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HOLT

2013 ROE to CFROI®, Fade and


Wonderful Companies

Greg Collett CFA


+44 (0) 207 88 33 643
greg.collett@credit-suisse.com
HOLT Custom Solutions

CONFIDENTIAL – For Education and Training Purposes Only


Agenda

Introduction
Accounting
Performance Measurement
Fade and Mean Reversion
Link to Valuation
Wonderful Companies
Questions

CLARITY IS CONFIDENCE HOLT


Accounting – how it all flows around

CLARITY IS CONFIDENCE HOLT


The Ideal Performance Metric

Issue Problem
Comparisons between old and new New assets = low return
companies? Old assets = high return

Short life tech company vs. longer life Ratio vs IRR


capital goods company?

Countries with high vs. low inflation? Income statement reflects inflation
Balance sheet to a lesser extent
Correlation with Total Shareholder Does a rising return lead to greater
Return (TSR). TSR?

Accounting manipulation? Financing manipulation does not always


improve TSR

CLARITY IS CONFIDENCE HOLT


The Ideal Performance Metric

Question ROE ROIC CROGI CROIGI CFROI

Old Assets/New
? ? ? ? ?
Assets
Asset Life ? ? ? ? ?

Inflation ? ? ? ? ?
Accounting
? ? ? ? ?
Distortions

CLARITY IS CONFIDENCE HOLT


Comparison of Financial Performance Metrics

Cash Flow
Return on
Investment

Cash Return on
Inflation CFROI
Adjusted Gross
Investment

Cash Return on CROIGI


Gross
Investment

Return on
Invested Capital CROGI

ROIC
Return on Equity

ROCE
ROE ROIIC
RONA
CLARITY IS CONFIDENCE HOLT
Return on Equity

ROE = Net Earnings / Book Equity.


It is a shareholder measure because it measures the return
on assets not funded by debt.
CFROI

CROIGI

CROGI

ROIC
Return on Equity

ROE

CLARITY IS CONFIDENCE HOLT


RoE – Changing Leverage Adds Noise to the Signal
Income 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000
Costs 700 700 700 700 700 700 700 700 700 700 700
EBIT 300 300 300 300 300 300 300 300 300 300 300
Interest 100 90 80 70 60 50 40 30 20 10 0
PBT 200 210 220 230 240 250 260 270 280 290 300
Tax 60 63 66 69 72 75 78 81 84 87 90
Net Income 140 147 154 161 168 175 182 189 196 203 210

Debt 1000 900 800 700 600 500 400 300 200 100 0
Equity 0 100 200 300 400 500 600 700 800 900 1000
Deb/(Debt+Equity) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%
ROE #N/A 147% 77% 54% 42% 35% 30% 27% 25% 23% 21%

1,200 160%
140%
1,000
120%
800
100%
600 80%
60%
400
40%
200
20%

0 0%
1 2 3 4 5 6 7 8 9 10 11

Debt Equity ROE

CLARITY IS CONFIDENCE HOLT


Understanding Inflation’s Impact on ROE

LIFO
Revenue Inventory
FIFO
- Expenses Wages

Net Income
Profit Depreciation
~
ROE =
Owner’s Equity ~
CLARITY IS CONFIDENCE HOLT
Inflation Can Seriously Distort ROE

20
Reported
Reported ROE ROE
using actual U.S.
15 inflation for a 6%
“real” IRR
project.
10

6% IRR Project
5 (Inflation Adjusted)

0
1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

CLARITY IS CONFIDENCE HOLT


Source: HOLT analysis
Return on Equity

Issue ROE Reason


Old Assets/New Neither net income nor equity
Assets
No refect asset age

Neither net income nor equity


Asset Life No refect asset life

Net income reflects inflation. Equity


Inflation No is an historical value

Accounting Both are subject to non-operating


Distortions
No distortions

TSR Tracking No Tracks poorly

CLARITY IS CONFIDENCE HOLT


Return on Invested Capital

ROIC is defined as NOPAT / Invested Capital and is key to Economic Profit analysis.

