Death of the Diversified Discount

While many accept the logic for the discount as an academic fact, a far more important lesson for investors lies in what the companies are actually doing with marginal capital and what return they earn on it. We can perform this analysis on firms in any industry, but the diversified space makes a poignant starting point, since these companies generally have strong cash flows, solid balance sheets, and heavy capital investing programs.

Plowing Cash Back into the Business
Instead of opting for a traditional earnings-based plowback calculation, we instead turned to the cash flow statements to get a sense of how the companies actually invested capital. Many firms use acquisitions in lieu of capital expenditures or research and development, so it makes sense to combine all of these items since they represent dollars not returned to shareholders. These categories tend to be fairly lumpy from year to year, so in our analysis we added investment across five years to have a fairly representative picture for each company. We divide this number by sales (for the last five years) to normalize the metric.

The median plowback rate within our diversified universe is 16% of sales.  Roper Industries and  Danaher lead the pack. Put simply, these companies have invested heavily for growth and made big bets on the future, with both of these companies setting aside over 20% of sales to acquire new businesses and grow internally. Conversely, companies like  Emerson and  United Technologies dwell at the bottom of the list with fairly minimal new investment in their respective businesses. The low levels of Emerson and United Technologies are of particular note because both companies have strong balance sheets and dominant positions in their markets. In our opinion, results from Emerson and United Technologies suggest that either few growth opportunities meet management's investment criteria or management is content harvesting yesterday's work and building cash.

Incremental Return on Investment
The real question is whether investors should be cheering or cringing when a company announces the next acquisition. While the quick math in a press release may give one indication of the implied assumptions in the valuation, the results are often hard to identify and rarely talked about post-acquisition. In order to unlock this mystery, we attempted to see how companies benefited from new money they invested.

Over the same five-year period as above, we took the change in average operating cash flows and divided by the change in the invested capital base. Because cash flows are inherently lumpy, we averaged them over a three-year period. This should tell us how much new cash new investments generated relative to the new funding required to generate that return.

ABB,  Honeywell , and Emerson stand out as firms that earn exceptional returns on new capital deployed. ABB shed some capital-intensive businesses and had the powerful tail wind of the emerging-markets power boom, but the sustainability of these incremental returns is suspect. Relief from restructuring has already taken hold and demand for power products has waned recently. In the case of Emerson, the company spends growth periods milking its assets and uses recessions to reinvest. Also baked into the numbers is the company's liquidation/divestiture of capital-intensive businesses in exchange for asset-light businesses. Through the period, Emerson returned $7.5 billion, or 7.5% of sales, to shareholders. More important for investors, the company is content returning excess cash to the shareholder. The title of empire builder likely does not apply. Honeywell has spent much of the last decade in restructuring mode, exiting high capital intensity/low margins businesses, instead plowing capital into aerospace and automation.

On the other end of the spectrum,  Philips Group and  Ingersoll Rand have returned less than 10% on new investments during the same five-year horizon. Each company has a variety of reasons for fitting in the suboptimal category, but the general culprit in each case is a big acquisition that hasn't delivered the results necessary to justify the deal. Still, it is comforting to see that companies are generally putting capital to work at rates that are higher than the cost of capital.

The Effects of Globalization
We also note that a lower tax rate on foreign income has played a significant role in the incremental return on invested capital for some industrials. Firms can create value simply by using operating cash generated by high-tax-rate economies to fund investment in countries with lower tax rates. This tax differential can mask operational issues with new investment. For example, Danaher's incremental return on invested capital during the five-year period between 2003 and 2009 is a decent 14%. However, during the same period, Danaher's marginal tax rate slumped from 33.5% to 24.6% as the impact of foreign taxes on the marginal tax rate increased from negative 3% to negative 11.1%. Had Danaher continued to invest at a 33.5% tax rate, the incremental return on invested capital would have dropped to 12%. Even though the company made its mark as an operational wizard in previous decades, the real driver of Danaher's cash returns has been expansion into lower-tax jurisdictions. Other large industrials like  General Electric ,  Eaton , and  Dover also benefited from lower tax rates.

Summary
We like businesses that generate high ROICs and then reinvest a major portion of operating cash back into value-creating ventures. The pitch to investors from diversified companies is that the companies are great at throwing off cash and can find other places to grow that will generate high returns and even more cash. We think this strategy has been prudent for all but a handful of companies over the last cycle. The space averaged returns in the midteens and clears our hurdle for capital costs. Although companies like Philips, Eaton, IDEX, and Ingersoll Rand may have paid a bit more than they should have for an acquisition, firms such as ABB, Honeywell, Emerson, and  Siemens have proved to be adept capital allocators in the last cycle with a blend of restructuring and acquisitions with clear adjacencies.

Roper and Danaher have solid reputations as savvy acquirers and operators that command some of the highest valuations within the diversified space, but our research shows that these companies are no better than average at investing the next dollar. While these firms are not necessarily destroying value, we think investors should buy firms like  Illinois Tool Works , Emerson, or Honeywell when valuations are attractive.

Although this analysis is unlikely to change any of our fair values, it does provide a good framework for identifying those companies that we most trust to earn a decent return.