The Inquisition : Is the 'Church of High RoE' selling elaborate lies?
High return on equity is peddled as a magic bullet by savvy fund managers and canny consultants. We dismantle the idea, brick by brick.
We come here today to burn the Church of ‘High RoE’ down. We come to ransack its holy altars, and poison its holy wells. Its defenders, many in numbers and strong in their clout, stand astride the gates, pitchforks and cutlass in hand.
However few we may be, we have the surety of truth and data (Yes, read to the end) behind us.
So help us God.
Convince not by Charisma. For, if a man plays the fool, then it's only fools he'll persuade. But appear to be the devil, and all men will submit.
- Pirate Captain Edward “Blackbeard” Thatch on guests on CNBC
The Plan
During the course of this piece, we will be invoking arguments from various fields of human knowledge. In the entire arc of this article, we will be attacking the idea behind coffee or other “canned” investing strategies. Hopefully by the end of this article you will be able to see the lie that the snakeoil salesmen peddle - “invest in high RoE strategies … rest under a shade and inherit the earth.”
The malaise infects us all - Boardroom prescription of RoE
Mark Gloria* rubbed his forehead as he mulled the next course of action. The meeting with the investors was due next week and the company’s growth was slowing down. The recent report from his CFO were troubling. His ‘man-Friday’, and COO of Altamira, Rajat Sethi looked on.
“Rajat, lets roll out Project Violet”
Sethi gave a curt nod and got up to leave the room. “And, Rajat, keep it quiet”
Altamira Ltd’s revenue growth has slowed down to a halt, and the only way to placate nervous investors is by shoring up its profits.
As Sethi, walked down the long marbled lobby towards the elevators, he surmised, Altamira will need an extra $ 135million to pad its slowing revenue.
Project Violet, if executed well, would do just that for Altamira Ltd.
The plan involved cutting costs across all the functions. Any projects not immediately revenue-contributing, will be put on freezer.
As Sethi, took the lift and pressed the button ‘6’, his mind recalled a conversation from 2 quarters ago.
“$60 million, Mark. Valuable $60million”. Sethi remembered pausing for dramatic effect. “We draw up a list of all projects that not revenue contributing and we axe it”
“But, wait”, interrupted Jade Holmes. Holmes, the Chief Growth Officer joined recently and was in charge of transformation.
“This plan is going to retire all the strategic projects, Mark”, Holmes was concerned.
“Even Haiku, Mark.”
“Jade, relax! We are just drawing up a plan. Sort of a umm… 5 year plan”, assured Gloria, with his characteristic comforting smile.
“Mark, we don’t innovate now, we wont have a market in 5 years.”
Gloria smiled and mouthed silently - “relax!”
Sethi, whipped out his cellphone, as he got into the elevator and typed 4 words to Mike Leto, the CFO.
“Project Violet is on.”
Leto, will be soon bringing a list of R&D project to axe. The previous CEO wanted Altamira to evolve, and transform the industry much like what Bell Labs did for Silicon Valley.
Sethi, Leto and Gloria, all young and upstarts, had no patience for these hand-wavy visions. Either a project is making money or its on the chopping block. Two full weeks later, a new Altamira emerged. Lean, mean and aggressive.
At least, that was how it was spun to the investors. Cracking down on projects like Haiku, released 60, R&D released 25, outsourcing of in-house manufacturing to China released 80.
With $165million cost saved and $135 million needed to show the growth, Mark Gloria even managed to sound magnanimous to the investors. “Ladies, and gentlemen, we not only grew, but also invested in our business back. We spent an additional $30million into our international sales force”
He left out the inconvenient fact, how he came across those 165million.
Two Ways of Shoring Up RoE
RoE, or return on equity, is a darling metric to investors and analysts. A proxy for the efficiency of the firm, it pervades the Wall Street, boardroom and even M&A conversations
But it so happens that RoE can be improved by two ways - the ‘way of innovation’, or the ‘way of cost cutting’.
It can either grow, which is equivalent to putting the existing resources of the company to ‘better use’ - this is the way of innovation. Or, alternately, it can cut the amount of resources it uses, also known as ‘way of cost cutting’.
Firms, always choose the latter. Because the way of innovation is hard. And this malaise infects the boardroom of most companies in modern economy.
Cutting the Flab or Killing Redundancies?
It is perhaps the failure of finance of the last 30 years, that it sees all costs as undesirable, and all costs as wastage. We disagree.
The Grey Swan offers two perspectives:
Not all cost are made equal.
Not all costs are costs
There are wasteful costs, and then there are necessary costs. There are investments masquerading as costs and there are costs pretending to be investments.
Take the example of a consumer goods company. It has a significant above the line advertising costs. But is it really a wastage? We disagree. We see it as necessary investments to maintain brand value.
