CapitalatWork

Our focus is on the ownership of publicly-traded investments like stocks and bonds, which we consider to be small parts of businesses that happen to be for sale. Through a wide array of information sources and screening tools, our analysts and portfolio managers are continuously looking for superior businesses with a measurable worth that might represent good to great value, irrespective of prevailing or future market trends.

At CapitalatWork, a sustainable superior business invariably relates to its superior free-cash flow generating capacities over a long time-horizon.

The CapitalatWork Valuation Methodology is based upon sound principles of Investment Analysis, integrating the academic concepts of Present Value (PV) and the Capital Asset Pricing Model (CAPM). The intent of our work is to put a reasonable “Theoretical or Intrinsic Value” on the Equity of a company, and to compare it to its market price.

A company’s ultimate reason of existence is to create value for its shareholders.  To do so, it obtains financing or capital, basically through the issuance of equity and debt it employs in acquiring productive assets.  These assets are then supposed to generate a return that remunerates the capital employed.

Whether a company does this efficiently or not will ultimately determine its value. At CapitalatWork, we are searching for value by looking at a company‘s generation of “Free Cash Flow” (FCF) and by comparing it to the market value of the capital that is effectively employed to generate the FCF, “the Enterprise Value”. 

• Enterprise Value (EV)

  We distinguish 6 components in EV: Equity, Debt, Minority Interests, Other Liabilities relevant to EV, Cash, Other Assets relevant to EV. 

  Mathematically,
  EV = Eq + D + Min + OL – C – OA

• Free Cash Flow (FCF)

  FCF reflects the cash flow that is generated by a company’s operations and available to all the company’s providers of EV.

  We distinguish 4 components:
  1. EBITDA, or Earnings before Interest, Taxes, Depreciation and Amortization
  2. Taxes (T)
  3. going concern Capital Expenditures (Capex) includes recurring expansion capex
  4. The Change in Working Capital Requirement (Ch.WCR), or the change in non-financial current assets minus non-financial current liabilities

• Three Stage Model

  Stage 1 : We estimate 3 punctual FCF’s for the first 3 fiscal years: FY1 is the current fiscal year.  In the FCF Table on the previous page, below FYI, the end date of the current FY is mentioned
  Stage 2 : The following 5 years, we let FCF3 grow by a rate G1
  Stage 3 : From year 9 on, we let FCF’s grow by a rate G2

• Three Modules

  Expected Rate of Return: the return we expect when investing at the current stock price, taking into account our FCF and Gi estimates. WACC is the Weighted Average Cost of Capital, used in PV calcs.

  Fair Value: Requiring a certain return, taking into account both operational and financial risks, we calculate the Theoretical Value of equity.

  Implied Growth Rate: at what rate do our estimated FCF’s have to grow in order to justify the current stock price, and the required return.

• Crash Tests

  We process crash scenarios, in which all punctual FCF’s and G1 are lowered by 20%.

• Ratios

  Some straightforward ratios are displayed.  E.g. FCF yield is expressed in FCF/EV.
  Financial Gearing is expressed in NC+ ND- / Equity.  Herein, whatever the case, NC+ is Net Cash, and ND- is Net Debt.

Diversification, the only “free lunch” in Financial Markets

It wasn’t until 1952 that it occurred to someone that risk could be defined with a number. In June 1952, the Journal of Finance published an article from an unknown 25-year-old graduate student at the University of Chicago. The title of the paper was “Portfolio Selection” and its author was Harry Markowitz. His paper was so innovative that it earned him a Nobel Prize in Economics in ... 1990.
Markowitz’s objective was to construct a portfolio for investors who consider expected return a desirable thing, and variance of return (or volatility) undesirable. He defined risk as volatility or variance. His basic insight was that the return of a diversified portfolio will be equal to the average rates of return of the individual holdings, and that at the same time, the volatility of the portfolio will be less than the average volatility of its individual holdings. The concept to link risk and return was nothing less than revolutionary.
The 1970’s were a dark period for investors. Until then, risk was in the gut, not in the numbers. Aggressive investors maximized return, conservative investors invested in bonds. Modern portfolio theory became accepted in the professional investment arena in the 1970’s.

Investing in a basket of stocks or in a basket of bonds allows an investor to lower the risk of his portfolio, without lowering the expected return. One of the great achievements of modern portfolio theory was to describe how a mix between stocks and bonds can alter the risk and return of a portfolio. As is shown in Figure 1, contrary to commonly held wisdom, a portfolio with 28% stocks and 72% bonds is less risky than a 100% bond portfolio and offers a higher return. The green line (the efficient frontier) displays the most efficient portfolios for all the different allocations (in %) between stocks and bonds.
Not all investors though, are prepared to take the risk of a mixed portfolio of stocks and bonds. Some investors want to have part of their assets risk-free. Nominal bonds and even cash though are not always risk-free. High inflation can lead to negative real returns, and a loss of purchasing power. In 1994 and 1999, bonds had negative returns. An investor who invested in nominal bonds in the 1970’s lost 50% of purchasing power during the decade. This is why at CapitalatWork we have always stressed that the only risk-free assets are inflation linked bonds (ILB’s). ILB’s are the only asset, that assure the investor of having a positive real rate of return. Combining the risk-free asset (ILB’s) with a mixed portfolio of stock and bonds offers the opportunity to investors to create a portfolio that delivers their required return, while minimizing risk.

