In this - part four - of a four-part series on fundamental business analysis, I will continue using SEI Investments (SEIC) as a case study taking readers through the three major components of a successful FBA. In this article, I will bring readers through the major steps in analyzing the history of SEI Investment’s growth and whether that growth can continue. In particular, I will focus on whether the company’s growth has added value - and will continue to add value - through scalability, capital allocation, and strength of management.
A Note on Value versus Growth
Many dyed-in-the-wool value investors look for companies with low price to earnings (PE), price to book (PB) and price to sales (PS) ratios (like my former co-worker and friend John Dorfman). Most don’t prefer to pay up for growth like I am. In my world, I find it hard to achieve long-term value creation by simply buying something super cheap and hoping it becomes less cheap. This certainly separates me from the Ben Grahams and Walter Schloss’ of the world. Some – like John – insist I’m not a value investor at all but rather growth-at-a-reasonable-price (GARP) investor.
Yet to me growth AND value are an essential part of my investment thesis as an asset manager. But it’s not just growth for growth’s sake. Many people cite the following quote from Warren Buffett to highlight his thinking that the distinction between growth and value is really just a straw argument.
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).
In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Most people put emphasis on the first part paragraph of this quote, and quite entirely miss the vital importance of the latter paragraph. That last sentence takes some time to sink in. I got a much better understanding of it now after running a business myself. Growth can most certainly have either a negative or positive impact. As a manager and owner, one is constantly pressed for growth – whether it be greater market share, increased revenue, earnings growth, etc. But one should always remember - growth comes at a cost and growth doesn’t always create value.
Utilizing SEI Investments, I wanted to evaluate the value of growth and its impact on long-term value creation. I think there are four major components to growth that need to be analyzed before an investor can be comfortable they are investing in a true compounding machine.
Scalable: The first area of interest is whether the growth achieved previously can be achieved in the future. In other words, is the growth scalable? This can be achieved in many ways. Is the market large enough that growth can be maintain simply by growing customer base regardless of competition? Conversely, if the market share is finite, can the company continue to capture market share by beating its competition? In the case of SEI Investments, according to Statista, the financial technology (FinTech) market has grown by 11.8% since 2008. Estimated CAGR growth through 2023 is 8.2% with an end value of $1.3B. Over the past 10 years SEI Investments has grown revenue by 4.6%, earnings by 10.8%, and free cash flow by 7.7%. These numbers include the Great Recession of 2008-2009 which hit the company’s growth hard. Looking at Statista’s market growth numbers, its entirely possible that SEI Investments could grow over the next 10 years just as well the previous 10. Its growth numbers are pretty much in-line with industry averages. Growth certainly seems scalable without even having to capture additional market share.
Capital Returns and Requirements: Growth adds no value if the cost of achieving it exceeds its financial benefits. One way to measure whether SEI Investments’ growth has added long-term value is to measure its return on capital (ROC) versus its weighted average cost of capital (WACC). In other words, is it making greater returns than it costs to finance it. For the period 2008 – 2018, SEI Investments’ average return on capital was 35.1%. For the same period, it weighted average cost of capital was 10.0%. Over the same duration, SEI Investments’ average capital expenditures averaged 5.4% of revenue. Here we have a company operating with small amounts of capital spending and high returns on capital. In my experience, these are hallmarks of a long-term compounding machine.
Quality Maintenance: Another essential component for having growth add value is that quality is not lost as the corporation expands its operations, staff, and product lines. Achieving rapid growth and developing an unhappy (and shrinking) customer base is not a means to achieving long-term value. One way to look at whether quality is being maintained (particularly in the service industry) is customer retention. Happy customers are long-term customers. In talking with SEI Investment’s management in October 2018 management cited the following retention rates by product group. Private Banks (94%), Investment Advisors (97%), Institutional Investors (96%), Investment Managers (94%), Investments/New Business (too early to tell). Retention rates in the mid-90s tell me that SEI Investments’ customers are a quite satisfied group and over time should provide the company with a strong and steady base for growth.