CFROI

CROIGI

Return on
CROGI
Invested Capital

ROIC

ROCE
ROE ROIIC
RONA
CLARITY IS CONFIDENCE HOLT
Return on Invested Capital

Operating Profit (EBIT)


- Effective Tax Charge
= NOPAT (Net Operating Profit After Tax)

NOPAT
ROIC =
Invested Capital

Total Assets
- Payables
- Other Current Liabilities
- Cash
= Invested Capital

CLARITY IS CONFIDENCE HOLT


Return on Invested Capital – Issues

Current Dollar income which includes


noncash items such as depreciation
and amortization

What does this ratio tell us


about performance?
NOPAT
ROIC = NOPAT and Invested Capital
Invested Capital are not in constant dollars!

Historical cost depreciated assets


Excludes off balance sheet items

CLARITY IS CONFIDENCE HOLT


Accounting Items Can Distort the Return Calculation

Example: Two Plants


• Managers A and B operate plants of equal capacity but with different ages
• Plants each have 20 year life, original cost of assets = 1,000

Plant A Plant B

NOPAT 100 100

Age of Assets 10 0 Manager B is


penalized for
Invested Capital 500 1,000 having a newer
plant!
ROIC 20% 10%

CLARITY IS CONFIDENCE HOLT


Return on Invested Capital

Issue ROIC Reason


Old Assets/New
No Asset age reduces assets
Assets

Asset Life No Not taken into account

NOPAT is current dollars,


Inflation No
Invested Capital is not
Depends on analyst
Accounting Distortions Maybe
adjustments (op leases)

CLARITY IS CONFIDENCE HOLT


Cash Return on Gross Investment

CFROI

Cash Return on
Gross
CROIGI
Investment

CROGI

ROIC

ROE

CLARITY IS CONFIDENCE HOLT


Cash Return on Gross Investment

NOPAT
+Depreciation
+Other non-cash
Operating After items
Tax Cash Flow
CROGI =
Gross Investment

Invested Capital
+
ROIC Accumulated
Depreciation
+
ROE Capitalized
Expenses

... by adding back non-cash items to NOPAT and accumulated depreciation to


Invested Capital

This captures the total value of investment in the asset base more accurately
CLARITY IS CONFIDENCE HOLT
Cash Return on Gross Investment

Example: Two Plants

Plant A Plant B

NOPAT 100 100

Depreciation 50 50 CROGI shows that


Operating After Tax managers A and B
150 150
Cash Flow are achieving
Invested Capital 500 1,000 similar cash returns
Accum ulated
500 0
on the original
Depreciation investment!
Gross Investment 1,000 1,000

CROGI 15% 15%

CLARITY IS CONFIDENCE HOLT


Cash Return on Gross Investment – Operating Leases

Plant A Plant B Plant C

NOPAT 100 100 100

Depreciation 50 50 0

Operating Leases 0 0 50 CROGI shows that


Operating After managers A, B and C
150 150 150
Tax Cash Flow are achieving similar
Invested Capital 1,000 1,000 0 cash returns on the
Accumulated original investment!
500 0 0
Depreciation
Gross Capitalised
0 0 1,000
Leases
Gross
1,000 1,000 1,000
Investm ent

CROGI 15% 15% 15%

These scenarios assume zero net working capital

CLARITY IS CONFIDENCE HOLT


Cash Return on Gross Investment

Net PPE/Gross PPE PPE Life


0.56 25.00

0.54
20.00

0.52
15.00
0.50
10.00
0.48

5.00
0.46

0.44 0.00
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011

1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Capex/Depreciation The Net/Gross plant ratio tells us that the PPE is
2.5 50% depreciated.
2.0
Capex/Depreciation is greater than one
1.5 indicating net growth
1.0
Plant life (GrossPPE/depreciation) has
0.5
increased. This could be caused by changes in
sector composition and weight over time.
0.0
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011

CLARITY IS CONFIDENCE HOLT


Europe>1bn Eur ex Financials. Source Credit Suisse HOLT 2 Oct 2012
Cash Return on Gross Investment

Issue CROGI Reason


Old Assets/New Accumulated depreciation is
YES
Assets added back

Asset Life No Not taken into account

Cash flow is current dollars,


Inflation No
Invested Capital is historical
Depends on analyst
Accounting Distortions Maybe
adjustments (op leases)

CLARITY IS CONFIDENCE HOLT


Cash Return on Gross Investment

What is the impact of inflation on the investment


made ten years ago?

