GLOBAL LONG-TERM

UNCONSTRAINED
THE POWER OF VALUE CREATION

JANUARY 2018 FOR PROFESSIONAL INVESTORS ONLY

Value creation has been a

topic of much discussion EXECUTIVE SUMMARY
among investors for decades
– and yet, for some, it still • M
 easuring a company’s value creation via
ROIC is a more robust measure of its potential
appears to be considered a for sustainable growth and a better indication
‘niche’ concept. of its underlying quality than other measures.

Rather than pursuing ‘quality’ • B

 uilding a portfolio of companies with a
high and sustainable ROIC gives investors a
(often over-simplified as superior pool of stocks which demonstrate
investing in bond proxies or persistent value creation over time.

other defensive stocks), we • 

The short-term outlook of markets means there
is a strong potential for high-ROIC stocks to be
believe adopting a mindset mispriced, creating opportunities for long-term
focused on a business’ return investors
on invested capital (ROIC), • N
 o two ‘value creators’ are alike – finding high-
can identify companies which ROIC companies which can grow sustainably
requires an active approach, consisting of
consistently create value in-depth research and extensive company
that ultimately translates engagement.
into improved shareholder
returns.

www.martincurrie.com
MEASURING A COMPANY’S TRUE CREATING A VIRTUOUS CIRCLE
VALUE: Value creation is a virtuous circle. Cash-generative
‘Quality’ is a highly subjective and notoriously difficult companies with sustainable capital allocation strategies
investment style to pin down. Common traits are create a positive feedback loop, enabling them to
companies that are well-managed, with strong balance promote consistent growth over the long-term. For
sheets and stable earnings. They may also have large investors, this means a superior pool of stocks, made up
competitive moats, progressive dividend policies or be of companies which can create value on a sustainable
in the growth phase of their lifecycle. basis.
But there are still many intangibles: what constitutes In allocating capital, there are four main options for
good management? Is capital used efficiently, or management teams:
frittered away on vanity projects? Are decisions • Invest in the business and grow organically through
motivated by meeting the next quarter’s guidance, or capex, usually by expanding capacity
ensuring the company builds for the future? • Invest in other businesses and grow inorganically
Value creation, a subset of quality, takes us closer to the through acquisitions (M&A)
idea of true quality. The term has been adopted by • Pay down debt – this might be high on the agenda
companies and investors alike, referencing both the for companies with too much leverage
sustainable growth of a business and its potential to
• Reward shareholders – either through ordinary or
generate shareholder value over time. In essence
special dividends, or share repurchases.
though, if a company can continue to create consistent
returns on investment over and above its cost of capital, The alternative to the above is allowing cash to pile up
the share price will take care of itself. on the balance sheet. This can be beneficial, the
company keeping its powder dry for future acquisitions
In attempting discovery of a stock’s fundamental value,
or projects. However, if allowed to accrue for too long it
many market participants focus on its price-to-earnings
can lead to an inefficient balance sheet, potentially
(p/e) ratio, or its tangible return (dividend, earnings or
raising the company’s cost of capital or making it an
free cash flow) as a shorthand for whether it is
M&A target.
expensive or cheap relative to the market. While
intuitive and allowing quick comparison across a range
of sectors and regions, multiples are blunt instruments
which overlook capital intensity (the level of capital
required to generate a unit of cash) and capital
allocation (how any excess cash is put to work by
management). Both these factors are very relevant
drivers of valuation, but often overlooked.
A better focus is on cash, or more specifically,
discounted cash flow (DCF) and the value creation
equivalence: enterprise value (EV)/invested capital =
VALUE CREATION, A
ROIC/ weighted average cost of capital (WACC). ROIC SUBSET OF QUALITY,
– a company’s net operating profit after tax (NOPAT)
divided by its operating assets is, we believe, the most
TAKES US CLOSER TO THE
comprehensive measure of financial return. By IDEA OF TRUE QUALITY. IN
comparison, return on assets (ROA), can be skewed by
excess cash on a company’s balance sheet, while return ESSENCE, IF A COMPANY
on equity (ROE) is unreliable when comparing two CAN CONTINUE TO
companies with different capital structures.
Investors may sometimes hunt for ‘quality’ attributes
CREATE CONSISTENT
among defensive stocks, such as utilities or consumer RETURNS ON INVESTMENT
staples, in the hope it can help them stand up to any
market storms. However, in general, this tends to mean
OVER AND ABOVE ITS
accepting lower returns. Assessing companies on how COST OF CAPITAL, THE
they create value provides a more robust measure of
their sustainable-growth potential and ability for SHARE PRICE WILL TAKE
through-cycle returns. CARE OF ITSELF.

