Morgan Stanley: One Job

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Introduction

Here’s a profile of a company. Do you want to buy the stock?

• This company will be profitable for each of the next 15 years. Both sales and net income will grow at close to a 40 percent compound annual rate. The company will also initiate a dividend in the third year, which will grow at nearly a 50 percent compound annual rate through the end of the period.

Here’s another profile. Do you want to buy the stock?

• This company will have negative free cash flow for each of the next 15 years. The level of debt will grow at a 34 percent compound annual rate over this time. Its cash balance will start at 2.5 percent of sales and will dwindle to 2.0 percent by the end of the period.

The answer to both questions should be “yes.” As you may have guessed, this is the same company, Wal-Mart Stores, Inc., from 1972- 1986. The annual total shareholder return of Walmart’s stock during this period was 29 percent versus the S&P 500’s 11 percent.

You would be forgiven for thinking the first profile sounds better than the second one. The company was consistently profitable and grew its top and bottom lines at a healthy clip. Establishing and raising the dividend also signaled management’s confidence in the future. The price-earnings ratio may have been high at times but at least there were earnings. We can’t say the same for many of the companies going public today. Nearly 40 percent of companies listed in the U.S. in 2019 lost money, up from fewer than 20 percent in the 1970s.¹

The negative free cash flow in the second profile tells you only that the company invested more money than it made. The firm required external financing, which led to rising debt and slim cash balances. But the second profile omitted the key fact that Walmart’s annual return on invested capital averaged 18 percent during that time, a level well in excess of its cost of capital. It spent more than it earned, but its investments had a high payoff.

Anticipating Expectations Revisions

The one job of an equity investor is to take advantage of gaps between expectations and fundamentals.² Expectations reflect the future free cash flows a company must deliver to justify today’s stock price. Fundamentals capture the company’s actual results. Tomorrow’s outcomes that are different than today’s perceptions lead to revisions in expectations that are the source of excess returns.

Expectations are like the odds on the tote board that a racehorse will win. Fundamentals are the result of the race. Handicappers know that you don’t make money by picking favorites. You make money by spotting
mispriced odds and investing accordingly.³

Lots of factors determine the timing, magnitude, and value of free cash flows. These include macroeconomic growth, interest rates, inflation, the ferocity of competition, and the industry’s spot in its life cycle. Because many of these are outside the control of investors and companies, they are generally not a source of excess returns.⁴ Investors should be aware of potential macroeconomic developments but generally agnostic as to which ones will unfold. Scenario analysis is an effective means to accommodate macro outcomes.

What is in an investor’s control is gaining a solid understanding of a company’s prospects for creating value. This requires a grasp of the basic unit of analysis, which answers the fundamental question of how a company makes money. The basic unit of analysis for Walmart, and other retailers, is the return on investment for a
store. Net present value is the tried and true way to conduct this analysis. A store creates value if the present value of future free cash flows it generates exceeds the investment the company makes in it.

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