Are you measuring return on what you spent ten


years ago or on what that investment is worth in
today’s money (current Dollars)?

CLARITY IS CONFIDENCE HOLT


Differing Inflation Rates Make International Comparisons Difficult

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Source Credit Suisse HOLT 2 Oct 2012
Cash Return on Inflation Adjusted Gross Investment

CROIGI is defined as Cash Return / Inflation Adjusted Gross Investment.

Cash Return on
Inflation Adjusted CFROI
Gross Investment

CROIGI

CROGI

ROIC

ROE

CLARITY IS CONFIDENCE HOLT


Cash Return on Inflation Adjusted Gross Investment

Operating After Tax Cash


Flow
Operating After Tax
Cash Flow
CROIGI =
Inflation Adjusted
Gross Investment
Gross Investment + Inflation
Adjustment on Gross
Investment
CROGI

ROIC

ROE ... by adding an inflation adjustment to the gross fixed assets to approximate
their value in today’s money.

This gives a fair value to the entire asset base, regardless of age.

CLARITY IS CONFIDENCE HOLT


Cash Return on Inflation Adjusted Gross Investment

Example: Two Plants

Plant A Plant B
Operating After Tax
150 150
Cash Flow
Gross CROIGI shows that
1,000 1,000 plant A’s return is
Investm ent
Age 10 0
actually less than B’s
when the value of
Inflation
220 0 investment is
Adjustm ent*
Inflation Adjusted compared in today’s
1,220 1,000 money!
Gross Investment
CROIGI 12% 15%

* Assuming 2% Annual Inflation

CLARITY IS CONFIDENCE HOLT


Why Is It Important to Adjust for Inflation?

Year 1 2 3 4 5 6 7 8 9 10
USA Inflation 3.9% 2.8% 2.6% 2.4% 2.5% 2.3% 1.6% 0.6% 1.4% 2.2%
SA Inflation 13.5% 12.7% 10.4% 9.8% 8.8% 8.4% 7.8% 7.7% 6.8% 6.2%
Avg Exchange Rate 2.76 2.85 3.27 3.55 3.63 4.3 4.61 5.55 6.12 6.94
Life (Years) 10

Analysys in USD
Cost in USD 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000
Accumulated Depreciation 100 200 300 400 500 600 700 800 900 1000
Net Asset Value 900 800 700 600 500 400 300 200 100 0
GCF 150 154 158 162 166 170 173 174 176 180 Grows with US inflation
Inflation Adjusted Cost 1,000 1,028 1,055 1,080 1,107 1,133 1,151 1,158 1,174 1,200 Grows with US inflation
ROIC 15% 17% 20% 23% 28% 34% 43% 58% 88% 180%
CROGI 15% 15% 16% 16% 17% 17% 17% 17% 18% 18%
CROIGI 15% 15% 15% 15% 15% 15% 15% 15% 15% 15%
CFROI 8% 8% 8% 8% 8% 8% 8% 8% 8% 8%
Analysys in ZAR
Cost in USD 2,760 2,760 2,760 2,760 2,760 2,760 2,760 2,760 2,760 2,760
Accumulated Depreciation 276 552 828 1,104 1,380 1,656 1,932 2,208 2,484 2,760
Net Asset Value 2,484 2,208 1,932 1,656 1,380 1,104 828 552 276 0
GCF 414 467 515 566 615 667 719 774 827 878 Grows with SA inflation
Inflation Adjusted Cost 2,760 3,111 3,434 3,771 4,102 4,447 4,794 5,163 5,514 5,856 Grows with SA inflation
ROIC 15% 19% 23% 29% 37% 48% 65% 94% 150% 318%
CROGI 15% 17% 19% 20% 22% 24% 26% 28% 30% 32%
CROIGI 15% 15% 15% 15% 15% 15% 15% 15% 15% 15%
CFROI 8% 8% 8% 8% 8% 8% 8% 8% 8% 8%