02
ANALYSING THE RETURNS OF THE VALUE CREATORS
In this simplified example, we can demonstrate how two theoretically identical companies, operating in the same sector and
with the same business prospects at the outset, can have vastly different outcomes, based on their approach to capital
allocation:
Company X generates free cash flow (FCF) equivalent Company Y, by contrast, has an identical FCF margin
to 10% of its annual sales, with a FCF margin of 10%, but reinvests heavily in the business, allocating 90%
is growing sales at 2% per annum but is operating at of capital to expansionary capex, paying out the
near-full capacity. Its management runs the business for remaining 10% of annual FCF in dividends. Company
income, therefore 100% of FCF is allocated to rewarding Y’s expanding capacity enables it to take market
shareholders through dividend payments. Nothing is share away from Company X. As a result, sales growth
allocated to expansionary capex. In our example, over accelerates by 2pp per year. In Year 5, shareholders
five years, due to serious capacity constraints, the receive a dividend of US$24, but it is sustainable and
company’s growth rate declines by 2 percentage points (pp) growing, so that by Year 20 Company Y’s dividend is
every year. In that time, its generous dividend policy means greater than Company X’s and it has an expanding,
shareholders gain US$100 per annum. However, this dividend well-invested business.
is not sustainable and by year 10 declines to US$90 in line
with sales. Despite its sector growing at 2% per annum,
Company X experiences falling sales. Shareholders –
initially attracted by generous dividends – are faced with
a declining (and ultimately unsustainable) income stream,
falling to only US$54 per annum in year 20.

Value creation: the positive impact of well-allocated capital (all figures in US dollars)
Company X Company Y

Year 0 Year 0
Year 1-5 average annual Year 1-5 average annual
Growth +2% Growth +2% expansionary capex
Sales: 1,000 expansionary capex Sales: 1,000
0 (97)
FCF: 100 Year 5 FCF: 100 Year 5
dividend dividend
(100) (77) (24)
(54)
Year 20 Year 5 Year 20 Year 5
Growth -6% Growth 0% Growth +10% Growth +4%
Sales: 541 Sales: 1,000 Sales: 3,853 Sales: 1,217
FCF: 54 FCF: 100 FCF: 385 FCF: 122

0 (116)
0 (257)

Year 15 Year 10 Year 15 Year 10

Growth -4% Growth -2% Growth +8% Growth +6%
Sales: 737 Sales: 904 Sales: 2,392 Sales: 1,628
FCF: 74 FCF: 90 FCF: 239 FCF: 163
0 (165)
(74) (90) (48) (33)

Dividends/share buybacks Average annual expansionary capex

Source: Martin Currie.

The data supplied is used for illustrative purposes only.
These examples are representative and do not reflect existing companies.

While Company X appears, on the face of it, to be an appealing investment, for an investor with a long-term time
horizon it is Company Y which has truly created value, generating through-cycle returns as a result of sustainable capital
allocation.

