I spend a lot of my day reading various reports, SEC filings, opinions and ideas. One of the reasons I love the deep value approach is that I am at my most content when sitting at the desk with a bug stack of stuff to read and numbers to crunch. Over time, I have found a handful of people are worth reading every time they put something out in the world. It is always full of either new information or thought-provoking conclusions that can help make me a better thinker and investor. I have their sites set up so that anytime they write so much as a sentence, it immediately pops up in my inbox.
One such individual is Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University. His work on corporate finance and valuation are some of the best things I have ever read on this subject. His blog and his website are full of useful information, and he shares reams of data for crunching numbers.
Earlier this week, he wrote a piece on excess returns by public companies, and found that far too many companies are value destroyers, rather than value creators. He found that more than half of all publicly traded firms listed globally earned returns on invested capital that were lower than the cost of capital in 2015. He has been doing this study for several years, and finds that the major reasons for underperformance are growth for the sake of growth, bad management and bad businesses.
It struck me that it would be very useful to set up a screen to find the chronic underperformers. I looked for those companies that earned less than their cost of capital in 2015 and had also failed to create value over the past 5 years. I used price to book value growth and thinned the underperforming herd down to just those who had negative book value growth over the past five years.
The resulting list of 306 companies had a lot of energy and resources companies. This is to be be expected, as the cost of commodities have dropped precipitously over the past few years. Even after setting these companies aside, there are still more than 200 companies that are destroying rather than creating value for shareholders.
The largest such company in the list was AT&T (T). Its return on invested capital is less than the weighted average cost of capital, and its book value growth over the past 5 years was negative 1%. T isn't the only major telecom company that is struggling: Sprint (S) is also not earning returns that beat its cost of capital, and five-year book value growth is basically flat.
Builders First Source (BLDR) is a prime example of an underperformer. BLDR was supposed to be one of the big winners of 2015. The stock doubled in the first few months of the year when the company made an acquisition that took it from a player in the southeastern U.S. market for residential construction material to a national player. This appears to be a case of growth for the sake of growth, as it has not yet lead to excess returns. The company's return on invested capital is less than the weighted average cost of capital and over the past five years, book value has declined by 32%, on average, a year.
I was surprised to find a lot of real estate investment trusts on the list. Given the recovery in the last few years in the commercial and multi-family markets, book value declines over the past five years are a surprise to me. While I am not averse to buying an underperforming REIT at a discount to net asset value, there are a number of larger REITs trading well above book value on the list of underperformers.
Although in general these stocks are probably best avoided, there is one thing patient value types might want to do with this list. A list of companies that is underperforming and shrinking book value and earning less than their cost of invested capital is going to be an activists shopping list. Indeed when I look at the list I see several companies that are currently the target of an activist campaign.
It is probably worth sitting down with a favorite beverage suitable to the time of day and checking the stocks on the spreadsheet, above, for activist involvement and recent 13D filings. One or two of these underperformers that are sold as a result of activist involvement can make a big difference for the 2016 bottom line.
I will be spending some time this weekend working with the idea of excess returns and their usefulness in helping us find potential winners -- and spotting bad businesses and bad management that we probably want to avoid.