GP Factor in USA 1.00 1.03 1.05 1.08 1.11 1.13 1.15 1.16 1.17 1.20
GP Factor in SA 1.00 1.13 1.24 1.37 1.49 1.61 1.74 1.87 2.00 2.12

Notes
1. A South African company buys an asset in US$ in 1991 and places it on its books in ZAR. The asset does not get revalued
2. The company produces a profit stream that can be priced in US$ or ZAR. Products are sold at a local price or global commodity price
3. It is assumed that NDA (working capital) is zero for the CFROI calculation.
CLARITY IS CONFIDENCE HOLT
Cash Return on Inflation Adjusted Gross Investment

Issue CROIGI Reason


Old Assets/New Accumulated depreciation is
YES
Assets added back

Asset Life No Not taken into account

Numerator and denominator


Inflation YES
are in current dollars
Depends on analyst
Accounting Distortions Maybe
adjustments (op leases)

CLARITY IS CONFIDENCE HOLT


Cash Return on Inflation Adjusted Gross Investment

What if two projects with the same return have


different lives?

How do you select the correct one?

For the same investment would you choose a 10%


project with a 5 year life or a 10 year life?

CLARITY IS CONFIDENCE HOLT


Ericsson and GSK’s returns look the same……..but are they?

ERICSSON LM (2009)

Gross Cash Flow €5,449


= = 15.9%
Gross Investment €34,343

GLAXOSMITHKLINE PLC (2009)

Gross Cash Flow £12,249


= = 15.9%
Gross Investment £77,174

CLARITY IS CONFIDENCE 30 HOLT


Source Credit Suisse HOLT 2 Oct 2012
Cash Flow Return On Investment (CFROI®)
Cash Flow Return
on Investment

CFROI ®

CROIGI

CROGI

ROIC

ROE

CLARITY IS CONFIDENCE HOLT


Why is Project Life so Important?

Gross Cash 50
Flow
Life helps measure the economic return earned today,
10 by forecasting how much cash flow will be received
over a realistic time period.

10% return? Consider a £100 investment that earns £10 in cash


Life = 4 Years flows for 4 years. The CROIGI return “looks” like 10%
(10/100), yet when life is considered, the economic
Current £ return (CFROI) is negative.
Gross
Investment

100
CFROI = - 3.1%

CLARITY IS CONFIDENCE HOLT


Why is Project Life so Important?

Consider that same £100 investment that earns £10 in cash flows for 30 years. The CROIGA
return “looks” like 10%, however, the cash flows are forecasted to last 30 years, making
the economic return 9.68%.

Non-Depreciating
Infl. Adj. 50 Asset Release
Gross Cash
Flow
10

10% return?
Life = 30 Years
Current
Gross
Investment

100 CFROI = 9.68%

CLARITY IS CONFIDENCE HOLT


CFROI® Not Distorted By Asset Mix

20

Machine Tools 10
IRR = 3.0%

10 Years

100
75

10
Distribution Company
IRR = 8.3%
10 Years

100

CLARITY IS CONFIDENCE HOLT


CFROI accounts for different asset lives

Traditional Return Metric (Ratio) CFROI

ERICSSON LM (2009) CFROI = 6.9%

Gross Cash Flow €5,449


= = 15.9%
Gross Investment €34,343 Asset life: 6.2 years

CFROI = 12.6%
GLAXOSMITHKLINE PLC (2009)

Gross Cash Flow £12,249


= = 15.9% Asset life: 12.4 years
Gross Investment £77,174

CLARITY IS CONFIDENCE 35 HOLT


Source Credit Suisse HOLT 2 Oct 2012
Adjustments Are Essential to True Economic Performance Measurement

Cash Flow Return


on Investment

Asset Life CFROI

Inflation Adjustment CROIGI

Accumulated Depreciation CROGI

Enterprise level
measure ROIC
Adjustments
ROE

CLARITY IS CONFIDENCE HOLT


Case Study: NOKIA

NOKIA CORPORATION
90.00 2500.00

80.00

70.00 2000.00

60.00

50.00 1500.00

40.00

30.00 1000.00

20.00

10.00 500.00

0.00
1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011
-10.00 0.00
ROE ROIC CROGI CROIAGI CFROI Price TSR (RHS)

ROIC is a very much more volatile measure and therefore very much
more difficult to forecast.