GLOBAL LONG-TERM UNCONSTRAINED 03

HOW THE MARKET MISPRICES VALUE SHAREHOLDER OR STAKEHOLDER?
CREATION Rising short-termism in markets suggests that a business’
longevity has become less of a priority for many investors.
We can delve deeper into how value creation persists over
The average holding period for stocks has reportedly
time by analysing the levels of ROIC among companies in
dropped dramatically from around four years in the 1960s, to
the MSCI ACWI over a 10-year period. Of the firms with a
a matter of months by the beginning of 2017. This decrease
high ROIC (greater than 20%) in 2007, around half
suggests a broader shift in investor mentality, where
remained at this level in 2016 (see Chart 1).
shareholders are more willing to pull the trigger early if
It is this persistence of high returns that mean-reversion
stocks do not appear to be performing as expected. In the
mindsets fail to recognise.
most extreme circumstances, a shareholder’s role is more
‘speculator’ than investor; in other words, finding a business
Chart 1: Destination of ROIC over a 10-year period
which demonstrates long-term value creation is deemed of
2007 2016 lesser importance than making short-term gains.
We believe, by adopting the mentality of stakeholder/owner
ROIC >20%: 46.5% – rather than shareholder – investors are able to access the
benefits, not just of the accumulative power of
ROIC >20% compounding over an extended holding period, but also of
ROIC 10-20%: 28.4%
avoiding the destructive erosion of capital from transaction
costs. This is where the market’s short termism is an
ROIC <10%: 25.1% opportunity for long-term investors, as it fails to assign
appropriate value to companies displaying intelligent capital
allocation, and therefore able to compound high returns
ROIC >20%: 14.1%
sustainably. While typically all stocks are priced to fade over
time by the market, we do not believe this should be the
ROIC 10-20%: 42.9% case for true value creators. When you adopt an investment
ROIC 10-20%
horizon of greater than five years, there is strong potential
for high-ROIC stocks to be mispriced.
ROIC <10%: 42.9%

ROIC >20%: 8.9%

THIS IS WHERE THE
ROIC 10-20%: 21.8%
MARKET’S SHORT TERMISM
ROIC <10%
IS AN OPPORTUNITY FOR
LONG-TERM INVESTORS, AS
ROIC <10%: 69.4%
IT FAILS TO ASSIGN
APPROPRIATE VALUE TO
Source: Martin Currie and FactSet as at 31 December 2016. Data calculated on
28 November 2017. Banks, insurance and companies with negative invested COMPANIES DISPLAYING
capital excluded.
INTELLIGENT CAPITAL
ALLOCATION, AND
THEREFORE ABLE TO
COMPOUND HIGH RETURNS
SUSTAINABLY.

04
VALUE CREATION AND EARNINGS YIELD – AN EX POST ASSESSMENT
To demonstrate the value creative power of companies with high and sustainable ROIC and how that value compounds
year on year, we address the Enterprise Value Added (EVA®) over the course of 10 years. In Chart 2, using our Global Long-
Term Unconstrained (GLTU) portfolio as a guide, we have selected the median value-creating stock’s ROIC and notionally
invested US$100 at that return for every calendar year over the course of a decade, doing the same for the market (using
the MSCI ACWI). There is a stark difference between the two; over the period the portfolio has turned US$100 into
US$576, versus the market’s US$148.
In Chart 3, we overlay the earnings yield (earnings/price) for the same 10-year period, again for the median value creator
and the market. We fix the stock price (p) at the 2006 level in both cases and vary earnings (e) by the actual earnings
growth achieved ex post each year. The earnings yield of the portfolio increases from 5.0% in 2006, to 13.8% in 2016. The
value creator has flipped from being more expensive than the market at the start of the period to less expensive since 2011.
The widening gap is due to the vastly superior earnings power of the value creators.

Chart 2: EVA® over 10 years Chart 3: EVA® & Earnings Yield over 10 years
700 700 16%

600 600 13.8% 14%

576 576
12.0% 12%
500 500
10%
US$

400 US$ 400

8%
300 300
6%
200 200
4%
148 148
100 100 2%
0 0 0%
2006 2008 2010 2012 2014 2016 2006 2008 2010 2012 2014 2016

GLTU MSCI ACWI GLTU earnings yield ACWI earnings yield

GLTU EVA ACWI EVA

Past performance is not a guide to future returns.

