Mutoro Group Partners, LP
“Your opportunity here and beyond this campus is huge, demanding, and vital. You are singularly able more than previous generations; not because you are smarter (although you may be) or because you have tools your predecessors lacked, but because you have time. Time is on your side, as is a chance to fashion an amazing future. Relish it. Use it. Revel in it.” – Toni Morrison
“When you buy a stock with a superior profit margin, an above average rate of return on invested capital, and sales that are growing faster than the industry’s or the country as a whole, you have time on your side.” – Thomas W. Phelps
“Time is the friend of the wonderful business, the enemy of the mediocre.” – Warren Buffett
Dear Partner,
Who is the best athlete of all time? Who is the greatest coach in sports history? What is the best movie of all time? Whatever your answer to these questions, it is unlikely that far from your thoughts were names such as LeBron James, Sir Alex Ferguson, or Casablanca. It is for a reason. Sports has trophies and playoff appearances. Hollywood has awards, box office results, and critical reception. Years of effort and strategy can often be enshrined in useful short-hand metrics for gauging and signaling quality. For better or worse, these metrics are used to parse the best from the also-rans. They are useful and accurate, even if we disagree on which to use and the results of the measurements.
Here is another question: What is the best business you have ever heard of? Nearly every time I have asked someone that question, they pause. It’s just not something they ponder. (I’m a fun dinner guest, I swear.) Too often in the world of business, it seems that employees of companies, managers of them, or business owners act like they know no objective sense of quality. The answer to the question seems just a matter of personal opinion or interest. But that doesn’t have to be the case. It is hard to claim one can make the best business and investment decisions without knowing what makes for the best businesses (and what makes for the worst). In business and investing, understanding rate of return helps.
There are several quick shorthand rate of return metrics that, if tracked over time, may signal whether a business has been both highly cash generative and industry dominant, two of the most important aspects of quality. In prior letters, I have cited as examples Return on Equity (ROE) and Return on Net Tangible Assets (RNTA). We did not dive deeply into either, in any case. The shorthand metric I want to focus on here is Return on Invested Capital (ROIC).
ROIC measures a business’s earning power relative to all the money that its owners have invested into it and its lenders have lent it. A simple way to derive it is to divide a business’s operating income after taxes over a given period by its total capital at the beginning of that period. Confused? Operating income is what is left of sales after you subtract its cost of goods sold and operating expenses, but before deducting its interest and tax expenses. Total capital is essentially the sum of a business’s debt and equity accounted for on its balance sheet. So, for example, if a hypothetical company had in its recent annual report $100 million in operating income, faced taxes of 20%, and its balance sheet showed $300 million in shareholders’ equity and $100 million in debt, it would have an ROIC of 20% (i.e., [$100 million x (1 - 0.20)] ÷ [$300 million + $100 million]). (For reasons we won’t go into here, in some situations, it would be appropriate to subtract the business’s cash from its total capital.)
Generally speaking, the returns you can expect in the long run from owning a business can only be as good as the underlying returns that business generates on the capital invested into it and its reinvested earnings. So, owning a company with a persistent 25% ROIC bodes better for an owner of that business versus owning something with a 10% ROIC. But not always. If that 10% ROIC business is likely to grow into a 20% ROIC business, it might be preferable over the 25% ROIC business. This preference is especially so if the business with a 25% ROIC business is likely to see the measure decline overtime to 10%. Here, as with many things, the future matters more than the past.
Like any analytical tool, ROIC has limitations and tradeoffs. For one, the formula just described above does not apply to all situations or companies, and no uniform definition makes sense every time. Moreover, standard benchmarks for what constitutes “good” or “bad” ROIC are dynamic and can change with the economy and vary across industries and over time. As such, they shouldn’t be employed in a vacuum. The investor Seth Klarman in his book Margin of Safety (1991) has a useful quote about this: “Rather than targeting a desired rate of return, even an eminently reasonable one, investors should target risk.” He’s right. Ratios like this provide useful information, but only if tracked long-term (versus a single year or quarter) and if used in combination with other knowledge and wisdom, often of a qualitative sort. They provide a useful method for recognizing and tracking the patterns that reveal the attractiveness of a company’s position within an industry and the ability of management to invest cash flows on behalf of shareholders.
