Charlie Munger said, "[o]ver the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result."
I believe by valuation, what Charlie Munger means here are low P/E or low P/B ratios. It may also mean a discount on the valuation coming from a discounted cash flow model. The quote is somewhat contradicted to what Howard Marks said, "[t]here's no asset so good that it can't be overpriced and become a bad investment, and very few assets are so bad they can't be underpriced and be a good investment."
The truth is somewhere in between. Charlie Munger is right for most stocks, and Howard Marks is right for all stocks as long as you have the ability to take over the company to force capital allocation decisions.
For example, let's say my expected return of a stock is 10%. Assuming there is a stock that has a free cash flow yield of 10% for the stock price, then if the company can reinvest the free cash flow at a return on invested capital (ROIC) or return on equity (ROE) of at least 10%, my expected return of the investment would be at least 10%. However, if the ROIC is 5%, my expected return would be only at 5% over the long-term. On the other hand, even with a low ROIC, if I can take over the company, I can decide to distribute all the free cash flow to shareholders, and my expected return would be 10% again.
Is there a scenario where a stock with a low ROIC (e.g. 5%), and with a low valuation (let's say P/E = 5), can still be a good investment if I cannot change the capital allocation decision of the company? Well, yes, if the company already has a good capital allocation decision!
If I can get a sustainable 10% dividend yield from a stock, then I can expect at least 10% return from the stock. The universe of stocks satisfying this criteria is not that large. Usually stocks with 10% dividend yield have some flaws which make their dividends not sustainable. To increase the universe, we can seek stocks with low P/E.
Think AT&T (NYSE:T) and Verizon (NYSE:VZ). They have been generous in their dividend policy. Assuming you believe they can sustain their earnings, then even with their 5-7% ROIC, you can still expect to earn at least 10% return assuming you pay low enough, for example, buying T at around $15 or VZ at around $31 in 2023 for a P/E of about 6.5x. Here is the calculation. T's dividend in 2023 is $1.11 annually with an expected EPS of $2.43. By paying $15.79 (precisely at a P/E of 6.5x), the dividend yield is 7%. The dividend payout ratio is 1.11/2.43 ~ 46%. When the company reinvests the retained earnings at 5%, the earnings growth will be 54% * 5% = 2.7%. The total expected return would be 9.7%, which is very close to my expected return of 10% even before including an increase in earnings which does not need any additional capital, e.g. a simple unit price increase of the service.
And it gets better for REITs (Real Estate Investment Trusts) and BDCs (Business Development Companies), because they have to distribute at least 90% of their taxable earnings. Their taxable earnings are usually lower than their usual metric of FFO (funds from operation, which can roughly be used as a replacement of "earnings" for a regular company), but from my experience, their dividends are usually sustainable if the payout ratio (dividend/FFO) is 60% or lower. Hence, a stock that is trading at P/FFO of 6.5 or lower is a potential good investment as long as the company can sustain its FFO (e.g. the properties of a REIT do not suddenly lose their tenants).
To make it simple and to compensate for the tax paid on dividends, I would generally use P/E or P/FFO < 6 as my cutoff line to determine if I want to buy stocks with low ROIC (or ROE) and generous sustainable dividends.
Last updated: 2023/09/11
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