CLARITY IS CONFIDENCE HOLT


Source Credit Suisse HOLT 2 Oct 2012
Case Study: NOKIA – ROIC – why so volatile?

18,000 90

16,000 80

14,000 70

12,000 60

10,000 50

8,000 40

6,000 30

4,000 20

2,000 10

0 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

NOPAT Operating Invested Capital ROIC (RHS)

Invested capital is the problem

CLARITY IS CONFIDENCE HOLT


Source Credit Suisse HOLT 2 Oct 2012
Case Study: NOKIA – ROIC – why so volatile?

40,000

30,000

20,000

10,000

-10,000

-20,000

-30,000
1991

1994

1997

1999

2000

2002

2005

2008

2010
1992

1993

1995

1996

1998

2001

2003

2004

2006

2007

2009

2011
Plant (Net) Current Assets Current Liabilities Other Long Term Assets

Current assets declined from 2000 to 2004 while current liabilities


remained relatively unchanged. Assets increased significantly from 2006
without a proportional increase in current liabilities.

CLARITY IS CONFIDENCE HOLT


Source Credit Suisse HOLT 2 Oct 2012
Case Study: NOKIA – ROIC – why so volatile?

60,000 35

50,000 30

25
40,000
20
30,000
15
20,000
10
10,000 5

0 0
1989

1990

1991

1995

1996

2000

2001

2005

2006

2010

2011
1988

1992

1993

1994

1997

1998

1999

2002

2003

2004

2007

2008

2009
Includes cash! Working Capital Gross Fixed Assets Gross Investment Gross Cash Flow (RHS) CFROI (RHS)

18,000 90
60,000
16,000 80

14,000 50,000 70

12,000 40,000 60

10,000 50
30,000
8,000 40
20,000
6,000 30

4,000 10,000 20

2,000 0 10
1989

1990

1991

1995

1996

2000

2001

2005

2006
1988

1992

1993

1994

1997

1998

1999

2002

2003

2004

2007
0 0
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Working Capital Gross Fixed Assets Gross Investment Gross Cash Flow (RHS)
NOPAT Operating Invested Capital ROIC (RHS)

CLARITY IS CONFIDENCE HOLT


Source Credit Suisse HOLT 2 Oct 2012 60,000
Case Study: NOKIA – through the CFROI lens

CLARITY IS CONFIDENCE HOLT


Source Credit Suisse HOLT 2 Oct 2012
Case Study: TESCO plc– Sale and leaseback has increased ROIC

CLARITY IS CONFIDENCE HOLT


Source Credit Suisse HOLT 2 Oct 2012
The Ideal Performance Metric

Question ROE ROIC CROGI CROIGI CFROI

Old Assets/New
No No Yes Yes Yes
Assets
Asset Life No No No No Yes

Inflation No No No Yes Yes


Accounting
No No Partial Partial Yes
Distortions

CLARITY IS CONFIDENCE HOLT


Conclusions

• Return measures are essential to our understanding of companies

• They can be volatile which makes forecasting difficult and uncertain

• Mean reversion happens

• Most important of all……………

• Returns are not a measure of either absolute or relative value.


• You need to know what you are measuring
• You need to know what your measure is telling you

CLARITY IS CONFIDENCE HOLT


Drivers of Firm Value

Firm Value = PV Cash Flows + Market Value of Investments

Returns vs. Discount Rate,


Firm Value =
∫ Asset Growth and hence, Sales Growth,
Competitive Advantage Period,
Fade Rate of Returns and Asset Growth

CLARITY IS CONFIDENCE HOLT


Valuation Continuum

PE Multiple Dividend Discount Model


Tobin’s Q
Value/Cost Discounted FCFF
Discounted EVA® Real
EV/EBITDA HOLT CFROI DCF Options
PEG Ratio
Price/Book Monte
Carlo
Price/Sales Gordon Growth Simulations
EPS Growth

Increasing Sophistication and Completeness

Cash Distribution Models


Relative Valuation Variance and
Cash Production Models Probability
Models
CLARITY IS CONFIDENCE HOLT
Rules for Value Creation – What is Good Growth?
Managing for shareholder value requires an understanding of the trade-off between cash flow returns and growth. Capital
should be allocated to positive spread businesses and projects that are creating value. Marginal businesses should concentrate
on improving operating efficiencies instead of growth.