Figure 1: Efficient Frontier

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One of the important criticisms on modern portfolio theory is the definition of risk. Is the risk of an investment really its volatility? Do we have to care about volatility if my investments go up? These are valid questions. At the heart of the definition of risk, lies the fact that human beings find it difficult to live with negative returns. And there, volatility comes into play. Because financial markets can fluctuate wildly over the span of a year, the possibility of a loss is high. This is especially true for stocks, and less so for bonds. This is shown on Figure 2. Important to realize is the fact that differences in volatility become smaller if you extend the investment period. Over longer time frames, the differences between bonds and stocks in volatility become minimal. Even stronger, in the past there have never been periods of 20 years being invested in the stock or bond market, that produced negative returns.

This is why the incorporation of the investment period becomes very important in deciding how to diversify your portfolio. As is shown on Figure 2, the famous efficient frontier that was described in the beginning of the article moves to the left (= less risk) when the holding period becomes longer. This means that risk to achieve the same returns becomes lower when your holding period becomes longer. The proportion of stocks in a diversified portfolio also becomes higher when the holding-period becomes longer.

Figure 2: Reduction of risk over time

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The only free lunch available in financial markets is diversification. The overwhelming evidence shows that combining a diversified basket of stocks with a diversified basket of bonds, and with a diversified basket of ILB’s, substantially reduces risk to achieve the same returns. Moreover, this proposition becomes even stronger, if you combine it with your holding period. “Time in the market” is more important than “timing the market” to achieve your financial goals.

Diversification: How much are asset classes correlated?

One of the pitfalls of modern financial markets is the extremely short-term view they impose on companies. Companies publish quarterly results, which leads some of them to attach too much importance to short-term results. One of the pitfalls of modern day asset management is the overvaluation of short-term results by investors. Investors attach too much importance to these short-term results. Investors evaluate their asset-managers over ever shorter-term horizons. It seems everybody loses respect for the overwhelming importance of “Time at Work” in financial markets. We at CapitalatWork want to educate our clients differently.

Before explaining our different attitude, let’s have a brief look at historical returns. The reference work on historical returns is written by professor Jeremy Siegel, “Stocks for the long run”. This is a book we strongly recommend to everybody with an interest in investing.

Figure 1 shows the annual stock market returns from 1802 to 1997 in the United States. The most striking conclusion is the stability of the real return (= nominal return – inflation) of 7% of equity investments over the periods 1802-1997 or 1871-1997, or the three major sub periods. This long-term stability is remarkable if one takes into account the dramatic changes that have occurred over these two centuries. This does not deny that over shorter-term horizons returns can fluctuate. Very striking in this respect are the differences in real returns over the time periods 1966-1981 and 1981-1997. It appears that over shorter time frames of 15 years returns can fluctuate wildly. Nevertheless, these fluctuations, mask the undeniable reversion to the mean that seems to be present in investing. Witness to that is the fact that over the period 1966-1997, covering the two different sub periods, the real rate of return of 6% is close the long-term average of 7%.

Figure 1: Historic Stock Returns

An analysis of fixed-income returns also leads to some interesting conclusions. Table 2 shows that the average real Fixed-Income return over the past two centuries has been 3.5%. But, opposed to real Equity returns, in the three major sub periods, we do not see the same stability in real returns. In fact, the real return for Fixed Income has fallen dramatically from 4.8% to 2% over the period 1926-2006. Also, the view that Fixed-Income is the safer asset should be questioned when looking at the post-war period from 1966-1981. The real return for Fixed-Income in that period was -4.2%. Fixed-Income investors lost 50% of their purchasing power in that disastrous period. So far for the safety of Fixed-Income, even over a 15-year period. The dominance of stocks over fixed-income securities is overwhelming for investors with long horizons.

Figure 2: Fixed Income Returns

Our attitude towards investing in the stock market is different from what is practiced by many investors. We stress the importance of “being in the market” as opposed to “timing the market”. The opportunity for investors that are not blindsided by short-term market movements, is enormous. Warren Buffett stated it like this in one of his famous quotes: “In the short run the market is a voting machine, in the long run it is a weighing machine”. Understanding this quote is important. It means that it is extremely difficult to predict the near future. Who knows what the stock market will do next year, or where interest rates or currencies will trade. Building an investment strategy on trying to “time the market”, on looking to the market as a voting machine, is extremely dangerous.

This is illustrated below. It shows that if you miss the best 17 months in equity in the period 1985-2005, your return would be approximately the same as that of an investment in US T-Bills!

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Our attitude towards investing in the bond market is also different from what is practiced by the majority of investors. We do incorporate “Time at Work” (turn into hotspot) as one of the hallmarks of our fixed income investments. Our strategy is built on looking to the market as a weighing machine. We value superior businesses, and history shows that in the long run the returns of the companies we invest in, simply reflect the realized free cash flows and the future growth of those free cash flows. In the long run the market will inevitably recognize the free cash flows realized by the companies we invest in.