High yield value investing

We think investors persistently undervalue companies with genuine predictability.

Nick Train, Finsbury Growth and Income Trust manager

When I invest in a company my hope is that it can continue to grow far into the future, and while the future is always unknowable to some extent, we can at least try to glimpse into the future by looking at the past.

We began this process last week by calculating a company’s Growth Rate, based on the assumption that companies which have grown faster than inflation in the past are more likely to do so in the future.

That may be largely true, but in many cases it won’t be. Some companies will have grown because of a one-off event, such as a boom in an important market which will only last a few years. Other companies will have grown both rapidly and consistently over a long period of time, but that growth may have been fuelled by high risk external funds such as debts and lease obligations.

So in addition to growth which beats inflation over the medium to long-term, I’m looking for growth which is both consistent and sustainable.

Measuring growth consistency

One way to measure the consistency of a company’s growth is to measure how frequently some key factor increase over a period of time. For me the key growth factors are capital employed, revenues, earnings and dividends per share.

In my experience though, capital employed tends to increase quite consistently for most companies. This means there isn’t much difference between the consistency of capital employed growth from one company to the next, so in my initial analysis I’ll just focus on revenue, earnings and dividend growth consistency.

Here’s the calculation:

As you might expect, I have a rule of thumb which help me avoid companies with relatively inconsistent growth:

As usual, this rule of thumb requires some judgement. For example, I might still invest in a company where earnings go down as often as they go up, as long as there is a clear upward trend over time across revenues, earnings and dividends (and preferably capital employed too).

However, I’m unlikely to invest in a company if its revenues or earnings have declined for five or six years in a row.

Let’s work through a quick example of how to calculate growth consistency, after which we’ll take a look at growth sustainability.

Ted Baker’s consistent growth

We looked at Ted Baker’s consistent track record of profits and dividends in week 1, so let’s expand on that and look at the company’s growth across revenues, earnings and dividends.

Year	Revenue PS	Earnings PS	Dividend PS
2009	358.7	29.6	16.7
2010	393.1	32.6	17.2
2011	449.2	41.4	20.6
2012	499.0	40.6	23.4
2013	587.9	49.9	26.6
2014	740.1	66.3	33.7
2015	875.9	81.0	40.3
2016	1023.7	99.3	47.8
2017	1191.9	104.5	53.6
2018	1326.8	118.3	60.1

Table 3.1: Ted Baker’s results for the ten years to 2018

If you look at Ted Baker’s 2018 results compared to its 2009 results, it’s easy to see that the company has grown. The data also gives the impression that Ted has grown consistently, but how consistently?

Let’s find out.

As you can see, Ted Baker’s growth was very consistent, with revenues, earnings and dividends all increasing by eight or nine. The maximum growth consistency score is 27, so 26 is of course very good.

This also means that Ted easily passes my growth consistency rule of thumb.

Next we’ll take a look at growth sustainability, because fast, consistent growth which is unsustainable is often a disaster waiting to happen.

Measuring growth sustainability

In almost all cases, long-term dividend growth is unsustainable without earnings growth, earnings growth is unsustainable without revenue growth and revenue growth is unsustainable without capital employed growth.

In practice, this means companies can only produce long-term sustainable growth if they employ more capital to fund more factories, warehouses, vehicles, machines, robots, offices, computers and an endless array of other capital assets. Or to put it another way, if you’re looking for sustainable dividend growth, you should start by looking for sustainable capital employed growth.

What is sustainable capital employed growth?

Capital employed consists mostly of equity capital, debt capital and leased capital, and these differ in terms of their risk profile and sustainability.

The easiest way for a company to employ more capital is to take on more debt or leases. You just sign up for a new bank loan or rental agreement and – hey presto – you have access to another retail store or factory. Any idiot can do that.

However, growing capital employed primarily through increased debt and lease obligations can be risky. Those funding sources come with relatively inflexible interest and rent costs, and if earnings growth doesn’t keep pace with interest and rent increases then eventually some sort of crisis is inevitable.

The alternative is equity capital growth. This is typically the most sustainable form of capital growth because equity funding doesn’t come with fixed expense obligations. Of course, shareholders expect a return on their equity, but unlike debt interest or rent, those returns don’t have to be paid out in cash on a regular basis (management can choose to cut or suspend the dividend, although it may cost them their jobs).