Return Measure Positive


Spread
Business Discount Rate
(Cost of Capital)

Neutral
Spread
Business Negative
Spread
Business

• Increase returns • Increase returns • Increase returns


Strategic
Options • Hold returns • Then grow • Reduce
and grow assets Reinvestment
• Divest or Liquidate

CLARITY IS CONFIDENCE HOLT


CFROI Observations: Fade Happens
Initial CFROI Ending CFROI (t+5)
(t+1) 80
240

60
180

15-20% 40
120

20
60

00
-5
-5 00 55 10
10 15
15 20
20 25
25

300
700
600
250
500
200
400
10-15% 150
300
100
200
50
100
00
-5
-5 00 55 10 15
15 20 25

1000
500
900
450
800
400
700
350
600
300
500
250
6-10% 400
200
300
150
200
100
100
50
0
USA Large & Mid-Cap: -5 0 5 10 15 20 25
1980-2005

CLARITY IS CONFIDENCE HOLT


48
Growth Observations: Fade Really Happens!

Initial Growth Ending Growth (t+5)


(t+1) 250
90
80
200
70
60
20-30% 150
50
40
100
30
20
50
10
00
-20
-20 -10
-10 00 10
10 20 30 40

700
140
600
120
500
100
400
80
10-20% 300
60
200
40
100
20
00
-20
-20 -10
-10 00 10
10 20
20 30
30 40
40
45
140
40
120
35
100
30
80
25
20
60
-20 to -10% 15
40
10
``

20
5
USA Large & Mid-Cap: 0
1985-2005 -20
-20 -10
-10 00 10
10 20
20 30
30 40
40

CLARITY IS CONFIDENCE HOLT


49
Research Focus: Better Stock Selection via Empirical Fade Signals

Assets Probability Forecasting


June 2011-present

CFROI Wonderful Companies


June 2013

Growth
Terminal Success
FCFF June 2012


Warranted Fade
 CFROI Performance
Price t 1 Handbook
DR October 2012

Economic Profit Pools


August 2013

*Reversion to the Mean

CLARITY IS CONFIDENCE 50 HOLT


*an up-coming article soon to be published by Michael Mauboussin and Dan Callahan from Credit Suisse Global Financial Strategies Team
Wonderful Companies

“Form is temporary. Class is permanent. The sportswriters’ cliché can also


be applied to companies. There has been a long argument that some
companies truly are better than others and will outperform through good
times and bad.”

– John Authers, Quality could still be underpriced by markets, Financial


Times, August 2, 2013, adapted from Wonderful Companies, Credit
Suisse, HOLT.

CLARITY IS CONFIDENCE 51 HOLT


Wonderful Companies

These are the “wonderful companies”

CLARITY IS CONFIDENCE 52 HOLT


Wonderful Companies: Global Transition Matrix

Companies which start in Q4 have a 51% chance of remaining there


Companies which start in Q1 have a 6% chance of getting to Q4 – turnarounds?

Q3 companies have 20% chance of hitting Q4 but 28% chance of Q2


Q2 companies have 28% chance of hitting Q1 but 23% chance of Q3

Downward probability (fade) is greater and turnarounds are very difficult to


achieve.

Source: HOLT Wealth Creation Principles , Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful? Bryant
Matthews & David Holland, June 2013
CLARITY IS CONFIDENCE HOLT
Wonderful Companies

Is future improvement in CFROI correlated with stock price change?


Is historical CFROI persistence correlated with stock price change?