Or, for example, take a case of a D2C startup like Ustraa. It spends a considerable amount to ‘acquire’ customers. Is it really a cost? Or is it an investment?
In the hypothetical case above, Altamira needed long-vision products like Haiku. Its a necessary investments which is pretending to be a cost. Haiku is necessary for Altamira to stay relevant in an evolving marketplace.
Do not think Altamira is a figment of imagination. Plenty of real life companies make this mistake.
Michael Dell, in 2004, addressed a group of students and used the bully pulpit to hammer home his pet idea - “you can go bankrupt by innovating”.
As the market innovated from PCs to mobile to cloud, Dell, the company lost its leadership position. Michael Dell was forced to take his eponymous company private at a valuation of $25billion, just 9 years later. Down 75% from the peak valuation of $100billion in 2000.
Geoffrey Moore, bestselling author of Crossing the Chasm and Escape Velocity, dissected Dell’s approach in an interview with me. He commented, “Dell solved the PC value chain problem. However, it did not identify the next problem to solve. The next problem was not obvious to Dell.”
The Bacteria, the Billionaire and Margin of Safety
Berkshire Hathaway, keeps anywhere between 10%-33% of its equity in cash and short term investments. Having 33% of equity in cash, is a severe drag on its RoE and Buffett, its CEO knows it. Yet Buffett says this:
"We never want to count on the kindness of strangers in order to meet tomorrow's obligations. When forced to choose, I will not trade even a night's sleep for the chance of extra profits". -Warren Buffet
Buffett adds - “the world can change in very, very dramatic ways”
To survive one must build reserves, reserves that prove costly in good times, but life-saving in bad times. And these are essentially RoE-negative. They reduce the RoE of the company.
What Buffett -the billionaire understands innately, nature exhibits vividly. Bacteria’s DNA consists of many sections of repetitive genes which perform the same action. This is a fantastic form of redundancy.
And remember, redundancy has a cost. Its inefficient, but necessary. The very same bacteria could have evolved with those genes performing a different action, and turning to a more complex organism.
Nature also duplicates roles across different species. Scavenging is performed by multiple ‘species’ (hyenas and vultures to fungus). Carbon fixing is performed in multiple ways (trees, mangroves, corals). The reason why nature ensures such redundancies is for the same reason why Buffett maintains cash reserves - to withstand shocks!
Prem Watsa, often dubbed as Canadian Buffett, and CEO of Fairfax Financials is holding about 22% of its assets in cash. Reason? Redundancy.
Even companies like Apple and Google are sitting on enormous cash reserves.
That is an enormous drag on their ‘RoE’. Yet they choose to do it? Because cash in hand is the ultimate insurance against a fast changing world. Cash is an optionality !
Civil engineers, architects and planners have always known about the concept of margin of safety. Having a margin of safety requires one to build for more than it is needed - which is inefficient, but serves as a necessary insurance.
Curse of High RoE aka Why our supply chain has come to a stand-still
Over the last 50 years, the love for just-in-time supply chain methodologies have driven optimization decisions. Under the continuous onslaught of costs, CXOs have kept slashing warehouse costs, inventory costs and outsourced whatever was possible.
Until now.
As COVID struck, the entire network of supply chain came unstuck. Packages which used to take 2 days to reach, now were stuck in ports for weeks!
The true reason behind it are beyond the scope of this article, but one thing is certain - the blind fanaticism to do away with any redundancy is the cause of this.
Ryan Petersen, the CEO and Founder of Flexport, a supply chain software company lays bare in his interview with Noahpinion. A brief snapshot is given above.
But the implications are clear when Petersen says - “we simply don’t have enough of these supply chain elements, or resilient systems” [emphasis added]
Lack of redundancy brings a system down. This is the exhibit 101.
The Rent Seeking in Cost-Cutting
Anyone who has ever started a company (the authors of The Grey Swan have to varying success), know innately, that growing revenues year over year is a a big ask. In this world of fast disruption, growing over a decade is rare.
Few CEOs achieve it. Those who do, have achieved it on the back of cutting edge of product innovation and a fanatical customer focus.
But what about those who seek to cut costs to shore up their profits? What about those, who see even innovation as a cost and every cost as expendable?
We, at The Grey Swan, see these CEOs as rent-seekers. Cutting costs with someone else (often lower level employees) taking the fall, winding down research projects and refusing to innovate - are all symptoms of CEOs who want their fat paychecks easy.
Cutting costs is easy. Growing revenues is tough. Dell realized it by himself. Today he is found singing paeans of innovation and parroting “change or die” maxims.
You either die a cost-cutting warrior, or live long enough to become an innovator.
The Fundamental Investor’s Fetish with RoE
Investors’ fetish with RoE is legendary. Higher the RoE, better it is for investing purposes - or so the idea goes. Plenty of investing strategies like Coffee Can, Magic Formula and everything in between is built to run on this idea.
