 Good day, film investors. I'm here with Peter Barkling, head investment manager at Niche Master Funds. I was present at their conference yesterday and one recurring team that also came out in the previous videos we made is Return on Capital. And it's also something that Charlie Munger, the most open investors of that demo who isn't afraid to get hated or something, he keeps telling us Return on Capital, Return on Capital, focus on companies that have high Return on Capital and you don't have to focus on anything else. We already mentioned this and we said we'll make a special video and Peter was so kind to make four points about what Return on Capital is. So it is an indicator of competitive advantage. Capital network accumulates faster due to compound interest. It generates cash flows, so shareholder returns and it offers a high price to book. So you reinvest at a good price to book value which is not the case with companies that have low Return on Capital. So those are the four topics that Peter has agreed to go through. So let's start by going through those four topics. Leave the word to you. It's easier. Okay, so the first one is really as an indicator of competitive advantage meaning that it's very easy for a company to say that we have a great competitive advantage but we don't make any money and then of course you know there's no logic. So if a company's competitive advantage is more than just wishy-washy talk, then it must lead to higher Return on Capital. That means also that if we find a company that has a high Return on Capital and it has so consistently over the years, then it must indicate that there is a competitive advantage because if not either the theory wouldn't work or there wouldn't be any various ventures competitors would have taken it away. So that's the first thing. High Return on Capital indicates in itself is a measure of quality. That's the first one. That's easy. Now the second one is actually the most powerful concept in investing which is compound interest. So if you buy anything and it compounds meaning it gives you a return of say 10%, then you pay 100, then you get 110, then it's 121 and then it moves on like that. It's not 120 in the 30, it's 121 because the 10% of the 10% the compounding. Now if you buy a 30% Return on Capital company, it compounds much, much faster and if at 40% and 50% you are talking, I mean much faster rates of compounding. Those companies are more expensive of course, unless nobody have found out what they usually have. But the value this leads to is I hesitate to say exponential, but it is exponentially higher than just the fact that the return on capital when that moves from 10% to 20%, the company's value more than doubles because of the compounding effect. When it moves to 4%, it gets again many times bigger. So that's the second point. Capital or net worth accumulates faster. And how can we, so even if we invest, so the price is usually higher of those companies and so we invest in that capital but the underlying capital will actually compound, which means that also the price of the stock will compound at the same rate or it's not linear. That depends on the market. When the market sees that oh this company's profits are growing much faster than, then the market tends to reward that, not always on a one-on-one basis and sometimes we have to wait for it. With the value gets unlocked. Yes, exactly. But the market tends to always find out that oops, this company's dividends are growing and growing and growing and so we better, more people get interested in the company, they buy it and that drives the price up. And the big difference here, I think you showed the chart yesterday about the compounding and differences of 10%, 20% and 30%. The key is here to just buy that such a company and be patient and let it compound. Yes, exactly. Of course there's a limit to how much you should pay for it but certainly a company that has 30% return on canvas versus one or is more than three times more valuable than one that only has 10%. What would be that limit? How much you should pay? That's what everybody wants to know. But that's okay, that's fair. So that's why you need to go back and say okay, so you have something that is compounding at 40% a year. Now that would be pretty hard to sustain for a very long time. So you have to go back and ask what is it in the business of this company that allows it to compound for 40% a year. Does the market really continue to grow? Because it will require a bigger and bigger market. And some markets you will see, well, maybe if it is a certain type of hospital equipment, once every hospital has this type of equipment the market will be done and so you need to understand that and so that's the only way you can really say how much can we pay for it because if something compounds at 40% per year forever then it doesn't matter what you pay for it. Somebody once commented that what would have happened if Jesus had put one dollar in the bank at the year zero and you try to do it on your pocket calculator and you will quickly find that it errors because even at just a 5% interest rate, one dollar at 5% since the year zero is more money than in the entire world at the moment. So in other words of course at some point it stops and that is what you need to understand. That's why you need to understand the business. 40% won't last forever. It can last for a long time but not forever. So that's what you put into okay what's the price? Try to estimate okay for how long can this go on? Will it slow down at what rate? At what rate let's hit peak and what will then be the dividends for example for investors? Okay that makes sense. So you have to then go back into the qualitative analysis. It's no longer just calculations and spreadsheets. It's really understanding is where does this money come from. So that's the second one. The third one was that the higher the return on capital the more cash flow a company generates. The reason being that especially a growing company if a company with a low return on capital grows very fast then it needs to spend if not all then almost all of its profits to reinvest in the business and that means there's nothing left for investors. The company gets bigger and bigger and the profits get bigger and bigger but the cash flow