- LHS - RHS

Improvements in CFROI are strongly CFROI persistence is strongly correlated


correlated with excess shareholder return with excess shareholder return
CFROI Change is measured as the difference between CFROI *Firms split into quintiles of CFROI Volatility, measured concurrently
(LFY+5) and CFROI (LFY) with excess shareholder return (over 5 years).
*Excess shareholder return is the annualized total shareholder return
of portfolio over 5 years less the annualized total shareholder return of
universe.

54
Source: HOLT Wealth Creation Principles , Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful? Bryant
Matthews & David Holland, June 2013
CLARITY IS CONFIDENCE HOLT
Wonderful Companies: Persistence and Return

CFROI persistence measured over 5 years.


Persistence factor is the slope coefficient (beta) in the equation: y = a + bX, where y = CFROI(t+5) and X = CFROI(t+0)

Source: HOLT Wealth Creation Principles , Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful? Bryant
Matthews & David Holland, June 2013
CLARITY IS CONFIDENCE 55 HOLT
Wonderful Companies: Is There Persistence in Corporate Returns?

Hotels Restaurants
Software & Services
& Leisure Software & Services
14 22
CFROI t+0 *CFROI t+5
5 1 t+0 t+5 1
-- ----------------------------
2 Mean: 10.0 11.7
1 Median: 10.710.511.2 14.5
2 Std Dev: 12.9 5.6
-- .75 3.9 ---------------------------- .75
7 IQR(t+0): 3.9 -- 17.5

Probability > CFROI

CFROI

CFROI
0 IQR(t+5): 8.4 -- 14.7
9 Obs: 7 9,169 7

.5 10.7 .5

3.5 -.5

.25 17.5 .25

0 -8
1985 1990 1995 2000 2005 2010 1985 1990 1995 2000 2005 2010
*most likely CFROI outcome
0 25th %-ile Median 75th %-ile 0 25th %-ile Median 75th %-ile
-40 -20 0 20 40
Global equities,
GlobalMarket
equities,
CapMarket
$250MMCap>$250MM
scaled scaled Global equities, Market Cap $250MM scaled
Source: Credit
Source:
Suisse,
Credit
HOLT
Suisse, HOLT Source: Credit Suisse, HOLT

Percent of Firms in remaining Quartile Percent of Firms in remaining Quartile


Ending Quartile Ending Quartile
Q1: -- Q2: - Q3: + Q4: ++ Q1: -- Q2: - Q3: + Q4: ++
Q1: -- 66 24 7 3 Q1: -- 47 30 17 6
Quartile

Quartile
Starting

Starting
Q2: - 24 51 21 4 Q2: - 32 35 23 10
Q3: + 9 26 52 13 Q3: + 16 32 31 21
Q4: ++ 5 9 26 60 Q4: ++ 9 14 30 48

Source: HOLT Wealth Creation Principles , Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful? Bryant
Matthews & David Holland, June 2013
CLARITY IS CONFIDENCE 56 HOLT
Wonderful Companies: Is There Persistence in Corporate Returns?

Source: HOLT Wealth Creation Principles , Was Warren Buffet Right: Do Wonderful Companies Remain Wonderful? Bryant
Matthews & David Holland, June 2013
CLARITY IS CONFIDENCE 57 HOLT
Wonderful Companies: Conclusions

• Corporate profitability is sticky


• Wonderful companies tend to remain wonderful
• Poor companies remain “stuck in the mud”
• Sustainable corporate turnarounds are difficult to execute
• Firms with excellent profitability tend to outperform those with the
worst return on capital.
• The outperformance improves if high quality firms are purchased at a
fair price.
• The outperformance can be further improved by purchasing quality
firms at a fair price that are exhibiting positive relative momentum.

