HOLT

November 2012

HOLT NOTES
bryant.matthews@credit-suisse.com 312.345.6187
Fade & Persistence of Corporate Returns raymond.stokes@credit-suisse.com 44.20.7883.6143

Definition applies for firms with an Empirical Competitive

Fade is the tendency to earn the mean real Fade evidence contains more than 75,000
required rate of return over time. Persistence unique firms with 830,000+ time observations.
is the tendency to earn the same return as in The study of Fade is aided by the use of CFROI,
the previous period. which removes distortions in operating returns
caused by accounting treatments, inflation, and
The Corporate Lifecycle other influences of time. HOLT eliminates as
All firms evolve along a corporate lifecycle. many of these distortions as possible so that its
From startup to mature, firms continually return metric (CFROI) is comparable across
adapt, develop, transition. Firms that survive countries and time, and is useful for
the full spectrum of the lifecycle evolve from benchmarking, forecasting, and continued
startup to high growth, fading winner, mature empirical research. These adjustments increase
(including cash cows), and finally turnaround. the reliability of HOLTs forecast CFROI and
Exit can occur at any point in the lifecycle, and Warranted Price estimates.
for numerous reasons, including bankruptcy,
acquisition, or delisting. In the HOLT Median CFROI Through Time
database, less than 50% of firms exist beyond based on starting CFROI
10 years. highest high average low lowest
Early lifecycle firms invest substantial
resources in their business, often without
immediate payoff. Returns are typically below
the cost of capital. Successful mid-lifecycle
firms earn excess profits but attract
competition. Competition eventually pushes
returns back toward the cost of capital, the 0 5 10 15
industry matures and growth rates decline. Not Years after formation
infrequently in late lifecycle, returns fall below Source: Credit Suisse, HOLT
Global Industrials, 1950-2011
the cost of capital and consolidation,
disinvestment and bankruptcy serve to
eliminate excess capacity, tending to push Fade as an Empirical Fact
returns once again back toward the average. Empirically, firms tend toward the average real
required rate of return of 6.0% over time.
Evidence above from 1950 through 2010, shows
that high and low return businesses tend toward
the average required yield. The chart displays the
median CFROI of firm groups based on their
starting CFROI level. From lowest to highest
CFROI, a clear and general tendency toward 6%
is observed over time. Because fewer and fewer
firms survive each passing year, fade research
includes a survivorship bias. This bias is offset by
HOLTs unique discount rate approach, which
measures an equilibrium-state required yield. A
significant benefit of this approach is that fade
HOLT & the Corporate Lifecycle estimates are produced based on average
Advantage Period (eCAP).
HOLT Treatment
HOLT fades all firms in a three-step process.
First, firms fade based on their unique lifecycle
characteristics over the initial 5 years of the
forecast, termed the explicit fade period. In
stage 2, the residual period, all firms fade such
that 10% of economic spread (CFROI-6) is
eliminated per year. In the Terminal period, a
firm is valued as a cost of capital perpetuity, or
equivalently, assets are wound down and
harvested from the balance sheet.
The primary determinants of fade are:
• CFROI Level
• CFROI Volatility
15 • Reinvestment Rate
10
CFROI Level is the strongest predictor of the
5 next period’s operating return. Higher CFROI
volatile firms fade toward 6% faster than lower
0
volatility firms. The average firm experiences
-5 about 25% volatility in its 5 year average
CFROI per year.
Firms with higher reinvestment fade faster
than firms with lower reinvestment. High
reinvestment rates are generally associated
with earlier lifecycle businesses, high
innovation, higher risk-taking, and aggressive
competition.
Example
Volatile Corp. (VOL) is a high growth, high
return mid-lifecycle business. Consensus
based CFROI in LFY+1 is estimated to climb
from 15 to 18%. CFROI deviation is high at
3.2. VOL grew assets at more than 25% last
year. HOLT forecasts CFROI to decline from
Volatile Company
CFROI % Forecast CFROI %
20

Research shows that stages of the corporate survivorship rates, while the discount rate 15