Source: Martin Currie and FactSet over periods to 31 December 2016. Data calculated on 30 September 2017. EVA® based on MSCI ACWI index and a representative Martin
Currie Global Long-Term Unconstrained portfolio, using the median stock for every calendar year. Earnings yield defined as E/P where the numerator, E, is the EPS of the
median earnings yield stock in 2006 inflated every year through 2016 by the median EPS growth; and the denominator, P, is the share price of the median earnings yield
stock in 2006 held constant throughout the period.

In Chart 3, the value creator’s earnings yield (right-hand scale) closely follows its enterprise value added (EVA®) over the 10
years, implying a relationship between earnings yield and the value created. In contrast the market’s earnings yield has
risen more steeply than its underlying value creation. This suggests (i) the market has become more expensive relative to
the portfolio and (ii) the market’s valuation is not backed up by the cumulative value it has created.

HIGH-ROIC STOCKS JUSTIFY HIGHER VALUATIONS

We can extend this analysis to look at how the market underestimates the persistence of value creation. Expanding on its
1990 book Valuation McKinsey has established the arithmetic relationship between ROIC and p/e.* Essentially, by
combining the principles of the Dividend Discount Model and the Sustainable Growth Model, at a given level of market
growth, the higher a stock’s ROIC, the higher its ‘justified’ p/e ratio – due to the lower re-investment required to achieve a
given level of growth.

*Source: All P/Es are not created equal. Nidhi Chadda, Robert S. McNish and Werner Rehm, McKinsey & Company, Spring 2004. Further reading: Valuation,
Tim Koller, Marc Goedhart, David Wessels, McKinsey & Company. 1990.

GLOBAL LONG-TERM UNCONSTRAINED 05

 Knowing the p/e ratio and ROIC of the market, in Chart 4 we have calculated the market-implied growth, which comes out
at 4.0%. The market (blue dot) sits on the ‘justified p/e’ curve, while the portfolio, again using GLTU as a proxy for value
creators (green dot), with a ROIC of 24.2% and a p/e of 23.5x sits just below it. Assuming the 4% growth rate applies to
both market and portfolio, the portfolio is modestly undervalued relative to the market. This approach validates the notion
that the portfolio merits a higher p/e ratio. The companies in the portfolio have materially higher ROICs, meaning they
have lower re-investment requirements to grow at a given rate than the market, therefore have more free cash available to
shareholders.

Chart 4: Analysing high-ROIC stocks against the market-implied growth rate

30

25

20
p/e ratio

15

10

0
7 11 15 19 23 27 31 35 39 43 47 51
ROIC (%)

Market implied growth rate 4.0% MSCI ACWI GLTU

Past performance is not a guide to future returns.

Source: Martin Currie and FactSet as at 30 June 2017. Representative Martin Currie Global Long-Term Unconstrained portfolio shown. Median ROIC and p/e shown. ROIC
excludes the two financial stocks held in the portfolio. Assumes a WACC of 7.5%.

CASH CONVERSION
However, these assumptions rest on the market and portfolio having identical levels of growth. In fact, we believe these
value creating stocks are able to grow faster than the market. As we can see in Chart 5, looking at sales growth and
earnings per share (EPS), taking the last seven years and consensus forecasts for the next three, there is evidence that
value creators are growing earnings faster than the market. Even more compelling, is that, based on FCF per share growth,
the portfolio has vastly superior cash conversion.

Chart 5: Superior Cash Conversion of Earnings

Sales growth EPS growth FCF per share growth
240 240 240

220 220 220

FCFPS growth (indexed)
Sales growth (indexed)

EPS growth (indexed)

200
200 200
180
180 180
160
160 160
140
140 140
120
120 120 100
100 100 80
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019

2010
2011
2012
2013
2014
2015
2016
2017
2018
2019

2010
2011
2012
2013
2014
2015
2016
2017
2018
2019

GLTU Index

Past performance is not a guide to future returns.