CLARITY IS CONFIDENCE 58 HOLT


HOLT

Appendix
From Cash To CFROI® (Internal Rate of Return)

Net Income (Before Extraordinary Items)


+/- Special Items (after tax)
Net Working Capital (inc Cash)
+ Depreciation/Amortization Expense
+ Inflation Adjusted Land & Improvements
+ Interest Expense
+ Investments (Non-Equity Method )
+ R&D Expense
+ Other LT Assets less Pension Assets
+ Rental Expense
+ Minority Interest Expense
+ Net Pension Cash Flow Adjustment £25
+ LIFO charge to FIFO Inventory
+ Monetary Holding Gain/Loss
- Equity Method Investment Income
Non-Depreciating Assets
£10 Gross Cash Flow

CFROI® = 6.0%
13-Year Asset Life
Net Book Assets
+ Accumulated Depreciation
+ Inflation Adjustment to Gross Plant
+ LIFO Inventory Reserve
+ Capitalized Operating Leases
£100 + Capitalized R&D
Inflation Adjusted - Equity Method Investments
Gross Investment - Pension Assets
- Goodwill
- Current Liabilities (Exc Short Term Debt)

CLARITY IS CONFIDENCE HOLT


Disclosure and Notice
This material has been prepared by individual traders or sales personnel of Credit Suisse Securities (USA) LLC ("Credit Suisse") and not by the Credit Suisse research
department. It is provided for informational purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or
services mentioned. It is intended only to provide observations and views of individual traders or sales personnel, which may be different from, or inconsistent with, the
observations and views of Credit Suisse research department analysts, other Credit Suisse traders or sales personnel, or the proprietary positions of Credit Suisse. Observations
and views expressed herein may be changed by the trader or sales personnel at any time without prior notice. Past performance should not be taken as an indication or guarantee
of future performance, and no representation or warranty, expressed or implied is made regarding future performance. The information set forth above has been obtained from or
based upon sources believed to be reliable, but Credit Suisse does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out
of errors, omissions or changes in market factors. This material does not purport to contain all of the information that an interested party may desire and, in fact, may provides only
a limited view of a particular security or market. Credit Suisse may participate or invest in transactions with issuers of securities that participate in the markets referred to herein,
perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. Also, Credit Suisse may have
accumulated, be in the process of accumulating or accumulate long or short positions in the subject security or related securities. This material does not constitute objective
research under FSA rules.

To obtain a copy of the most recent Credit Suisse research on any company mentioned please contact your sales representative or go to http://www.credit-
suisse.com/researchandanalytics.

FOR IMPORTANT DISCLOSURES on companies covered in Credit Suisse Investment Banking Division research reports, please see www.credit-
suisse.com/researchdisclosures.

Backtested, hypothetical or simulated performance results have inherent limitations. Simulated results are achieved by the retroactive application of a backtested model itself
designed with the benefit of hindsight. The backtesting of performance differs from the actual account performance because the investment strategy may be adjusted at any time,
for any reason and can continue to be changed until desired or better performance results are achieved. Alternative modeling techniques or assumptions might produce
significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor a guarantee of future returns. Actual results will vary
from the analysis.

The HOLT methodology does not assign ratings to a security. It is an analytical tool that involves use of a set of proprietary quantitative algorithms and warranted value calculations,
collectively called the HOLT valuation model, that are consistently applied to all the companies included in its database. Third-party data (including consensus earnings estimates)
are systematically translated into a number of default variables and incorporated into the algorithms available in the HOLT valuation model. The source financial statement, pricing,
and earnings data provided by outside data vendors are subject to quality control and may also be adjusted to more closely measure the underlying economics of firm
performance. These adjustments provide consistency when analyzing a single company across time, or analyzing multiple companies across industries or national borders. The
default scenario that is produced by the Credit Suisse HOLT valuation model establishes the baseline valuation for a security, and a user then may adjust the default variables to
produce alternative scenarios, any of which could occur. The HOLT methodology does not assign a price target to a security. The default scenario that is produced by the HOLT
valuation model establishes a warranted price for a security, and as the third-party data are updated, the warranted price may also change. The default variables may also be
adjusted to produce alternative warranted prices, any of which could occur. Additional information about the HOLT methodology is available on request.

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Credit Suisse Group AG or its affiliates in the United States and other countries.

HOLT is a corporate performance and valuation advisory service of Credit Suisse

© 2011 Credit Suisse Group AG and its subsidiaries and affiliates. All rights reserved.

CLARITY IS CONFIDENCE 61 HOLT