Last week we began this series with a review of the first two of eight factors of successful businesses. 1) Management are owners/founders or otherwise act as if they are. 2) High returns on capital will often dispense with the need for high debt. Today we move on to Part 2 with an analysis of factors #3 and #4. Factor #3 is that the company reinvests profits, rather than perpetually raising new equity. Factor #4 is stable management who often promote from within. Companies discussed include Technology One, Sirtex, Domino’s Pizza, and Flexigroup.
3. Re-invest profits – don't perpetually raise new equity.
Let's again look at Technology One (TNE) a position our fund has held for about five years. As previously discussed, it meets both factors #1 (Managers are owners/founders or otherwise act as if they are) and #2 (High returns on capital dispense with the need for high debt).
Unsurprisingly, TNE also meets many of the other factors of successful businesses including #3. It has not issued any material new capital (other than minor issues as part of employee incentive plans) in the 16 years or so of its listed life. In 2000 it had 303m shares on issue. Today it has barely 3% more, at 310m shares on issue.
The power of a business with high returns on invested capital (factor #2) combined with low capital needs translates into a stable share count and high total shareholder returns (+ 800% over 16 years for TNE). Furthermore, TNE's high returns allow it to fund itself without the need for debt. The end result is a company with no debt and no need for new equity issues. This is truly a unique business franchise.
Sirtex (SRX) is another example of the power of compounding shareholder returns on a stable shareholder equity base. Similarly to TNE, it also listed in 2000 and at the time had a share count of about 54m shares. Today it has a share count of 57m shares, a rise of about 5% over 16 years. This lack of dilution from new equity issuance over the period combined with growth and high returns on capital delivered total shareholder returns of about +1100% or around 12 times its share price in 2000.
On the other side of the coin, there are many companies that don't sufficiently re-invest profits or otherwise have such low returns on capital that they are unable to fund growth internally without debt. These businesses are typically the serial offenders in blowing out their share count and also have high levels of debt.
As any long term investor in airlines will well know, the global aviation sector has a very poor industry structure. Industry returns on capital are low and profits are volatile. Contrast then the share count increase for businesses like Qantas (+67% over 16 years) and Virgin Australia (+210% over 15 years). No surprises that both have high debt levels and poor total shareholder returns (Qantas +48% over 16 yrs – around +2.4% pa, Virgin Aust -86% over 13yrs).
We could go on and on….with the resources sector, in particular, having a very poor history of equity capital stewardship. Some of the worst offenders include Beach Energy (+715% share issues over 16yrs) and Cockatoo Coal with an eye-watering +6100% increase in shares on issue over the ten years since listing.
4. Stable management who often promote from within.
If there is one over-riding factor that is critical when investing in small caps, it is management quality (honesty, integrity, and competence).
Some of the good things we like about investing small companies include being in the earlier and faster growth stage of their development, being more focused by typically operating in only one industry sector and being better able than larger companies to exploit disruption, innovation, and change. However, all these positives can quickly become negatives without good management there to exploit them. And a good management team will often grow their own successors.
Contrast this to poorly performing companies who are constantly changing management and tend to appoint from external candidates. These outcomes occur because of thin resourcing or otherwise as a way of bringing in an external change agent to fix existing problems.
Domino's Pizza (DMP) and Flexigroup (FXL) are examples of the good and not-so-good of factor #4.
Domino's senior management team are all long serving and, like their pizzas, are internally grown. The CEO, Don Meij started in 1987 as a pizza delivery driver at the Redcliffe store in Brisbane. CEO of Europe, Andrew Rennie, started in 1994 as a Darwin store franchisee, ultimately owning 13 franchised stores before moving into the corporate team as CEO Australia. Nick Knight, the recently appointed CEO of Australia & NZ also started as a single store franchise owner, ultimately owning the largest network of franchised stores by 2012. Even CFO, Richard Coney, has been with the company for 20 years. Domino's is the ultimate textbook example of the stable, high performing and internally grown management team.
Flexigroup, on the other hand, is onto their third CEO in 5 years. An initially successful strategy of growing in point-of-sale finance in Australia, led by prior CEO John DeLano, has found the going tough in recent years. After DeLano left in 2012 to return to the USA, the company appointed an ex-Telstra executive as the new CEO. Not only was he an external appointment and thus did not fully understand the unique culture built up by DeLano, but he also had neither a sales nor finance sector background. Soon enough, other senior management (who should have been the internal candidates for CEO) also left the firm. Some like ex-CFO Garry McLennan and ex-head of Global Operations, Doc Klotz went on to greater success in the same industry with Eclipx Group.
The problems just kept mounting for FXL with stalled growth due to failed new initiatives and increased competition in existing divisions. Another change of CEO saw the appointment of an ex-CBA executive as the current CEO. This time around it's a case of the right industry background but the wrong culture (they need a CEO with a challenger mindset, not incumbent's mentality).
Read Part 1, where we examined key factors #1 and #2 here: (VIEW LINK)
Next is Part 3, where we examine key factors #5 and #6:
5. Do not needlessly diversify a good core business.
6. Earnings are all-inclusive, not "underlying".
Written by Victor Gomes, Portfolio Manager. Contributed by UBS Asset Management Australia: (VIEW LINK)