(This is Part 3 of a four part series. Part 1, Part 2, Part 4.)

In Part 1 and Part 2 of this series, we explained how low growth stocks exhibit what we believe is an underappreciated risk profile and we provided a case study of an investment we made that worked out poorly due to this risk manifesting itself. In Part 3, we’re going to examine why low growth risk is a bigger risk to the highest quality companies which generate high returns on invested capital (the very companies we focus on owning at Ensemble Capital) while low growth risk is less pronounced for weak companies that don’t generate above average returns on capital.

As much as we talk about return on invested capital (ROIC), what also matters is the amount of capital a company can put to work at these high returns. Most simply, ROIC measures how many incremental dollars of earnings a company earns by reinvesting their earnings.

As a simple illustration, a company with an average 10% ROIC needs to invest 50% of their earnings to grow 5% (10%*50%=5%). A company with a 50% ROIC only needs to reinvest 10% of earnings to grow 5% (50%*10%=5%). In the former case, $0.50 of every dollar of earnings is not needed to fund growth, while in the latter case $0.90 is not needed to fund growth. This means that the higher ROIC company will generate 80% more free cash flow than the average ROIC company making the company 80% more valuable. This is why we focus on ROIC in our analysis. High ROIC businesses are significantly more valuable than average ROIC companies even when they produce the same level of growth.

This isn’t just an academic exercise. The higher ROIC=higher value theory is apparent in market prices. For instance, the payroll processing company Paychex has been awarded a high valuation by the market over time even while generating modest growth. But Paychex generates near 100% returns on invested capital. Using the math in the example above, we can see that the stock should trade at a PE multiple of about 90% above the average stock. 100%*5%=5%, so 95% of earnings are available to distribute to shareholders. 95%/50%=90% premium.

And guess what, over its long history, Paychex has traded at an average PE of 30.5x vs the S&P 500 of 16.2 or an 88% premium.

ROIC isn’t a secret formula. But its value is deeply under appreciated by most investors. That’s why so many Wall Street analysts have regularly under estimated the value of the business. In many Street reports on Paychex, the analyst acknowledges the quality of the business, but points to the modest growth rate to argue that since it is pretty similar to the growth rate of the overall market, Paychex should also have a market like PE ratio. But as we just showed, a company with the ROIC profile of Paychex should trade at a much higher PE ratio than the average company even if their growth rate is similar to the average company. And we’ve shown this is actually how the market prices stocks even if many investors underappreciated the value of ROIC.

However, ROIC is only valuable if there is growth available and so it is productive to reinvest your earnings. If we use the exact same example as above, but you assume 1% growth you get a company with an average 10% ROIC needs to invest 10% of their earnings to grow 1% (10%*10%=1%). A company with a 50% ROIC only needs to reinvest 2% of earnings to growth 1% (50%*2%=1%). In the former case, $0.90 of every dollar is not needed to fund growth, while in the latter case $0.98 is not needed to fund growth. This means that the higher ROIC company will generate 9% more free cash flow than the average ROIC company making the company 9% more valuable.

So even under conditions of low growth, high ROIC businesses are worth more than average ROIC businesses. But the premium value of high ROIC is related to the amount of growth that high ROIC can be applied against. You can do the same exercise using high growth rates and you’ll find that the premium for the high ROIC business increases. So long term sustainable growth rates have an outsized impact on high ROIC business. For better or for worse.

High ROIC businesses are very efficient deployers of capital in terms of the bang for the buck they get on new dollars they invest into their business. But being so efficient means that when their growth opportunity declines, they don’t get that much benefit to their free cash flow. Average ROIC businesses on the other hand are so capital inefficient that while lower growth is bad, it frees up a lot of additional cash flow when growth slows.

Most investors focus on the relatively near term financial results of a company. But most of the value of a company is based on its long term cash flows. This is why the long term sustainable growth rate has such a large influence on valuation. No business can grow faster than the economy over the long term because the math of compounding growth rates would lead to the company becoming bigger than the whole economy before too long. But businesses certainly can grow slower than the economy. So while fast growth firms have more risk if you’re focused on near term results, low growth companies exhibit more risk if you care about long term results and this risk is compounded if, like Ensemble, you intentionally target high return on capital companies that generate a lot of additional value from each incremental unit of potential growth.

As of the date of this blog post, clients invested in Ensemble Capital Management’s core equity strategy own shares of Paychex (PAYX). These companies represent only a percentage of the full strategy. As a result of client-specific circumstances, individual clients may hold positions that are not part of Ensemble Capital’s core equity strategy. Ensemble is a fully discretionary advisor and may exit a portfolio position at any time without notice, in its own discretion.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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