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Deploying Capital

Return on invested capital is central to our investment philosophy and strategy. The role of an active fund manager is to allocate capital under its control to the companies who will most productively utilise that capital.  Productive use is generating returns on invested capital above the cost of capital with the latter being the average return that can be achieved from other available investments.  Note the future tense here – past returns are a strong indicator of the potential to generate high returns in the future but it is the return on marginal capital invested that dictates the success of the investment along with the amount of capital that can be invested.  The latter sets the future growth rate.

Many fund managers centre their process around the ‘valuation’ that the current share price implies for the company seeking to invest when the shares appear inexpensive  However, that valuation will reflect the view, of generally well informed investors, of the marginal returns on future capital invested and the amount of capital likely to be so invested.  So a company that is currently investing in projects or acquisitions where returns are likely to be at or below the cost of capital will look cheap on popular valuation measures such as the PE ratio or dividend yield.  However, this strategy tends to result in business decline reflected through reduced free cash flow, a weakening balance sheet and ultimately bankruptcy. Conversely, a company that is clearly able to invest at high marginal returns will generally look more expensive but will see improved free cash flow and balance sheet strength over time. In general, investors tend to over-estimate the ability of management to turnaround a company allocating capital poorly whilst also under-estimating the positive compounding effect of investing capital at high rates of return over lengthy periods. The latter underpins our approach.

However, students of Warren Buffett will note that both in his partnership years (prior to 1965) and in some of his most successful Berkshire Hathaway investments, he identified companies where management had identified strategies to invest marginal capital at rates much higher than historic rates and where growth had longevity but this was not recognised in the market valuation (Sanborn Map, Buffalo News, GEICO).  Such situations are rare.  A current example in the portfolio is Next and a prior example, still held on a compounding rationale, is RELX.