Brighter Spark,You’ve hit a nerve with me on this subject, for...

Brighter Spark,

You’ve hit a nerve with me on this subject, for it is one of my favourite chestnuts.

My standpoint, definitively and unequivocally, is that fundamental, long-term investing is THE best, risk-adjusted, path to wealth creation.

The problem is that people find it very hard to do.
But it is, in fact, very easy.

How?

Through the phenomenon of what I call ORGANIC GROWTH in SURPLUS CAPITAL GENERATION
(Now there’s a phrase you won’t often hear quoted on the HotCopper site, where the overwhelmingly dominant investment “strategy” is chasing the squiggles on the chart...aka, the Greater Fool Theory, i.e., someone will – hopefully – take the stock off me at a higher price than what I paid for it).

When companies can grow the rate at which they generate surplus capital, the result is an increase in their INTRINSIC VALUE.
AND WHEN A COMPANY’S INTRINSIC VALUE INCREASES AT A RATE HIGHER THAN THE RATE OF INFLATION, THEN THAT COMPANY INCREASES THE WEALTH OF ITS SHAREHOLDERS.

That’s not merely a flaky opinion of mine.
It’s an economic axiom.

AND THE ULTIMATE MANIFESTION OF A RISE IN INTRINSIC VALUE IS A RISE IN THE SHARE PRICE...MAYBE NOT WITHIN A DAY, A WEEK, A MONTH, OR EVEN SIX MONTHS, BUT ULTIMATELY THE MARKET VALUATION OF AN ENTERPRISE WILL COINCIDE WITH ITS INTRINSIC VALUE.

INCREASING FREE CASH FLOW ORGANICALLY BY 10%PA OVER TIME RESULTS IN 10%PA INCREASE IN INTRINSIC VALUE, WHICH WILL SEE SHARE PRICE APPRECIATION BY A COMMENSURATE AMOUNT .


Because I believe it to be critically important, let’s spend a few minutes dwelling on what ORGANIC GROWTH in SURPLUS CAPITAL GENERATION means.


“SURPLUS CAPITAL GENERATION”:
In its simplest form, the capitalistic enterprise takes economic inputs (raw materials, labour) and modifies them via the “business model”, and generates economic outputs (goods and services).
The inputs require capital to be procured and the outputs generate capital when sold.

[At this stage you might think I’m insulting your intelligence, but stay with me here...it’s important]

It might sound self-evident, but it is desirable – indeed, essential, I would have thought - that the capital generated from selling the outputs EXCEEDS the capital required to procure the inputs.

For it is through this EXCESS, or SURPLUS, that the entrepreneurs, or the providers of the capital (either Debt or Equity Capital) that started the enterprise, get a return on their investment.

But the bizarre thing is that sustainable EXCESS, or SURPLUS, CAPITAL GENERATION is in fact a rarity among listed companies.

I have not conducted the definitive study on this, but over 20 years of investing has led me to conclude, intuitively, that maybe just One-in-Two publicly-listed companies can – over a long enough period of time of, say 7 or more years – generate surplus capital, i.e., they don’t need to issue new equity to keep their doors open for business.

I can think of many ASX100 companies that could technically not continue to operate were it not for their ability to access equity capital periodically, for example QAN, QBE, LEI, BLY, BKN, ARI, BSL, and almost every resource company outside of the major ones who have attained sufficient scale.

And invariably when the companies whose Operating Cash Flow coming in the door is sufficient to pay for the Capex requirements of the business, and leave a bit leave over for shareholders, it is not by much.

Having studied a great many of cash flow statements over the course of my life, my sense is that when OCF exceeds Capex, it is by a factor of 1.5 times, on average. Very rarely is the ratio sustainably in the high, single figures or in the teens.


“GROWING SURPLUS CAPITAL ORGANICALLY”:
Of the One-in-Two enterprises that are, in fact, able to generate surplus capital on a sustainable basis, a mere One-in-Ten of those companies, in turn, are able to grow over time the level of surplus capital they generate, at a rate that exceeds the rate of inflation.

Overwhelmingly most companies, when they are fortunate enough to be capitally self-sufficient, without needing recourse to equity market capital in order to keep their doors open for business, simply cannot increase the level of this excess cash generation in an organic fashion. Any growth needs to be acquired.

And when growth is acquired, it tends to be done inordinately badly. The Acquisition Road is littered with the carcasses of failed strategies that have done little other than destroyed shareholder value.

I have what I call the Rule of Ten when it comes to acquisitions strategies embarked on by publicly listed companies:
“For every TEN acquisitions that are made, FIVE will definitely destroy shareholder value, FOUR might earn their cost of capital, and just ONE will succeed in adding to the intrinsic value of the acquiring company”


So, to summarise: My observations and experience have taught me that a mere One-in-Twenty companies possess the characteristics of ORGANIC GROWTH in SURPLUS CAPITAL GENERATION

In other words, of the 2,500-odd companies listed on the Australian Stock Exchange, just 100-odd fit the bill of companies that I believe have the ability to organically grow their surplus capital generation, i.e., Investment-Grade companies.

The trouble that the current generation of investors has – myself included - is that it is the product of a highly unusual period of investment history, namely the decade-and-a-half leading up to the GFC.

During that time everything went up...my 100 Investment Grade stocks, as well as the 2,400 companies that don’t generate organic surplus capital generation (and therefore don’t increase their intrinsic value).

So the whole thing back then certainly was a BUY-AND-HOLD market for even the most novice of punters who needed only enough intelligence to fill in an online broking application form.

Now that the pre-GFC insanity has been accosted, and the Emperor has indeed been expose for wearing no clothes, everyone is wailing and gnashing their teeth about how tough things are, and how BUY-AND-HOLD is dead, and how the market is being manipulated by the “Big Guys” (whoever they are).

Fact is, BUY-AND-HOLD is not dead, and never will be as it is dictated by laws of arithmetic and fundamental enterprise economics.

It is still very much alive – and always will be – for the businesses that organically grow the rate at which they generate surplus capital and distribute it to their shareholders.

The trick is to find these businesses because, as I’ve said, they are scarce.


Here endeth the tirade.
I’ll step off the soap box now.