Let us see how our portfolio stacks up on ROIC:
Company C is an American manufacturer of equipment used in the construction and automotive industries. I originally learned of the company through reading Pat Dorsey’s The Little Book That Builds Wealth: The Knockout Formula for Finding Great Investments (2010). My confidence around Company C’s dominant market position arose later, though, during my diligence process. I found and read a 2011 lawsuit by the Federal Trade Commission (FTC) against Company C. The FTC challenged an attempted acquisition by Company C with the accusation that it was anti-competitive. Its lawsuit against the company repeatedly cited Company C’s dominance in its primary markets. After a three-year investigation, the FTC forced Company C to sell the newly acquired business. Because of its uniquely advantageous positioning in its value chain, hurdles like this haven’t slowed Company C down. Its average ROIC over the previous ten years is 26.3%. Its average ROIC in the three years spanning fiscal 2016–2018 was 28.9%. This 28.9% is roughly in line with the average from the three years at the beginning of this decade, 2009–2011, which was 30.8%. We first acquired our position in Company C in Q2 2015. At the end of the most recent quarter, Company C was 2.7% of our portfolio.
Company F is the U.S.-based leader in a large, consolidated industry with high regulatory and economic barriers to entry and scale. Its industry was once one of the most beloved in the world by consumers and investors alike. It then became one of the most hated by both. Now its shenanigans are tolerated by most consumers, but some investors are gradually realizing it is a gold mine with real customer captivity. (Figuratively a gold mine, not literally.) Over the last ten years, the average ROIC for Company F was 18.2%. However, this masks the real story here, which is one of a markedly improved competitive landscape and meaningfully advantageous industry economics. For the three-year period that was 2009–2011, its average ROIC was 9.7%. However, for the last three years, 2016–2018, its average ROIC was 20.5% on the back of strong free cash flow, savvy share repurchases, and aggressive deleveraging by management. Its fundamentals show strong signs of persisting even if the business cycle turns, though many still doubt this. Because we care more about future earning power than casual popular sentiments, this is fine by us. We acquired our position in Q3 2017. It was 10.1% of our portfolio at the end of the most recent quarter.
Company G is a holding company for a portfolio of several leading digital consumer brands that sell online recurring subscriptions. We first acquired our position in Q2 2018, attracted by the investment merit present from the combination of its plummeting share price but rock-solid economics. Company G only has public financials dating back to 2012. In the seven years since, its ROIC is 20.1%. Over the previous three fiscal years, 2016–2018, its average ROIC was 22.9%. This 22.9% is slightly above its average ROIC over 2012–2014, 19.0%. As with Company F, the fundamentals here are improving, though I believe we are just seeing the beginning of how much so. Company G is the leader in an ignored, misunderstood, and growing market that I believe has significantly higher potential than many estimate. Time will tell. At the end of the most recent quarter, Company G was our largest holding at 14.4% of our portfolio.
Company H is the dominant player in a few global markets that have recently come under intense regulatory scrutiny. We first acquired our position in Q3 2018. In the previous ten years, its ROIC is 30.6%. This 30.6% is markedly down from where it was at the beginning of the decade. For the three years 2009–2011, its average ROIC was 61.6%. Its average ROIC for 2016–2018 was by contrast 26.2%. It is not that the business has gotten worse but that it went from a position of having literally zero competitors to having two (with little room for others). Its once astronomical returns became merely outstanding. As described in my Q3 2018 letter, greater regulation ironically strengthens its competitive position. Company H was 12.3% of our portfolio at the end of the quarter.
