Sketch notes on PDF of Einhorn 2006 talk at Value Investing Congress.
2 types of business:
1. capital-intensive – a business where the size of the business is limited by the amount of capital invested in it., e.g. nearly all manufacturers, distribution companies, most finanical institutions and retailers.
2 non-capital-intensive – a business where growth is limited by things other than capital – generally intellectual or human. e.g. pharma, software, some consumer goods like Coca Cola. Drug companies are generally limited by the composition of their patent portfolios rather than their raw manufacturing capacity. Most services companies are in this category, too.
For type 2 companies, ROE is irrelevant. If Coke or Pfizer had twice as many manufacturing plants, the incremental sales would be minimal. When the capital doesn’t add to returns, ROE doesn’t matter. So price-to-book is irrelevant. all that matters is how long, sustainable or even improvable the company’s competitive advantage is.
Investment banks are non-capital intensive people businesses when they provide corporate finance advice. From there, they can generate more revenue by facilitating customer orders – i.e. lending them money. Then the do proprietary trading. In other words, they become increasingly sucked into a capital business. So ROE goes down. The irony is that these are the companies that people come to in order to get advice on corporate finance and capital allocation.
For capital intensive businesses, it is better to prefer at the right price businesses with low ROE, where you think the ROE will improve, as opposed to high or medium ROE businesses. High ROE capital intensive businesses have hard-to-sustain ROW, due to competition. Really bad things happen to earnings when a 25% ROE turns into a 10% ROE. Great things happen when a 10% ROE becomes a 15% ROE.
ROE can increase in three ways: better asset turns, better margins, and by adding financial leverage. Look for companies that can expand the ROEs in as many of these levers as possible.
One thing to look for is high working capital to sales. If this ratio is above industry peers, and the company can shrink this ratio, it can free up excess cash or alternatively grow its revenues.