High RoE is a bad investment. Period. To prove this point, our in-house data-wrangler has put in together a fascinating study.
We backtested a high RoE strategy which selectively invests in high RoE stocks (anything with 3 year RoE above 35%). We eliminated anything less than INR 100cr in market capitalization.
We found something stunning. The strategy is no better than usual run of the mill balanced fund. It performs well in good times, and mediocre in bad times. But most importantly, bulk of its returns come from a few select years (like the go-go years of 2009 and 2020).
Implication? Remove the outlier years and the strategy significantly underperforms.
Do note the severe underperformance in the churning years of 2008, 2011 and 2018 bear markets.
Ladies and Gentlemen, the results are in.
Adopting a high RoE company will lead to a roughly 50-50 chance of landing a winner. We got a 185 winners to 184 winners over the last 15 years. Oh yes, the median return per ‘pick’ was a puny 1%.
Ladies and Gentlemen, we might just toss coins.
Small Fish in Big Pond & Your Margin is my Opportunity
Gillette India clocked a 1900crore revenue in 2016. A traditionally high RoE company, by any angle, it grew the lazy way - adding more blades.
This lack of innovation, exposed a fatal flaw in Gillette’s strategy. Its failure to study an average user, created scope for startups like Dollar Shaving Club in US and Bombay Shaving Company in India.
These upstart companies learnt that the big incumbent they always feared turned out to be a mere smoke. The startups simplified their offerings, avoided the route of high margins and innovated in their delivery models.
Adjacent startups like Ustraa, The Man Company and Beardo soon followed, with a combined revenue of ~300crores going from zero a mere decade back. While Gillette India revenues have been flat over the last 6 years,[1,2,3] D2C companies are commanding eye popping valuations.
Today’s “high-RoE companies” have high RoE, because they have cut all avenues of growth for themselves. This opens up the spaces for disrupters to move in. As Jeff Bezos says, your margin is my opportunity!
Bharat Shah in his book, “Of Long Term Value and Wealth Creation from Equity Investing”, drove a stake through value investing. But unknown to him, he also shot the HIGH ROE vampire with a silver bullet.
Shah, says - there are small fishes in small ponds, big fishes in small ponds and small fishes in big ponds. Only in the last case, do investors make real money. Or in other words, its not RoE that matters, but the opportunity that lies ahead of the company, that matters.
Put in other words, if a company had big enough opportunity ahead of it, it would spend all of its power to capture it. As a result, its accounting profits would be lower because its marketing/R&D/sales force expenditure would be very high. Implying low RoE.
High RoE on the other hand implies a lack of opportunities that lie ahead of the company.
This is the reason why the High-ROE strategy, that we showed earlier, is lacklustre. Companies having high-RoE is banking on past success and market offers lack-lustre valuation expansion to it.
The Bad Promise of Good RoE
Famous Buy Side analysts use their considerable media presence to wax eloquent on high RoE companies in ‘leadership’ positions.
They argue for a 10% revenue growth and a 15% RoE threshold, as a canned worry-free approach to long term investing.
This is laughable, because first - it is in no way, a high RoE strategy.
The narrative of companies with high RoE in leadership position continues to confuse DIY investors.
Screener.in is replete with high RoE screeners, and we can guess, that investors follow them as well.
This is misleading at best and harmful at worst. Fundamental investors would do better to give up their faith on “Blind Faith” type screens, and rest it on a vanilla balanced fund (80%-20% equity : debt)
RoE is also notoriously easy to manipulate. RoE, or return on equity, can be pumped up by replacing part of the equity with debt. RoE as such makes no distinction between a company that is inherently profitable, and that is padding its RoE with extra debt. It treats both of them same.
In this world of cheap debt, many companies are raising fresh debt. It just so happens that, investors who follow the dogma of high RoE, risk exposing themselves to corporates high (pun intended) on debt.
For followers of such approach, they not only need to shun their blind worship but also find new gods.
What do we suggest?
Shun modern accounting and metrics dependent upon them: We, at The Grey Swan look at ESOP accounting, investment accounting and RoE with suspicion. They are broken and an investor has to do quite a bit of pro-forma adjustment before they can make it usable
Thrive & Survive: the only metric needed: We count growth and risk-aware management strategy to be the fundamental drivers of returns.
High Growth eats High RoE: Between investing in high RoE, low growth companies and low RoE, high growth- we always settle for the latter. You can’t avoid risk in either. The first exposes investors to opportunity cost, the second financial cost. But between explicit and implicit costs, we must settle for explicit and financial cost is an explicit cost
Those who peddle simple solutions, have something to gain at your expense: At Grey Swan, we don’t believe in pandering to your sensibilities. Because we believe, we are not here to peddle simple solutions. Neither should you fall for them. No matter, who peddles it.
Oh yes, did we mention, balanced funds perform better than High RoE strategy?