Michael Price Speaks His Mind

A broker raises his hand. One of about two hundred and fifty who have filled a ballroom at the Westin Galleria hotel, he has come to hear the Franklin Resources road show starring portfolio manager Michael Price. With the addition of Mr. Prices’ Mutual series funds to the Franklin stable, plus all of Templeton funds, Franklin Resources has transformed itself from a firm dominated by fixed income funds to an equity powerhouse. The transformation has moved Franklin from a mere 8 percent equities to 53 percent.

“How do you feel about technology stocks?”, the broker asks.

Mr. Price, whose face recently adorned the cover of Fortune Magazine with the headline, “The Scariest S.O.B. On Wall Street” because his large positions in major companies have forced mergers and put CEOs out of work, is quick and direct in his answer.

“How can you determine value in something that changes so rapidly? We’re value investors. We look for value today. We get nervous about something that may be completely different in a year or two.

“You won’t find much technology in our portfolios… but there is one exception. Phillips.There, we look at their record company and their other properties and we figure the technology is free. That’s what we like. Value.”

Later, in a private interview, I ask Mr. Price his view of the current market and its opportunities.

“You mean like what do I do now?

“You have to err on the side of caution. It’s time to prefer the value side of the market. It’s risky as hell to be out there with Coca-Cola, thinking they are going to continue growing forever.

“There are still value groups that have gotten hammered. The healthcare companies, for example. Or the tobacco companies. There has been a lot of progress on the litigation front.

“But this market is very picked over. You’ve got to look for value. That’s all we do. We look for stocks that are too cheap based on their asset value and we do that by benchmarking against prices for similar companies that have been acquired.”

Where is he finding value now?

“We’re buying smaller cap value stocks in Europe— companies that are poised for downsizing.You’ll never see our stocks on the new highs list. They will be on the new lows list. We wait for that. We look to fund companies that are over-leveraged. We look for distress. We set a price we will pay and buy equity. It’s all simple. It’s not rocket science.

“It’s Wall Street that makes it complicated. What Max Heine ( his mentor and the founder of Heine Securities, the firm purchased by Franklin Resources) and Warren Buffet did was to boil it all down to buying companies when their value was deeply discounted. I think the Street creates too much noise— options, derivatives, triple witching hours and all that.” ( Significantly, major Price funds like Mutual Beacon and Mutual Shares how have European stock holdings that account for as much as 21 percent of portfolio assets, an indication that the value he seeks is getting harder to find in the U.S. market.)

Then what should investors look for?

“First, a company selling at a discount from asset value. Second, a management that owns shares. The more, the better. Third, a clean balance sheet— little debt— so there is less financial risk. It doesn’t work to buy things that are highly leveraged. If you do those three things, you’ll do fine.”

Isn’t this what Warren Buffet does?

“No. The mind set is similar. But Buffet is different. He can identify businesses with very unique franchises. We’re not good at that. We’re not. We look for value.”

Such as?

“All right. We own shares in BIC, the French razor company. It sells at one third the earnings multiple of Gillette. We feel comfortable with that. I don’t know how to value a Microsoft, a Disney, or an America Online. Microsoft and Disney may do well forever. But I don’t know.

“I can’t buy a Planet Hollywood. There, you got a lot of stars but it still came down to having 30 hamburger joints with a market value of $1 billion.”

And there you have it. It isn’t rocket science. When you look at a stock, just ask yourself if you’re paying an interplanetary price… for a hamburger joint.

The Dallas Morning News, “Michael Price Speaks His Mind,” December 15, 1996.

Return on Capital Employed

We discussed two of the more popular measures investors use to gauge the relative profitability of a company—return on assets (ROA) and return on equity (ROE). Both represent management’s ability to generate profits; however, both give an incomplete picture of the capital base that management has at its disposal, since they consider only total assets (in the case of ROA) or total equity (in the case of ROE). Anyone who has taken a basic accounting course knows that the capital structure of a company is composed of assets, owners’ equity and liabilities. A third measure—return on capital, or return on capital employed (ROCE)—adds a company’s debt liabilities to the equation to reflect a company’s total “capital employed.”

Return on capital is used by Joel Greenblatt to identify good businesses in his popular book “The Little Book That Beats the Market” (John Wiley & Sons, 2006) and its follow-up, “The Little Book That Still Beats the Market” (John Wiley & Sons, 2010). Return on capital measures the operating profit of the tangible investment (capital) that company management uses to generate that profit. In other words, return on capital measures how much profit a company earns on every dollar invested in inventory and property, plant and equipment. The higher the return on capital, the greater the company’s ability to expand in order in grow earnings. Likewise, high profitability and earnings growth should, in theory, attract investors who, in turn, will bid up the share price.