doesn't. So there's nothing. I think we have to differentiate here. The company usually shows extremely high operating cash flows but then we have to minus the capital as expenditures and then we get to free cash flow which is what you are talking about. And it's the free cash flow I'm talking about. Yes that's correct. That's correct Sven and because the free cash flow is what the company can use to buy bank shares and to pay dividends and to make acquisitions if they want. Or to reinvest but it's already reinvested. So it's after that capital level and if you have a company that makes a very high return on capital then it follows by definition that as it grows it needs less capital as new investment and the remaining cash that has been generated is free and can be used to pay dividends, pay buy back shares or do something entirely different or pay back a debt if the company has any debt. Would you dare to give us an example what would be now a company that an investor that is looking for such a company or that you have in your fund would fit those criteria? I mean pretty much every all of our largest positions in there in the pretty much all investments in our fund has that profile because it is so crucial to us because without cash flow it's all a dream about what will happen in the future and we want companies that are already generating cash flow. So your fund is practically something that represents okay we are buying great businesses with that's generating cash flows from shareholders which means that you are investing in a business and the business is actually what provides the return to your investment. Yes that's correct and I mean you asked for an example Decra we talked about yesterday it generates more and more cash every year and has been for the last 15 years at least. And what is not for example what are the valuations if an investor sees Decra now what does he have to pay for that? Right now they are paying I think at my last check the price earnings ratio if you use that as a valuation it's a 22 or there about okay price book value maybe I mean I have to check that but certainly at least five but here comes there and then I can take that and leave that to the fourth point which is the great thing about when you have a company with a high return on capital it tends also when investors find out to get a high book value. However if the book value is price to book value is five times that means that you pay more than five times the capital that is in the company. Let's say a value investor like the basic grand value investors would not do because that's not that would not be a value from a book perspective but that's because in Graham's time valuations were much lower and we have seen later Buffett and Munger completely changed their strategy from Graham and Cigar but to what we are talking here. But here's the here's the neat thing about it though is that if a company like Decra deserves a price book of five or even eight even ten many pharmaceuticals at more than ten the profit that you make that is not paid out to you as dividends but that stays in the company gets reinvested at a price book ratio of one. You see that the effect that that in itself is a compounding effect that the more the the company makes the more you invest indirectly at a price book of one but it actually has a value a market value of five book of eight and that helps to drive up the sale price very very fast sometimes. Yeah so if Decra continues to do that over the next ten years or what are your expectations was how much does Decra actually make in cash flows how much did it make the last year? About 60 million British pounds at that free cash flow before acquisitions. With their return on capital where do you see the free cash flow of course this is just an estimation but in ten years. Well that's a dangerous game but I can tell you that ten years ago it was like 10 or 15 so it has again quintrupled. So it quadrupled and the stock price followed probably. Stock price has totally settled yes. With the same fundamentals the return on capital it is possible that it does the same over the next ten years. If the company keeps growing if it doesn't bump into something yes and things never go as planned in this business sometimes they go better than planned. That's why you are not putting all your money. Exactly yes. How many companies do you have in your fund? We have 25 at the moment and that's a few too many so we aim at I think the optimal is about 20. 20 all right because we want to be able to really follow them closely. And then if something goes wrong or the management does something or the return on capital or it gets eaten away by the competition what you can you probably you don't lose much because there are still valuable companies but on a ten year basis now when I'm comparing this it's the ones that do good go up four times and the ones that don't do good probably don't lose much in the long term or so it doesn't when I'm putting this into the long term performance you only need practically a few winners that will keep doing that and that will make great returns. That's true but actually somebody ourselves also pointed out that in practice it turns out to be more important to avoid losers. Okay. So if you can only avoid the worst losers so we spend a lot of time trying to win out the losers because the others you can't really predict it's easier to predict failure that's another thing than to predict success because success is almost always a result of somebody really brilliant that you don't know. Whereas failure is you can see when companies make classic mistakes too broad diversification too fast internationalization too broader product and all these things we know from business. As I'm here I'm going to seize this opportunity I think we have a topic for another video which is how to avoid value traps and how to avoid losers and that definition of discussion on the definition of value investing what it actually is because it's vague I think in the perspective of investors. Well thank you Peter for this perfect explanation on what return on capital is how it works when it comes to investing and investors viewers will see us in the next video talking about value and the dangers of value investors and how we define that. Sure. Thank you.