We can break equity growth down into two types:

1. Equity growth from rights issues
2. Equity growth from retained earnings

Rights issues occur when management ask shareholders for more money, in exchange for newly issued shares. Rights issues are often used to fund long-term investments (such as a new factory or an acquisition) when the returns on those investments are highly uncertain.

This can be sensible because it matches uncertain returns from the investment with a funding source that has extremely flexible repayment terms (dividends are optional and equity funding is perpetual, i.e. it never has to be repaid).

Although using rights issues to fuel growth isn’t necessarily a problem, it can be if the amounts raised are very large. If a rights issue is used to fund a very large acquisition, for example, the time and effort required to integrate the acquired company can be seriously disruptive to the acquirer’s existing business.

The most common way for management to raise additional equity funding from shareholders is to simply retain earnings instead of paying them out as a dividend. 

This is also the most sustainable way to grow capital employed, for two reasons:

First, as I’ve already mentioned, equity capital doesn’t come with fixed costs. Second, retained earnings are usually relatively small compared to existing capital employed (typically something in the range of 5% to 20%). This is an amount of additional capital that most companies can absorb and deploy whilst maintaining the structural integrity of the business.

Since retained earnings are usually the most sustainable driver of long-term growth, we can use the rate of retained earnings to calculate a company’s sustainable growth rate.

Calculating a sustainable growth rate

Imagine we have a company with £100 million of equity capital, £50 million of debt capital and £50 million of leased capital. Total capital employed is therefore £200 million.

Over the next year, the company produces £20 million of earnings and pays a £10 million dividend, so £10 million of earnings are retained.

That £10 million is added to the company’s existing £100 million of equity, leaving year-end equity at £110 million, an increase of 10%.

With a 10% increase in equity capital, the company has the funds to invest in more assets which should drive earnings growth. Management decide that with the increased earnings potential, taking on a proportional amount of additional debt and lease obligations is prudent.

A proportional increase means that management will increase debt and lease obligations by 10%, in line with the increase in equity. And since equity capital, debt capital and leased capital are all growing at the same rate, total capital employed will grow at the same rate as equity.

This gives us the sustainable growth rate:

sustainable growth rate = retained earnings / equity * 100%

In other words, if a company produces a return on equity of 10%, then 10% is its maximum sustainable growth rate. Also, the more it pays out as a dividend the lower its sustainable growth rate will be. To grow faster than its sustainable growth rate, a company must either raise additional equity through rights issues or increase debts and leases faster than equity, both of which increase risk.

This gives us a simple rule of thumb:

This is a good starting point, but there’s a problem with the sustainable growth rate. It’s based on the assumption that existing debts and leases are sustainable, and that proportional increases in those financial obligations will also be sustainable.

That is quite a large assumption, so I prefer to use a more cautious version of the sustainable growth rate which I call the self-funded growth rate.

Calculating a self-funded growth rate

The self-funded growth rate is basically the same as the sustainable growth rate. The only difference is that instead of assuming debt and lease obligations can grow sustainably in proportion with equity, we assume that truly sustainable growth is funded purely by retained earnings.

This isn’t necessarily true, but it does give us a very conservative view of how a company should fund its growth.

If retained earnings are the sole driver of capital employed growth, then capital employed growth will be limited to the net return on capital employed. In other words, the calculation for the self-funded growth rate is:

self-funded growth rate = retained earnings / capital employed * 100%

For example, if a company produces a net return on capital employed of 10% and retains all of those earnings, then its maximum self-funded growth rate would be 10%. As before, if some earnings are paid out as a dividend then retained earnings and the self-funded growth rate will be lower.

If you see a company where capital employed growth consistently exceeds the self-funded growth rate, then that growth has been at least partly driven by some combination of rights issues and increasing debts and leases.

In many cases that will be quite reasonable. Most growing companies will be growing their earnings and so will be capable of increasing their debt and lease burdens, at least to some extent.

However, if there is a very large gap between a company’s actual capital employed growth over several years and its self-funded growth rate, then that could be storing up problems for the future.

Here’s another simple rule of thumb:

We can see how these ideas play out in the real world by taking another look at Ted Baker.

Ted Baker’s sustainable and self-funded growth rates

As we’ve already seen, Ted Baker produced impressively rapid and consistent growth over the period from 2009 to 2018. Now we’ll check to see how sustainable that growth really was.

Table 3.1 contained the company’s earnings and dividends per share, so to calculate the sustainable and self-funded growth rates we’ll also need equity per share and capital employed per share.

