Increasingly, equity investors are being outnumbered by speculators. Many market participants are trying to predict beyond consensus expectations and outguess the rest of the market, driving down stock holding periods and disconnecting prices from reality. For disciplined investors, sustainable excess returns can be generated by investing with a longer-term time horizon, reducing speculation, and by finding shareholder-oriented management teams that allocate capital wisely.
In many ways, equity markets are turning into a casino-like environment, where the likes of high-frequency traders, ETFs and hedge funds are driven by extreme short-term bets. Most of these market participants are seeking to gain an edge on next quarter's revenue or earnings trends. These participants have average holding periods less than six months, react violently to economic data and, when the markets are declining, are quick to exit. The fact that so many investors already are expending so much effort to forecast future outcomes mean that there isn't much of an exploitable “edge” in following this path. For long-term investors, this market provides favorable arbitrage opportunities where a company's capital strength isn't reflected in its stock price.
Finding solid long-term opportunities means evaluating new ideas from the perspective of a business owner. We think about the capital structure and put ourselves in management's shoes: how could we deploy this capital to reward shareholders or protect the company in a prolonged bear market? Effective capital allocation is one of the most important determinants of value creation, but not a primary focus for the majority of investors. By analyzing the value a healthy balance sheet can create, the margin of safety becomes more concrete and portfolios are less likely to be populated by potential big mistakes that can undermine performance. Unlike revenues, the capital structure is under management's control. Our analysis is not necessarily that a management team will utilize this asset to create value, but that the flexibility is there to protect on the downside if fundamentals go awry.
Limiting the impact that an underperforming stock can have upon a portfolio is central to long-term investing success. Historically, portfolios that incorporate this tactic tend to capture most of the market upside while absorbing 20% to 30% less during the down part of the market cycle. So what do companies with strong capital profiles look like? Typically, they are high-margin, stable companies with an underlevered capital structure, which preferably operate in oligopolistic environments with strong pricing power. These companies typically produce ample free cash flow, allowing more flexibility to create shareholder value through efficient capital allocation decisions. Also, our work confirms that higher return-on-capital companies tend to outperform market benchmarks over a reasonable holding period.
With cash stockpiles at major corporations hitting record levels, the environment for capital allocation and this capital-focused value investment discipline is very favorable. Interest rates remain extremely low and equity risk premiums are comparatively very expensive, opening up great opportunities for companies to create value through capital allocation. We have uncovered situations where the equity risk premium has risen above 1,000 basis points in non-distressed businesses. In the historical context of a more normal spread of 200 to 300 basis points, this 1,000+ spread offers corporations almost unprecedented leverage to utilize their balance sheets without impairing their overall financial health. The weighted cost of capital for the average company remains inflated with too much expensive equity, due to an overly cautious mindset as a result of the 2008 financial crisis, political uncertainty, and lack of confidence with the sustainability of the economic recovery. Capital allocation can reduce this cost by repurchasing shares and thus increasing the value of the remaining equity.
While we have seen more focus on shareholder-oriented capital allocation recently — particularly special dividends, double-digit increases both in the dividend and the payout ratio, and accelerated stock repurchases — most corporation balance sheets remain too conservative. Free cash flow is continuing to outpace dividends and buyback increases. The payout ratio for the S&P 500 is still below 33%, which is considerably below the historical average of 50%. Investors have noticed as well, and are becoming increasingly vocal in their demands to do more with this cash.
The alignment of management interests with shareholders is another critical determinant. Without this part of the equation, the other factors usually do not matter. Management needs to think and behave like a long-term business owner, and we want to see their incentives aligned with like-minded, long-term shareholders such as ourselves. Insider ownership and incentives based on such measures as return on capital, margins and shareholder value creation are more desirable than shorter-term, cash-heavy, option packages which often encourage dilutive acquisitions and other dubious strategies that may destroy shareholder value over time.
Management teams with a vested ownership stake and a well-constructed incentive system should be incredibly motivated to use their strong financial condition and today's imbalances between the costs of debt and equity to reallocate between the two and unlock this latent value on the balance sheet. Over time, the rewards can accrue both to insiders and external shareholders, so it's a win-win situation.
The potential to create value through efficient capital allocation has never been greater and will not last forever. At some point, confidence will return, rates will rise and equity risk premiums will decline to normal levels. Long-term value investors will be hard pressed to find better arbitrage opportunities at the expense of short-term focused participants. Institutions and companies alike should be more aggressive with these opportunities, because we may not see it again in our lifetime.
Stephen Goddard is the founder and CIO of The London Co.