Source; FactSet and Martin Currie over periods to 31 December 2016. Data calculated as at 30 June 2017. Representative Martin Currie Global Long-Term Unconstrained
portfolio shown, using seven years of sales, EPS and FCF per share data, and three years of consensus forecasts. Please note that this strategy is unconstrained by any
benchmark. For illustrative purposes, we compare the strategy to the MSCI ACWI. All data is calculated in US$. 2017 – 2019 numbers use estimated data.

However, genuine value creators are rare. Crucially, of the companies in Chart 1 with a lower ROIC in 2007 (under 10% at
the start of the period, 69.4% had remained at this low level, with only 8.9% moving up to the top bracket. The ability to
create value is clearly difficult to master. The test therefore for investors, is to identify these companies where high ROIC
(that is, value-creating firms) can be sustained over the long term.

06
 THE CHALLENGE: FINDING THE TRUE debt, rather than put it back into the business. Among
these cash-generative companies, it is essential we have
VALUE CREATORS a thorough understanding of their capital allocation
Screening for 10 consecutive years of value creation (high- decisions and in our engagement there are a number of
ROIC) stocks eliminates around 85% of the companies in key signposts we look for which constitute good
the MSCI ACWI. However, as we take a long-term time practice. We would expect many value creators to
horizon, pinpointing the businesses with the potential for allocate the highest proportion of spending on capex,
sustainable value creation goes further than a simple essentially reinvesting in the business so it will still be fit
‘quality’ screen and therefore requires more than for purpose in 10 or 20 years’ time. Value-creating
quantitative analysis. Making a qualitative judgement on a technology companies, or those with low capex
business’ potential demands a fundamental active approach, requirements would be likely to focus their attention on
in-depth research and extensive company engagement. capitalised operational expenditure such as R&D, or
From this we gain a greater depth of knowledge on corporate software development. We would be concerned by an
ethos and the rationale behind all material company decisions. aggressive use of share buybacks and overpayment on
No two value creators are made alike. As Chart 6 shows, dividends. These would suggest two things: firstly, that
companies can be highly capital intensive, such as a railway the company has no more room left to grow, and
operator, or a semiconductor manufacturer, which are both secondly, it could be a sign the firm is leveraging up its
required to spend large amounts of capex every year. On the balance sheet.
other hand, some companies displaying high ROIC are very
LONG-TERM STRATEGY (NOT SHORT-TERM
asset light, such as software providers or IT services
companies. There are industries where we consider it unlikely TACTICS)
to find value creators, most notably banks and energy stocks. We look for evidence that a company is guided by a
However, all levels of asset intensity are valid, as long as we genuine focus on long-term sustainability – as opposed
believe there is a consistent ROIC over WACC.* to a predominance of so-called ‘quarterly capitalism’,
where management is fixated on short-term numbers.
Chart 6: No two value creators are made alike
A key area to look at here is M&A activity: we would
– decomposition of ROIC
45
prefer a company to grow by organic means, but also
look for the rationale behind any deals – smaller M&A,
40
as an accretive way of growing the business, could be a
35 sign of a company which has its long-term future firmly
Net operating profit after tax

30 in focus. A potential red flag would be if the M&A has

the appearance of empire building and growing the
25
size of the company at all costs. This would suggest
20
potentially unsustainable growth rates, beyond the
15 company’s continued reach or capability.
10
APPROPRIATE MANAGEMENT
5
INCENTIVES
0
0.0x 2.0x 4.0x 6.0x How a company incentivises its management speaks
Asset turns
volumes about its potential for sustainable value
ROIC: 10% 20% 30% 40%
creation and we want to see remuneration structures
Past performance is not a guide to future returns. which are sufficiently balanced between long-term
Source: Martin Currie and FactSet over periods to 31 December 2016. Data calculated capital allocation and short-term performance. We look
on 31 October 2017. Representative Global Long-Term Unconstrained portfolio stocks for compensation packages which include metrics such
shown excluding two financial stocks, as well as one stock for scale purposes.
as ROIC, EVA® or FCF, to ensure that management is
aligned with the long-term future of the business. For
In order to find these companies, we look for both
example, looking again at M&A, a management team
sustainable growth and good stewardship of capital:
which is incentivised to focus solely on growing the
GOOD CAPITAL ALLOCATION company will not be penalised for over paying. On the
contrary, it is likely to be rewarded, as the stock will now
We have demonstrated the power of sustainable capital have a higher EPS and, on paper at least, will look like a
allocation, so first and foremost, for us, is a company’s ability better prospect for investors. Management which is
to reinvest in the business. We would expect firms which incentivised to provide robust stewardship of
are genuine value creators to have a far lower debt-to- shareholder capital, is less prone to disproportionate
equity ratio than the market – clearly companies which are outlays on M&A, paying over the odds for assets.
over-leveraged are forced to spend cash on reducing their
*For financial stocks, which have very little invested capital, we use ROE to assess their value-creation ability.

