“In theory, theory and practice are the same. In practice, they are not.”
– Albert Einstein
In this quarter’s letter we will examine our investment approach in both theory and practice.
At Avenue we define our investing style as quality investing. We pursue a strategy of investing in companies who have certain high-quality characteristics, which we believe gives these businesses a high probability of earning consistent profits into the future.
As investors we care about our companies earning high and consistent profits because ultimately that is what drives wealth creation for long-term investors. When a company can grow their profits over time that leaves more money to either be reinvested in the company, or to be returned to investors through dividends and share repurchases.
There are several characteristics we define as being high quality and they include: good returns on capital, low capital intensity that is internally financed, and the ability to reinvest in the business at good rates of return.
When a company demonstrates these characteristics and is trading at a fair valuation this gives us the best opportunity of making a successful investment.
Focusing on these characteristics is our approach to investing. With this regard, a recent research report by Morgan Stanley from April 2024 caught our attention.
The author discussed a distinction made by Professor Aswath Damodaran, a Professor of Finance at the Stern School of Business at NYU, about the difference between ‘pricing’ and ‘valuing’ a business.
According to Professor Damodaran, sometimes known as the ‘Dean of Valuation, ‘pricing’ a business means assigning a multiple to measure current or prospective earnings and then determining what the stock ‘should’ be worth given your assigned multiple.
Below is an example of this way of thinking:
An investor says to themselves: “XYZ stock earns $2 per share and is trading at 12x earnings, meanwhile its competitor ABC, who also earns $2 per share, is trading at 16x earnings. Because of this discrepancy I think XYZ stock is undervalued and should be worth 16x earnings, like its competitor.”
Professor Damodaran would agree with Avenue that this approach does little to understand where the $2 in profits comes from, how durable and sustainable that level of profits is, and how likely that level of profits is to grow into the future. It also doesn’t assess whether the companies XYZ or ABC are even good businesses in the first place.
Our approach to valuing a business involves estimating the future earnings power of the business by studying and understanding a firm’s fundamental characteristics. This means spending time understanding the qualities of the business that allow it to generate its profits.
Does the business earn good returns on capital? Does it require new financing to reinvest in the business? Does it earn high rates of return on its reinvestment? Do they have a strong market share with a consistent business, or do they sell a commodity product? All these characteristics matter greatly to the future outlook for a business’s profits.
The reason why the investment industry focuses so heavily on ‘pricing’ businesses rather than valuing them is twofold. First, because this is generally what is taught in university finance and through professional programs like the CFA Institute. It becomes taught and ingrained in young professionals starting their career. Because many investors use the same approach it further gets reinforced as the way to do things. Second, pricing businesses is a simpler process, and it makes for easy surface level comparability between businesses and sectors in the stock market.
Professor Damodaran argues that most investors spend their time pricing rather than valuing businesses. The article from Morgan Stanley highlights a survey conducted of equity analysts on this topic. Of the 2,000 respondents surveyed 93% answered that they use a market multiples approach to analyzing a company, while 88% said they use price-to-earnings multiples to evaluate businesses.2 Both of these approaches fall into the category of pricing rather than valuing businesses.
Our approach to valuing businesses begins with looking at the return on capital the business earns. In theory, when a business earns good returns on their invested capital it means they are good at using the capital employed in their business to generate profits. Profits should always be compared to the level of capital required to produce them. This is the ultimate yardstick.
In practice let’s see what that looks like. One of our investments that best represents this focus is AutoZone, which is an aftermarket automotive retailer based in Memphis, Tennessee. When doing our initial research on AutoZone we concluded it was a stable business with a long track record of earning high returns on capital.
AutoZone has stable demand for their products which is largely dependent on annual vehicle miles driven in the United States and the average age of used cars.
They have a dominant position in their market, and they sell products that are essential for their customers day-to-day lives. They also have a strong brand loyalty and a very disciplined approach to capital allocation.
The combination of all these characteristics led us to believe we were investing in a high-quality business.
We purchased our investment for $1,120 in November 2020 and at the time the company had earned $73.62 per share over the previous year. We thus purchased our investment at 15x earnings.
In the 4 years since our initial investment the company has earned a cumulative $15.8 billion in profits. $3.6 billion has been reinvested back into the business through capital expenditures, while $13.6 billion has been used to repurchase shares which benefits long term investors.
The growth in profits per share from $73.62 to $153.82 over the past 4 years has been possible because of the characteristics of the business and because of the ongoing reinvestment they have made in their business.
When a company such as AutoZone earns high returns on capital, we cheer on their reinvestment of profits back into the business. In this case we would prefer to not receive a dividend because each dollar of reinvested earnings has the potential to generate high returns through their reinvestment.
What is remarkable about their results is how consistently high their return on capital has been over the past 20 years. The below graph shows the annual return on capital for AutoZone (blue) versus the S&P 500 (orange). There are very few companies with this level of consistency.
Bryden Teich