Year	Equity PS	Capital employed PS
2009	146.1	381.1
2010	159.4	433.3
2011	181.9	454.8
2012	197.1	520.7
2013	228.5	616.3
2014	257.6	708.9
2015	317.7	763.4
2016	387.3	1185.9
2017	472.6	1416.6
2018	502.4	1409.6

Table 3.2: Ted Baker’s equity and capital employed, 2009 – 2018

Over the ten years from 2009 to 2018, Ted produced average earnings of 66.4p and paid average dividends of 34.0p. This gave the company average retained earnings of 32.4p. Ted also had average equity per share of 285.1p.

We can use this information to calculate the company’s sustainable growth rate:

With an annualised capital employed growth rate of 17.9% and a sustainable growth rate of 11.4%, it’s clear that Ted Baker’s growth over that decade was fuelled to a considerable extent by increasing debt and lease obligations faster than equity (there were no rights issues during that period).

The implication is that Ted’s historic capital employed growth rate will not be sustainable in the longer-term, because eventually its debt and/or lease burden will become intolerable. And with such a large gap between actual and sustainable growth rates, there is a real risk that Ted’s rapid growth has sown the seeds of future problems.

Let’s see how Ted’s actual growth compares to the more conservative self-funded growth rate.

As you can see, Ted’s self-funded growth rate is just 4.1% compared to a sustainable growth rate of 11.4%. There is a significant difference because Ted’s capital employed is much larger than just its equity, mostly due to Ted’s extensive use of leased capital, primarily in the form of rented stores. 

The self-funded growth rate says that if Ted Baker were to fund its growth purely from retained earnings and without increasing its debt or lease liabilities (perhaps by leasing stores for five years or so with a single cash payment up front, paid for out of retained earnings), then it would be able to sustain a growth rate of no more than 4.1%.

That’s a very long way short of the company’s actual 18% capital employed growth rate, and it  highlights just how much Ted has depended on higher risk external funding to fuel its rapid growth.

But as I’ve said before, not all external funding is bad, and some use of external debt, lease or equity funding is quite sensible for most companies. So while fully self-funded growth may be the ideal, what I’m really interested in is the degree to which external funding has been used to drive growth.

We can measure this with the growth funding ratio.

Calculating the growth funding ratio

One way to measure the degree of external growth funding is to compare the amount of additional external funding taken on to the average earnings produced over the last ten years.

The higher the ratio of external growth funding to average earnings, the less sustainable the company’s growth has been.

Here’s the calculation:

Note that we use nine-year figures for EPS and DPS in the calculation as EPS and DPS 10 years ago did not contribute to capital employed growth in the last ten years.

A negative growth funding ratio means that all of the companies growth either was or could have been funded by retained earnings. A positive growth funding ratio means that retained earnings alone were not enough to drive the companies growth, so additional external funds were required.

As with most financial ratios, the growth funding ratio provides a more meaningful result when measured over a five or ten year period. Let’s see how it works out for Ted Baker.

Ted Baker’s growth funding ratio for 2009 to 2018

To calculate Ted’s growth funding ratio we’ll need its earnings, dividends and capital employed for the period, all of which we already have in Tables 3.1 and 3.2.

Ted’s total external growth funding from 2009 to 2018 comes to 10.2-times the company’s average earnings. In plain English that means it raised more external funds to drive growth than it made in profit over those nine years.

That’s a lot of additional funding and it shows up in the company’s financial statements. They show that Ted’s debts went from zero to £129 million between 2009 and 2018 while lease liabilities went from £100 million to £276 million.

In late 2019 and early 2020, Ted Baker surprised shareholders (of which I was one at the time) with a string of profit warnings, a dividend cut and then a full dividend suspension.

Tough trading conditions were blamed, but I now think the company’s aggressive use of external funds to drive growth far above its self-fundable and sustainable growth rates was the underlying root cause.

Rapid growth requires lots of new stores, new staff, new supply chain partners, new customers, new processes, new management and so on, and all of these have to go through a long and expensive experience curve before they can operate anywhere near optimally. Combine all this newness with the relatively fixed costs of rapidly increasing debt and lease obligations and it’s no wonder Ted Baker eventually ran into serious problems.

To use a driving analogy, growing too fast is like driving too fast. It doesn’t matter how safe the car is. Even the sturdiest Volvo will crash and burn if it’s being driven too fast down a bumpy, twisty road late at night.

