Stock investors must narrow down decisions to first principles
Fancy EPS valuations come with some extra padding, and let us not overlook that
Most investors, when they commit, see only a stock price.
They spend far too much time and effort – compounded by an ecosystem of analyst and commentators who perpetuate the same thinking – watching, predicting, and anticipating price changes and far too little time understanding the business they now own and are a part of.
As a consequence, their trading habits emanate from ideas that are not even theirs. The underlying narrative is to begin with some overall opinion about a stock (do you like it or not ), then try to figure out what other people might do with that stock- buy or sell.
The financial facts are largely ignored. In this mental model, the objective is to figure out what other people would value, rather than what the business is actually worth. This has been a worldwide phenomenon.
Markets have largely tilted towards tech companies, with the consequence that whatever is new and disruptive is by definition more valuable (notice the recent hysteria on AI companies coinciding with predictions of ‘overweighting’ this sector).
This is classic herd mentality, and when the hype dies down, so do the valuations. Companies that report ersatz earnings tend to focus on EBITDA, rather than cashflow earnings, which is a useful way to deflect attention away from the ability of companies to return cash to their shareholders.
Since most companies retain a percentage of their previous year earnings as a way to increase their equity base, there is no reason to merely focus on record earnings per share growth. There is nothing spectacular about a company that increases its EPS by 20 per cent if at the same time the equity base grows by the same amount.
Just a ‘savings account’ approach
This is no different from putting money in a savings account and letting the interest accumulate and compound. Increasing cash earnings become the key variable as a percentage of invested capital. Just how important are cash earnings?
In a study conducted from a universe of 750 companies over 50 years, the highest quintile free cashflow stocks outperformed the lowest quintile by 8.5 per cent per year. The second highest quintile outperformed by 2 per cent.
When we evaluate companies that have listed over the last year in the UAE capital markets, the underlying cashflow growth has been strong (otherwise known as ‘owners earnings’). In an overwhelming number of cases, their share performance has outperformed world averages, such as by Salik, Empower, ADNOC Distribution, Bayanat, Americana.
More critically, the timeframe to evaluate these companies by their share performance is still too narrow. When it comes to cashflow earnings, these companies consistently come in at the top quintile of earnings when compared to not only their peers globally, but in the entire investible universe.
Keeping is simple
These are not companies that trying to solve difficult business problems or fundamentally changing direction, but rather producing and/or providing simple goods and services and doing it in a cost-efficient manner that allows for business owner earnings to grow and be returned. More crucially, these are all companies that operate in large and growing markets, where the potential for expansion is large (either through domestic population growth and/or regional/international forays).
This cannot be more true than for ADNOC Gas, which is on course to be one of the largest players in the world in the LNG and natural gas space. One of the key components is the visibility of earnings and dividends, which in an era of increasing interest rates, should carry a high weightage.
ADNOC Gas IPO fills the boxes
ADNOC Gas provides that comfort for investors, and hence the overwhelming response it generated, from institutional and individual investors alike. As the Western media starts to pay greater attention to the economic value generated by domestic companies, managerial performance is finally being analyzed and recognized for what it is – a consistent ability to generate superior returns with a high degree of predictability.
People who invest in capital markets have had expectations of generating 10 per cent per annum. Some of these expectations were skewed in an era of zero interest rates and the surge in tech stocks.
If that is the hurdle, surely it would make sense to invest in companies that generate a greater rate of return on equity on their businesses (the way banks or credit analysts would look at companies in determining whether to lend to businesses).
It would make sense if the management were treating the businesses as their own, such that optimization of the return on capital would be at the top of the hierarchy of values. Such an approach forces the investor to think about long-term business prospects rather than short-term market chances.
It is this shift in thinking (which the Western media has started to pay attention to) where the UAE is leading the charge in offering a near ‘goldilocks’ investment zone for investors.
Sameer Lakhani
The writer is Managing Director of Global Capital Partners.