Management Ability: Management has to have the ability to manage growth that achieves long-term value for its shareholders, the company, and their employees. Obviously achieving high returns on capital and equity demonstrate a certain ability to wisely allocate capital. Another great measure is to take a look at goodwill on the balance sheet. Goodwill is simply the difference between what management pays for an asset and its actual value. The values employed are somewhat subjective (meaning defining current value), but it’s obvious management might not be great capital allocators when you see vast amounts of goodwill written off over time. In SEI Investments’ case, the company carries just $64M in goodwill on a balance sheet that has $1.9B in total assets. This represents just 3.3% of total assets. For the 10 years previous to 2018 that number was 0%. No question that management has wisely allocated capital over time.
Conclusions
The process of fundamental business analysis should give an investor a much better understanding of a potential holding. Whether it be the company’s financial position, its competitive moat, or management skills (along with many other aspects of the business), the investor should be able to have a conversation about the company that demonstrates a deep knowledge of how the company makes money, how it’s going to keep making money, and how it will compound value to its shareholders over the long-term.
SEI Investments is a gem of a business. As a holding in Nintai Partners’ investment portfolio, it steadily added to my long-term investment returns. When I first purchased the stock in 2003, I paid $14.41/share. The company was generating $2.86/share in revenue and $0.71/share in free cash flow. It was achieving return on equity of 43.7% and return on capital of 57.8%. When I sold the company in 2015 the company was generating $7.87/share in revenue and $1.97/share in free cash flow. It was generating 26.1% return on equity and 50.3% return on capital. I sold the shares at $51.29/share. I would have likely continued to hold the stock if I hadn’t closed down Nintai Partners. I repurchased the shares while at Dorfman Value Investments.
I hope this series has helped investors understand the value of conducting fundamental business analysis for any possible addition to their portfolio. Achieving a deeper understanding of how a company makes money and its potential to add long-term value to your portfolio returns can be a huge advantage over Wall Street who remain focused on quarterly earnings. As an individual investor, this long-term advantage can make all the difference between adequate and outstanding returns.
A Note on Value versus Growth
Many dyed-in-the-wool value investors look for companies with low price to earnings (PE), price to book (PB) and price to sales (PS) ratios (like my former co-worker and friend John Dorfman). Most don’t prefer to pay up for growth like I am. In my world, I find it hard to achieve long-term value creation by simply buying something super cheap and hoping it becomes less cheap. This certainly separates me from the Ben Grahams and Walter Schloss’ of the world. Some – like John – insist I’m not a value investor at all but rather growth-at-a-reasonable-price (GARP) investor.
Yet to me growth AND value are an essential part of my investment thesis as an asset manager. But it’s not just growth for growth’s sake. Many people cite the following quote from Warren Buffett to highlight his thinking that the distinction between growth and value is really just a straw argument.
“Most analysts feel they must choose between two approaches customarily thought to be in opposition: "value" and "growth." Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing. We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).
In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.”
Most people put emphasis on the first part paragraph of this quote, and quite entirely miss the vital importance of the latter paragraph. That last sentence takes some time to sink in. I got a much better understanding of it now after running a business myself. Growth can most certainly have either a negative or positive impact. As a manager and owner, one is constantly pressed for growth – whether it be greater market share, increased revenue, earnings growth, etc. But one should always remember - growth comes at a cost and growth doesn’t always create value.
Utilizing SEI Investments, I wanted to evaluate the value of growth and its impact on long-term value creation. I think there are four major components to growth that need to be analyzed before an investor can be comfortable they are investing in a true compounding machine.