Company I is a large American-based global financial services firm. It is essentially one of a few key players in an oligopoly. Companies compete in the industry on perceptions of trust, privileged access, and high-touch service around singular events in the lives of corporations and wealthy individuals. Because it is a financial services firm, ROIC unfortunately does not readily tell the story of its performance. Let’s stick to the plot and analyze this another day. We acquired our position in Company I in Q4 2018 during the market tumult that finished the year. At the end of the most recent quarter, Company I was 5.3% of our portfolio.
Company J is a digital conglomerate of software applications and consumer hardware businesses. We first became owners of Company J in Q1 2019. At the end of the quarter, it was 2.3% of our portfolio. Its average ROIC the previous ten years is 16.9%. For the three years 2009–2011, its average ROIC was 21.4%. Its average ROIC for 2016–2018 was by contrast 14.1%. Is this another case, as with Company H, of a business coming down to Earth? It’s complicated. The thing about Company J is that it has since 2009 grown its revenue at an average rate of 21.5% per year. Said another way, its revenue has almost sextupled over the last decade (i.e., grown six-fold). It has created mountains of cash while doing this and shows little sign of stopping. If we adjusted our ROIC formula by subtracting cash out of total capital, it would have an average ROIC the prior ten years of 47.4% instead of 16.9%. Whether we did this or not, Company J is a growing and robust business no one has been able to disrupt.
Company K is a European protective packaging company. Since 2009, Company K’s ROIC has averaged 13.2%. The last three years, 2016–2018, its ROIC averaged 14.0%. The three years at the beginning of this decade, its ROIC was 9.7%. We could chalk this improvement to it coming out of a recession. However, let us not be so kind; the competitive landscape was miserable ten years ago irrespective of the economy and this was not a great business to own. Today, Company K is consolidating a highly fragmented market through acquisitions. Moreover, new competitors do not seem to be emerging in the wake of the old ones. Underlying this drive for expansion through acquisition is an appealing organic trend, namely growth in e-commerce and the need for safe, cost-effective, and environmentally-sound commercial packaging solutions. In 2008, small competitors were 56% of Company K’s home market. Today they are 38% and declining further as the market consolidates around Company K. As it has done so, its ROIC has grown. I first learned of Company K in the summer of 2017, though I did not find it available at an attractive price relative to its value until Q1 2019. Because it is a small-cap company and its publicly traded stock is illiquid, I had trouble buying more of it at the prices then available. It was at the end of the second quarter 1.1% of our portfolio.
Company L designs, advertises, and distributes mass-market luxury consumer products. We first acquired it in Q1 2019. At the end of the second quarter, it was 5.8% of our portfolio. During the three years at the beginning of this decade, 2009–2011, its ROIC was 50.1%. It has come down. The last three years, 2016–2018 its ROIC was 23.0%. Over the last ten years, its average ROIC was 36.7%. As with Company H, it has seen its ROIC decline from astronomical to merely outstanding. As with Company J, its revenue has grown massively the last ten years, rising an average of 22.5% every year. It has, at the same time, also grown its operating income 22.1% per year. It is incredibly remarkable to grow both of those six-fold as Company L has done. However, as I said earlier, in investing, for better or worse, the future matters more than the past. I do not think that Company L’s revenue and operating income will again sextuple. Yet while the future is more important than the past, the present is where we live. At the time I bought Company L’s shares, they seemed incredibly cheap, regardless of whether its future returns on capital are astronomical, outstanding, or merely average.
****
Stock prices fluctuate in the present. Sometimes those fluctuations cause the total market value of our portfolio over a given quarter or year to look better or worse than the broader markets or peer funds. That’s much less important than how the businesses we own are doing in the long run. If we pay fair prices for businesses that promise a high and persistent rate of return, with managers that are trustworthy and that competently reinvest earnings, and we hold onto our positions through market volatility, we will have time on our side.
The fund finished the first six months of 2019 up 14.4% net of fees and expenses. The exhibit below shows the composition of our portfolio at the end of the second quarter:
Portfolio Holdings
I am grateful for your partnership. As always, please feel free to email me or call if you have any questions about this letter.
Sincerely,
Godfrey M. Bakuli
Managing Partner