Or to use a building analogy, if you build your house as quickly as possible with little or no regard for the integrity of what you’re building, don’t be surprised if it falls down during the first storm.

Turning consistency and sustainability into Growth Quality

Rather than keep track of two separate metrics, I prefer to combine growth consistency and growth sustainability into a single Growth Quality score.

The first part of this Growth Quality score is just the sum of the company’s revenue, earnings and dividend growth consistency scores.

The second part is a bit more complicated, but not much more.

I want revenue, earnings and dividend consistency to all have a similar weighting in the Growth Quality score, and I want growth sustainability to have a similar weighting too.

For that to work it would be useful to express the growth funding ratio as a range from zero to ten (similar to the range of values for growth consistency), rather than as a positive or negative number with no upper or lower limit. Zero would be for companies that used little or no external growth funding while ten would be for companies using a dangerous amount of external growth funding. That begs the question:

What constitutes a dangerous amount of external growth funding?

I don’t have a huge amount of data to go on, but over the last ten years I have invested in two companies which grew rapidly using external funding and then collapsed in a broken and exhausted heap.

Both these companies (Ted Baker and Chemring) had growth funding ratios of more than 10.

Other relatively high growth companies which I’ve owned had much lower growth funding ratios and, in the case of companies like Burberry or Dunelm, negative ratios (so growth was effectively self-funded). These companies have had anything like the problems of Ted Baker or Chemring, so perhaps a growth funding ratio of 10 is a reasonable indicator of dangerous growth.

Turning back to our zero to ten growth sustainability score, if a negative growth funding ratio is very good and more than 10 is dangerous, there’s an easy way to convert that into a score from zero (dangerous) to ten (very good):

Of course, this is calculated automatically in my Company Review Spreadsheet. But if you choose to do it manually it isn’t that complicated. Here’s the calculation for Ted Baker:

This gives Ted Baker a growth sustainability score of zero out of ten, which I think is suitable given its post-2018 problems, most of which I think were driven by its excessively rapid externally-funded growth.

To be on the safe side, I’ve set my growth sustainability rule of thumb well above the dangerous level of zero:

With this rule in place, it’s clear that despite Ted Baker’s impressively rapid and consistent growth, the unsustainability of its growth makes it an unsuitable investment for a defensive value portfolio.

Now that we have a growth sustainability score, we can get on with calculating the Growth Quality score:

In the calculation above, the maximum growth sustainability score is ten while the maximum growth consistency score is 27. This gives us a maximum possible score of 37, which is why we divide by 37 to convert the total into a percentage.

Once again I have a rule of thumb for growth quality, which should help to rule out companies where growth isn’t sufficiently consistent or sustainable:

Let’s have a look at how the Growth Quality score works in the real world with an example.

Burberry’s Growth Quality

I’ll use Burberry because it’s a good example of a company with high Growth Quality. Table 3.1 shows Burberry’s revenue, earnings and dividends per share up to its 2018 annual results.

Year	Capital employed PS	Revenue PS	Earnings PS	Dividends PS
2010	287.5	268.2	34.4	14.0
2011	319.1	338.1	48.3	20.0
2012	386.2	418.0	59.3	25.0
2013	404.9	447.6	57.0	29.0
2014	464.7	520.9	72.1	32.0
2015	546.9	563.5	75.1	35.2
2016	554.2	563.7	69.4	37.0
2017	596.3	625.5	64.9	38.9
2018	522.5	636.4	68.4	41.3
2019	586.2	655.3	81.7	42.5

Table 3.1: Burberry’s ten-year results to 2018

We can convert that wall of numbers into a single Growth Quality score which will make it easier to understand just how consistent and sustainable Burberry’s growth really was.

First we’ll need to calculate its growth consistency.

Now we need to calculate growth sustainability, the first step of which is to calculate the growth funding ratio.

Now that we have Burberry’s growth funding ratio, we can convert that into a growth sustainability score.

We can now calculate Burberry’s Growth Quality using its growth consistency and sustainability scores:

91.9% is a very high Growth Quality score. It reflects the fact that Burberry has produced some of the broadest, most consistent and sustainable growth of any FTSE 100 company over the ten years to 2019.

Next week

Next week I’ll outline how I look for companies with above average profitability, because high profitability is one of the best indicators of a company with strong competitive advantages.

Here’s a summary of the rules of thumb we’ve covered this week.