GLOBAL LONG-TERM UNCONSTRAINED 07

A DEEPER DIVE CONCLUSION
Central to our assessment is a detailed analysis of Even allowing for interest rate normalisation in the US,
financial statements, in order to assess the quality of a muted global growth is set to be a factor in markets for
company’s earnings and the true health of its balance some time to come. This, we believe, plays to the
sheet. Our proprietary accounting diagnostic review strengths of value creators, which we would expect to
(ADR) is an essential tool in drawing out issues that outperform the wider market in all scenarios, other than
may not be immediately obvious. The ADR is also a where the market is rising sharply and volatility is high.
vital part of engagement as it leads to more searching
Of paramount importance is the persistence of value
questions behind company decision making.
creation and investors can take advantage of the
Ultimately, if a company does not disclose the
market’s mispricing of companies which display
necessary information for the ADR, it will not be held
disciplined allocation of capital over a longer period of
in the portfolio. As signatories since 2009 of the
time. Screening for stocks with a long track record of
Principles of Responsible Investment (PRI), analysis of
value creation gives an advantaged starting point, but
ESG factors is also integrated into every stage of the
building conviction requires deeper analysis of capital
investment process. Significant emphasis on
allocation, accounting diagnostics and a firm
stewardship provides us with a better understanding
understanding of ESG. In this way we can identify the
of the mechanisms of a company’s decision-making
companies planning for the future – not just the next
process. For example, we assess: governance risks,
quarter.
including board structure and independence; social
risks, such as health and safety, cybersecurity or low
wages in the supply chain; and how the company
reports on material environmental factors, such as
carbon emissions and mitigation. Risks to a business
OF PARAMOUNT
model of, for example, the introduction of a global IMPORTANCE IS THE
framework for carbon pricing, is worth considering in
any long-term investment thesis.
PERSISTENCE OF VALUE
CREATION AND
INVESTORS CAN TAKE
ADVANTAGE OF THE
MARKET’S MISPRICING OF
COMPANIES WHICH
DISPLAY DISCIPLINED
ALLOCATION OF CAPITAL
OVER A LONGER PERIOD
OF TIME.

08
IMPORTANT INFORMATION
This information is issued and approved by Martin Risk warnings – investors should also be aware of the
Currie Investment Management Limited (‘MCIM’). It following risk factors which may be applicable to the
does not constitute investment advice. strategy:
Market and currency movements may cause the Investing in foreign markets introduces a risk where
capital value of shares, and the income from them, to adverse movements in currency exchange rates could
fall as well as rise and you may get back less than you result in a decrease in the value of your investment.
invested. Emerging markets or less developed countries may
Past performance is not a guide to future returns. face more political, economic or structural challenges
than developed countries. Accordingly, investment
The document may not be distributed to third parties
in emerging markets is generally characterised by
and is intended only for the recipient. The document
higher levels of risk than investment in fully developed
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markets. This strategy holds a limited number of
upon in connection with, any subsequent contract
investments. If one of these investments falls in value,
or agreement. It does not constitute, and may not
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Data calculated for the representative Global Long- holds an Australian Financial Services Licence (AFSL
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