lifecycle produce predictable and repetitive includes default risk. This approach is highly 10
general patterns of behavior. The study of reasonable, since DCF forecasts should only be 5
-4 -2 0 2 4 6
Fade is event-based (historical fact). The made for going-concerns, while risk should
application of fade within the HOLT include some estimate of default. Stable Company
Framework is predicated on general principles
CFROI % Forecast CFROI %
of economics and Finance. HOLTs research of HOLT forecasts CFROI for a period of 5 years. 15
the corporate lifecycle has been on-going for Beyond this, there is little empirical evidence that 10
over 40 years. Continuing research improves CFROI (or any return on capital metric) can be 5
forecast CFROI, resulting in stronger accurately predicted. An exception to this rule 0
predictions. HOLTs growing body of empirical -4 -2 0 2 4 6
18 to 14% by LFY+5. Above-average fade is over time, as evidenced by empirical research histories, and very high reinvestment rates for
driven primarily by the volatility exhibited in and acknowledged by economists. this group make forecasting especially
returns and high reinvestment, which is challenging. On the Lifecycle chart on the
correlated with subsequent reduction in Perpetual returns previous page, the blue-shaded background
operating returns. Numerous analyst models embed a perpetual highlights the regions of the Lifecycle where
economic spread where the operating return HOLT is particularly good at forecasting
In contrast, Stable Corp (STAB) is a stable, exceeds the cost of capital. Fade ensures that all probable fade. Note, that the early lifecycle
mature firm, earning positive CFROI of nearly firms earn zero economic profits in outlying years. stage is un-shaded, showing that this stage of
11.5% year after year. Combined with modest the Lifecycle is an area for further research
growth of 2.5%, STAB is predicted to Normalizing Process and improvement, which is on-going at HOLT.
continue to earn nearly the same CFROI of Most analyst models attempt to “normalize” the
11.5% over the next 5 years. excess profits or losses embedded in near-term Cyclical firms comprise a large percentage of
forecast cash flows by the end of the explicit all publicly traded stocks. The earnings of such
Starting in year 6, both firms are forecast to forecast. HOLTs forecast CFROI is based on the firms are generally highly correlated to the
lose 10% of their economic spread (CFROI- most likely outcome, given a firm’s CFROI Level, business cycle. Most economists agree that
6%) / year. CFROI Volatility and Reinvestment Rate. anticipating cyclical inflections or even the
length of a cycle is extraordinarily difficult. The
Advanced Concepts Probabilistic HOLT model works well for cyclical firms,
Windsorized (removal of outliers) CFROI has a Because HOLTs forecasted cash flows in the since cyclical firms exhibit strong mean-
normal-shaped distribution, as follows: explicit period are based on empirically derived reverting properties. HOLT continues to
fade rates, and fade thereafter in order to revert research cyclical firms to determine if
Normal (Gaussian) Distribution
s.d.
to the long-term mean CFROI, its cash flow improvements in its forecasts can be achieved.
0.20
-4 -3 -2 -1 0 1 2 3 4
1.1
forecast and warranted price estimate represent
0.18 1 the mean expected outcome for a firm given its Is HOLT a “black box”?
0.9
Probability Density

0.16
0.14 0.8 unique combination of fade drivers. In other HOLT is very candid with clients regarding its
Cumulative
Probability

0.12
0.10
0.08
0.06
0.04
0.02
0.00
-2 -0.4 1.2 2.8 4.4 6 7.6 9.2 10.8 12.4 14
CFROI
Sector/Industry Effects
HOLT recognizes distinct business models for
Industrials, Regulated Utilities, and Financials.
Regulated Utilities “piggy-back” off of the
Industrials fade research, using an intercept
adjustment to isolate the distinctly lower
CFROI level of most regulated utility firms. A
separate fade model is used for Financials.
The primary drivers of fade for Financials are
similar to Industrials: CFROE level, CFROE
volatility, and reinvestment rate. The sample
principles of a corporate lifecycle, competition,
and mean-reversion apply.
Regional Effects
Regional differences in fade exist. For
Industrials, Japan has a significantly lower
average CFROI than most other economies,
captured by an intercept adjustment. For
Financials, regional differences are recognized
for Japan, Continental Europe, and Emerging
Markets, with US Financials displaying
significantly higher average CFROE.
Benefits
Terminal growth rate issue
A material benefit of Fade is that it explicitly
avoids estimating a terminal multiple. Terminal
multiples are subject to manipulation and can
contribute to outsized valuation effects.
Instead, economic profits and losses are
forecast to eventually earn the cost of capital
0.7
0.6 words, if a thousand iterations were run using valuation model and fade techniques.
0.5
0.4
empirical fade data and Monte Carlo simulation, Research is available on the topic of Fade, and
0.3 the mean expected NPV cash flow forecast we strive to help our clients understand the
0.2
0.1 would be equal to HOLTs estimated Warranted valuation methodology in its entirety. HOLTs
0
Price. fade algorithms are under constant
investigation. Clients seeking more information
should speak to their local Sales
representative.
Relevant Academic/Practitioner Studies
• Chan, Louis K. C., Jason Karceski, and
Josef Lakonishok. “The Level and
Persistence of Growth Rates.”
• Mauboussin, Michael J. “Death, Taxes, and
Reversion to the Mean.”
• Madden, Bart. CFROI Valuation: A Total
System Approach to Valuing the Firm.
Oxford, Great Britain: Butterworth-
Heinemann, 1999.
Drawbacks
• Holland, David and Tom Larsen. Beyond
Near-term mean reversion isn’t always the norm
Earnings: A User’s Guide to Excess Return
Not all firms fade toward 6% immediately.
Models and the HOLT CFROI® Framework.
Successful early lifecycle firms can fade
London, England: John Wiley & Sons Ltd,
significantly above 6% as market share expands.
2008.
Cyclical firms can exhibit long periods where
CFROI continues to move above or below 6%, as
• Brandes Institute, “Global Small Cap Stocks:
the cycle marches on.
A Life Cycle Perspective.” August 2008
Early lifecycle firms make up a small percentage
of HOLTs database, and an even smaller • Malkiel, Burton G., “The Efficient Market
percentage of investible stocks. These stocks Hypothesis and Its Critics”, Princeton
University, CEPS Working Paper No. 91,
often have binary outcomes: great success or
spectacular failure. Still, the potential for great April 2003
success often makes these stocks an attractive
investment thesis. The volatility in returns, short
 HOLT
November 2012

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