Scalable: The first area of interest is whether the growth achieved previously can be achieved in the future. In other words, is the growth scalable? This can be achieved in many ways. Is the market large enough that growth can be maintain simply by growing customer base regardless of competition? Conversely, if the market share is finite, can the company continue to capture market share by beating its competition? In the case of SEI Investments, according to Statista, the financial technology (FinTech) market has grown by 11.8% since 2008. Estimated CAGR growth through 2023 is 8.2% with an end value of $1.3B. Over the past 10 years SEI Investments has grown revenue by 4.6%, earnings by 10.8%, and free cash flow by 7.7%. These numbers include the Great Recession of 2008-2009 which hit the company’s growth hard. Looking at Statista’s market growth numbers, its entirely possible that SEI Investments could grow over the next 10 years just as well the previous 10. Its growth numbers are pretty much in-line with industry averages. Growth certainly seems scalable without even having to capture additional market share.
Capital Returns and Requirements: Growth adds no value if the cost of achieving it exceeds its financial benefits. One way to measure whether SEI Investments’ growth has added long-term value is to measure its return on capital (ROC) versus its weighted average cost of capital (WACC). In other words, is it making greater returns than it costs to finance it. For the period 2008 – 2018, SEI Investments’ average return on capital was 35.1%. For the same period, it weighted average cost of capital was 10.0%. Over the same duration, SEI Investments’ average capital expenditures averaged 5.4% of revenue. Here we have a company operating with small amounts of capital spending and high returns on capital. In my experience, these are hallmarks of a long-term compounding machine.
Quality Maintenance: Another essential component for having growth add value is that quality is not lost as the corporation expands its operations, staff, and product lines. Achieving rapid growth and developing an unhappy (and shrinking) customer base is not a means to achieving long-term value. One way to look at whether quality is being maintained (particularly in the service industry) is customer retention. Happy customers are long-term customers. In talking with SEI Investment’s management in October 2018 management cited the following retention rates by product group. Private Banks (94%), Investment Advisors (97%), Institutional Investors (96%), Investment Managers (94%), Investments/New Business (too early to tell). Retention rates in the mid-90s tell me that SEI Investments’ customers are a quite satisfied group and over time should provide the company with a strong and steady base for growth.
Management Ability: Management has to have the ability to manage growth that achieves long-term value for its shareholders, the company, and their employees. Obviously achieving high returns on capital and equity demonstrate a certain ability to wisely allocate capital. Another great measure is to take a look at goodwill on the balance sheet. Goodwill is simply the difference between what management pays for an asset and its actual value. The values employed are somewhat subjective (meaning defining current value), but it’s obvious management might not be great capital allocators when you see vast amounts of goodwill written off over time. In SEI Investments’ case, the company carries just $64M in goodwill on a balance sheet that has $1.9B in total assets. This represents just 3.3% of total assets. For the 10 years previous to 2018 that number was 0%. No question that management has wisely allocated capital over time.
Conclusions
The process of fundamental business analysis should give an investor a much better understanding of a potential holding. Whether it be the company’s financial position, its competitive moat, or management skills (along with many other aspects of the business), the investor should be able to have a conversation about the company that demonstrates a deep knowledge of how the company makes money, how it’s going to keep making money, and how it will compound value to its shareholders over the long-term.
SEI Investments is a gem of a business. As a holding in Nintai Partners’ investment portfolio, it steadily added to my long-term investment returns. When I first purchased the stock in 2003, I paid $14.41/share. The company was generating $2.86/share in revenue and $0.71/share in free cash flow. It was achieving return on equity of 43.7% and return on capital of 57.8%. When I sold the company in 2015 the company was generating $7.87/share in revenue and $1.97/share in free cash flow. It was generating 26.1% return on equity and 50.3% return on capital. I sold the shares at $51.29/share. I would have likely continued to hold the stock if I hadn’t closed down Nintai Partners. I repurchased the shares while at Dorfman Value Investments.
I hope this series has helped investors understand the value of conducting fundamental business analysis for any possible addition to their portfolio. Achieving a deeper understanding of how a company makes money and its potential to add long-term value to your portfolio returns can be a huge advantage over Wall Street who remain focused on quarterly earnings. As an individual investor, this long-term advantage can make all the difference between adequate and outstanding returns.
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