The ROCE Formula

As we mentioned earlier, many investors use return on equity (net income divided by shareholders’ equity) or return on assets (net income divided by total assets) to judge the profitability of a business. By comparison, return on capital employed, as defined by Greenblatt and others, is calculated as follows:

ROCE = EBIT/tangible capital employed


EBIT = earnings before interest and taxes,

Tangible capital employed = adjusted net working capital + net fixed assets.

This definition of return on capital uses the pretax operating earnings of a company instead of net income, which is used in the ROA and ROE calculations. By using EBIT (earnings before interest and taxes), we ignore debt levels and tax rates, which will differ from company to company. Instead, we focus on profitability from operations relative to the cost of the assets used to produce those profits.

Looking at the denominator of the return on capital calculation, tangible capital employed is used instead of total assets (used to calculate ROA) or equity (used to calculate ROE) to better capture the actual operating capital used by the business. ROE, by focusing on equity, ignores assets financed via debt, while the total assets figure used in calculating ROA includes intangible assets and other assets that may not be tied to the primary operation of the firm or assets that are financed by suppliers.

Tangible capital employed is the sum of adjusted net working capital and net fixed assets. Net working capital is typically defined as current assets less current liabilities. However, we take this one step further by narrowing our focus to accounts receivable, inventory and cash needed to conduct business less accounts payable. A company must fund its receivables and inventory, but does not have to pay money on its payables as long as they are paid off within the terms of their specific agreement. In effect, therefore, payables are an interest-free loan. Cash and short-term investments are also (usually) excluded, since they are not used to run the current operations of the company. To include cash that may not yet be employed would be to overstate a company’s capital and reduce its return on capital. Again, the focus of return on capital is on the actual capital the company has invested in its business. Lastly, net fixed assets are defined as property, plant and equipment less accumulated depreciation.

Calculating ROCE

Table 1 shows the calculation of return on capital for retailers Target Corporation (TGT) and Wal-Mart Stores, Inc. (WMT), along with the relevant financial statement data. The financial data used for Wal-Mart is as of October 31, 2011, and for Target the data is as of October 29, 2011. We used AAII’s fundamental stock screening and research database program Stock Investor Pro as the source for the numbers. However, the data is easily found in SEC filings and on financial websites such as Yahoo! Finance and SmartMoney.com.

calculate roce

Earnings before interest and taxes, the numerator of the ROCE formula, is simply the sum of operating income over the last 12 months (trailing four quarters). The adjusted net working capital figure used in the denominator ignores cash and short-term investments on the current assets side of working capital because they are not used in current operations of the firm and are assumed to not yet represent operating assets. However, some analysts include cash and short-term investments if excluding them results in a negative net working capital position.

Interpreting ROCE

From our calculations at the bottom of Table 1, we see that Wal-Mart has a return on capital employed of 21.5% versus 14.8% for Target. Based on these figures, Wal-Mart appears to be making better use of its capital relative to Target. A high(er) ROCE can indicate that a company can reinvest a greater portion of its profits back into its operations, to the benefit of shareholders. The reinvested capital is, in turn, employed at a higher rate of return, which helps generate higher earnings growth.

When comparing financial measures such as return on capital, it is a good idea to compare firms in similar lines of business, which is one of the reasons why we chose Target and Wal-Mart for our example. While we see that Wal-Mart’s ROCE is higher than that of Target, there isn’t a lot to be gained from using data from a single point in time. Financial analysis yields the greatest insights when analyzing trends over time. Companies that are able to generate higher returns on capital year after year are apt to have higher market valuations relative to companies that consume capital in order to generate profits. A declining ROCE may point to a loss of competitive advantage.

ROCE is especially useful for evaluating capital-intensive firms, or those that require large amounts of initial capital investment before they can begin producing products. Examples of these firms include utilities and oil and gas companies.

Profitability Ratios

Profitability ratios measure a company’s ability to generate earnings relative to its expenses and other costs. For most company profitability ratios, larger values relative to its industry or to the same ratio from a previous period are better.

Two well-known profitability ratios are return on assets (ROA) and return on equity (ROE). Both gauge a company’s ability to generate earnings from their investments, but they don’t exactly represent the same thing.

Return on Equity

Return on equity (ROE) measures how much net income was earned as a percentage of shareholder’s equity. More simply, its can show how much profit a company generates with the money shareholders have invested.

ROE is calculated as net income divided by common equity (it does not include preferred shares). Common equity is assets less liabilities. Some ROE calculations use average common equity over a specified period. You can also calculate ROE using common equity as of the beginning or end of a period.

