Why you should invest in good companies

By Terry Smith in Fund Manager View, 5th Feb 2015 - 1:06pm Terry Smith is the founder and chief executive of Fundsmith

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  1. Terry Smith

In order to understand why you should seek to invest in good companies you first need to define what a good company is. In my view, a good company is one which creates value for its shareholders by making a high return on capital-significantly above its cost of capital-across the business end economic cycle.

Several points arise from that statement. Firstly, what is return on capital? It is usually measured by the Operating Profit of the business, divided by the capital employed, being the equity capital or shareholders’ funds plus the net debt of the business, expressed as a percentage.

Secondly, what is the cost of capital? The cost of debt is relatively easy – you can find a reference to the cost of bonds a company has issued in the accounts, and if there is bank debt you can just use the interest charge divided by the average of opening and closing debt as the percentage cost. Cost of equity is trickier to ascertain and is usually taken as a so-called risk free rate, such as the yield on government bonds in the same currency that the company operates in, plus a premium to compensate for the additional risks inherent in equity investment.

This slightly complex formula probably explains at least in part why so few investors seem to try to work this out. Too much time is wasted on spuriously accurate measures of cost of capital, which can only ever be an estimate. If in doubt, assume 10%.

Why is this important? Companies are just like us in some respects. If you borrowed money at 10% pa year and invested it at a 20% a year return you would become richer. But if you invested at 5% you would become poorer. Similarly, a company which makes return above its cost of capital become more valuable – it creates value for its shareholders – and vice versa.

But don’t all companies create value for their shareholders? Sadly not. There are some industries which are prone to make returns below their cost of capital much or all of the time, such as the airline industry which has probably not created value for shareholders throughout most of its existence.

Surely if a whole industry just keeps destroying value, why would anyone invest in it? It seems hope springs eternal for some investors. They invest in companies which do not make adequate returns and so destroy value because they hope they will change – that a change of management, an upturn in the business cycle, a takeover or industry consolidation will alter this fundamentally poor characteristic.

Of course it rarely does, but that’s not the only problem. Such events are not only rare and difficult to forecast, but whilst fund managers wait for their investments in bad companies to come good they steadily erode value by the equivalent of borrowing money from you the shareholder and investing it at an inadequate rate of return.

Conversely, when you own shares in a good company you can be sure that its value will rise over time.

 

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