and asset growth at an unattractive price is unlikely 05 Through December 31, 2013 Source: Credit Suisse HOLT, company reports and AB US Software Companies (Average) to deliver results. Instead, we believe that identifying companies with strong and stable CFROI that are also trading at an attractive valuation is a winning formula. Our valuation approach also focuses on cash. We use an economic value added (EVA) model based on our own detailed forecasts of future cash flows, using differentiated research to understand industry dynamics and other factors affecting a company s future cash generation. We apply a discount rate based on historical real equity returns adjusted for company-specific factors, such as its level of debt. Then, we compare the EVA a company s intrinsic value to the company s current market value. A difference signals that a stock may be trading at a discount or a premium to its long-term intrinsic value: we look to invest in companies where our research suggests a discount of at least 20%. BEWARE OF BLIND SPOTS Like any financial metric, historical CFROI isn t perfect. Investors who rely on it for a cash-flow analysis must be aware of the blind spots. + + Restructuring This is often the result of a crisis. A company that s in the process of being turned around might not appear on the CFROI radar, because it had weak cash flows in crisis years. But a successful restructuring could push returns higher + + External effects Companies exposed to influences beyond their control might display swings in their cash flows. For example, fluctuations in commodity prices can undermine the reliability of cash flows from oil producers, airlines and nonregulated utilities + + Disruptive forces Radical change is a fact of life in many industries today. Some companies that look stable from a historical perspective may discover that their moats are shrinking because of new technology. Think about traditional retailers, which had stable cash flows in the past but might face huge challenges from new rivals as consumer sales increasingly shift to online markets 6 For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public.

7 DISPLAY 5: CFROI FAVORS ASSET-LIGHT SECTORS Average Monthly CFROI, (Percent) DISPLAY 6: FUNDAMENTAL ANALYSIS VERIFIES SUSTAINABILITY OF CASH-FLOW SIGNALS Consumer Staples 19.5 Information Technology 18.7 Healthcare 14.5 Industrials 11.9 Consumer Discretionary 11.5 Financials 10.9 Materials 8.6 Telecom 8.1 Energy 7.3 Utilities 4.4 Average Analysis + CFROI + Industry Dynamics + Key Value Drivers + Capital Discipline Insight and Judgment Thesis + Financial Model + Intrinsic Model + Worst-Case Scenario + Minimum 20% Upside From November 30, 2007, through December 31, 2014 Source: Credit Suisse, MSCI and AB Source: AB MANAGING PORTFOLIO RISK CFROI is a tool for bottom-up stock pickers. Yet some sectors are likely to look consistently more attractive than others on a cash-flow basis (Display 5). Companies with asset-light business models, for example, tend to have much higher returns. Examples include technology companies and nonbank financial firms. Consumer-oriented companies that can generate higher margins also rank high in CFROI. Companies like these can be expected to feature prominently in a portfolio based on cash-flow returns. Industries that are more reliant on assets and more susceptible to cyclical trends tend to be less attractive on a cash-flow basis. In the capital-equipment sector, many companies are very asset intensive and are also exposed to cyclical market trends. Telecom operators are similarly unattractive; running a phone network is a very asset-intensive business that often generates subpar returns and disappointing revenue growth. A naïve, high CFROI portfolio would probably be biased toward sectors with high cash-flow returns. However, with an active approach, promising investment opportunities can be found from time to time in sectors and industries that tend to rank lower in terms of cash-flow returns. Of course, it s important to understand the risks that a portfolio of companies with high and stable CFROI may be exposed to. Unintended exposures such as country and sector weights, growth or value biases, or macroeconomic exposures frequently shift and must be actively managed. Our approach is to carefully minimize such exposures and maximize the effect of stock selection. In our view, this is one of the best ways to create a portfolio with powerful long-term return potential and consistent results through market and economic cycles. By counting on cash, investors can gain the conviction to overcome short-term pressures. Our research suggests that CFROI has a reliable track record of pointing to companies with strong business models that have what it takes to withstand challenges and deliver results. To be effective, a cash-flow analysis must be coupled with a rigorous view of valuation based on a thorough analysis of a company s business model, financial position and competitive environment (Display 6). And because CFROI is not widely used as a central component of stock selection, we believe that putting it at the center of an investment process can lead to a portfolio with differentiated positions and low correlations with other comparable equity strategies. For institutional investor and financial advisor use only. Not for inspection by, distribution or quotation to, the general public. COUNTING ON CASH 7

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