Return on equity helps gauge how efficient a company is at generating profits. Firms with consistently high returns on equity, especially relative to industry norms, typically have some type of competitive advantage.

One drawback to return on equity, however, is that it doesn’t tell you whether or not a company has an excessive amount of debt. Remember that shareholder’s equity is assets less liabilities, which include a company’s short- and long-term debt. Therefore, the more debt a company has the less equity it has, which will result in a higher return on equity. This highlights the need to analyze the trends in the underlying data fields of any financial ratio you may be using.

Return on Assets

Return on assets (ROA) measures how efficiently a company uses the firm’s assets to generate operating profits. ROA also measures the total return to all providers of capital (debt and equity). If a company carries no debt, its ROE and ROA would be the same.

In general, a high return-on-assets ratio means that a company’s assets are productive and well managed. This does not necessarily apply to firms in capital-intensive industries because they tend to have higher levels of fixed assets, which can translate to lower ROAs.

Likewise, some companies may have assets levels that are “understated,” such as those with high levels of intangible assets. Intangible assets are non-monetary assets that cannot be seen, touched, or physically measured, such as trademarks, brand names, and patents. However, accounting rules don’t recognize these assets on the balance sheet. For example, Microsoft will have far fewer assets on its balance sheet than Ford.

Issues such as these make it important that, when comparing ROA and ROE across companies, you make sure that the companies are in similar lines of business.

ROA is generally calculated as net income divided by total assets. Sometimes average total assets is used to avoid anomalies in net asset values.

In addition, some formulas will add back interest expense in order to use operating returns before costs of borrowing.

Using ROE and ROA in Tandem

It is best to look at return on equity and return on assets together. While they are different figures, when used in tandem they offer a clearer picture of management effectiveness. When ROA is solid and the company is carrying a reasonable amount of debt, a strong ROE is an indication that management is doing a good job of generating returns from shareholders’ investment. However, if ROA is low and the company is overburdened with debt, a high ROE can mislead investors into thinking things are better than they actually are.

Applying the Concepts

This table shows Amazon’s ROA and ROE for the last seven fiscal years along with industry medians from Stock Investor Pro. As you can see, Amazon’s ROA was fairly low in 2003. In fact, it was negative for multiple years prior. During these years, Amazon.com was spending more than it made, which is not uncommon for a start-up company (the company started in 1994 and went public in 1997). The company was losing money and purchasing assets during its first years. Amazon.com’s first profitable year was 2003.

amazon roa roe

The ROA jumped to a high of 21.8% in 2004 when Amazon had its second most profitable year. Amazon had its most profitable year in 2008, but it also increased its assets by 125%, dragging down the ROA to 8.7%. These numbers indicate that Amazon may have been better at turning its assets into revenues in 2004 than it was in 2008.

As for Amazon’s ROE, the company had negative shareholder’s equity (the value of its assets was less than its liabilities) until 2005, making its ROE negative.

Looking at 2007 and 2008, you can see that the ROE is 58.5% and 33.3%, respectively. If Amazon was so profitable in 2008, why was its return on equity much lower than in 2007? Amazon issued 7.8 million shares of stock during 2008.

Comparing Amazon’s ROA and ROE to its industry ratios, you can see that Amazon has recently been beating the retail industry’s averages. However, taking a closer look at Amazon’s financials shows that starting in 2007, the company took on a lot of debt. As discussed earlier, higher levels of debt can inflate ROE.

As for ROA, you can see that when Amazon became profitable in 2003, its ROA became positive and since 2004 has been higher than the industry average. As an on-line company, Amazon has less physical assets than other retailers with store locations, which could account for the high ROA as compared to other retailers. In this case, it would be useful to compare Amazon’s ratios to another on-line retailer with a similar structure.

This example illustrates that it is just as important to understand the inputs that go into a ratio calculation as it is to interpret the results.

Ricky Sandler: Industries and Sectors to Avoid in Stock Investing

Ricky Sandler, when asked by Value Investing Insight what industries or sectors he focus, said he avoids investing in oil and gas, commodities, utilities and biotech industries.

It’s easier to describe what we don’t do: oil and gas, commodities, utilities and biotech. We fundamentally believe that energy and commodities have been value destroying businesses over time. At the same time, their value tends to be driven by the price of a commodity that we have no ability to predict. With utilities, they don’t tend to be businesses that can create excess value. They might be nice surrogates for bonds, but not much more. In biotech, we just have no illusions that we know how to analyze the business. Outside of these few areas, just about anything else is fair game.