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Valuation Framework

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  • This information is intended to be general in nature and should neither be construed as investment advice nor a recommendation of any specific security or strategy.

    Published October 2013. For financial professional use only. Do not distribute to the public.

    The ROIC CurveValuation Framework

    Content:

    I. Theoretical Drivers of Firm Valuation

    II. Why Focus on ROIC?

    III. Using the ROIC Curve as a Screening Tool

    IV. ROIC Curve Empirical Results

    V. The ROIC Curve Versus Traditional Valuation Anomalies

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    For financial professional use only. Do not distribute to the public.

    EXECUTIVE SUMMARY

    This paper examines the effectiveness of various valuation drivers in screening for companies that are potentially pre-disposed to outperform on a relative basis. Of the five drivers put forth by Merton Miller and Franco Modigliani in their seminal 1961 work on valuation, our analysis narrows to one driver that has proven over time to be an effective filter: Return on invested capital, or ROIC. This does not mean that Miller-Modiglianis other drivers are any less important; our conclusion is that ROIC is better deployed in a screening phase of an investment process and the other drivers, less effective as screens, are better utilized later in the fundamental research phase of our investment process as validation or rejection of the screen findings. Based on our findings, we believe:

    ROIC is an effective, time-tested screen for finding companies with the potential to outperform

    As an initial screen, it is superior to the four other Miller-Modigliani valuation drivers

    The ROIC Curve, our proprietary screening mechanism, plots the relationship between ROIC and Enterprise Value/Invested Capital (a proxy for market valuation) and effectively reveals which companies may be mis- priced by the market and are therefore potentially pre-disposed to outperform

    When coupled with rigorous fundamental research, which then includes other Miller-Modigliani measures and other drivers, this screening mechanism has produced proven investment results over time

    Executive Summary

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    For financial professional use only. Do not distribute to the public.

    Guggenheim Investments Value (GIV) strategy seeks investment opportunities in which a companys long-term fundamental expectations and/or risk profile implied by the current stock price are materially different from our internal assessment of the firms intrinsic value.

    Our investment philosophy has the following key components:

    Bottom-up stock selection

    Concentrated positions with portfolio weightings based on relative conviction level

    35 year average time horizon

    Preference for companies with stable or improving competitive positions

    Sell discipline based on deteriorating fundamentals, valuation materially exceeding internal estimate, portfolio rebalancing (risk control), or better investment opportunity elsewhere

    Valuation and rigorous fundamental analysis constitute the two core elements of our research

    A key component of GIVs internal valuation methodology is the ROIC Curve, a graphical representation of the relative valuation of companies across a benchmark universe. The ROIC Curve is based on the relationship between a firms return on invested capital (ROIC) and the ratio of enterprise

    value to invested capital (EV/IC). This relationship is described in more detail later, but we begin with a brief discussion of the academic valuation theory that underpins the ROIC Curve and an explanation as to why ROIC is a relevant factor for valuation screening.

    With regard to quantitative measures, although we utilize many metrics to establish a companys intrinsic value, we believe that return on invested capital is the most reliable and robust. We also point out that intrinsic value is an effective risk-management framework: Buying business at a discount doesnt just offer a large potential upside; it also helps limit losses by allowing for margin of safety if the investor is wrong.

    In sum, we believe that intrinsic value is a rational approach that can help investors avoid being either paralyzed or whipsawed by the markets irrationality, volatility and often-conflicting messages. We find that such dislocations can actually unearth many attractive opportunities for astute investors, but that price charts and other external indicators can easily lead investors astray.

    We believe that in order to find viable long-term opportunitiescompanies that are currently earning more than their cost of capital, have a record of protecting capital and are in a strong competitive position to grow that capital once the current recession turns aroundinvestors must adopt a bottom-up value framework.

    Value Investment Philosophy

    VALUE INVESTMENT PHILOSOPHY

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    For financial professional use only. Do not distribute to the public.

    At the most basic level, the theoretical value of a firm is equal to the present value of its future cash flows. In their seminal 1961 paper, Merton H. Miller and Franco Modigliani provide a breakdown of the components that drive the discounted cash flow valuation of a firm:

    Normalized net operating profit after tax (NOPAT) A proxy for the current (or steady state) cash flow generation of the firm, without accounting for future reinvestment (growth) opportunities.

    Return on invested capital (ROIC) Return on the firms investments.

    Reinvestment rate (growth) Growth rate of NOPAT, based on ROIC less the

    amount distributed to the firms investors (dividends, share buybacks, and debt service).

    Weighted average cost of capital (WACC) Return demanded by investors based on the fundamental risk of the firms cash flows.

    Competitive advantage period (CAP) Period over which a firm can generate ROIC that exceeds firms WACC. Only growth related to investments where ROIC exceeds the WACC will create incremental shareholder value.

    The ROIC Curve utilizes ROIC as the key driver of valuation.

    Theoretical Drivers of Firm Valuation

    I. THEORETICAL DRIVERS OF FIRM VALUATION

    II. WHY FOCUS ON ROIC?

    A reasonable question to ask is why GIV focuses valuation screening on ROIC rather than the other valuation drivers identified by Miller and Modigliani. It is important to note that GIV investment professionals integrate all of the valuation drivers in their detailed fundamental analysis and construction of discounted cash flow models. However, there are several benefits to using ROIC for a quantitative valuation screening methodology and certain drawbacks to each of the other Miller and Modigliani valuation drivers with regard to valuation screening.

    There are five key attributes of ROIC that make it a strong factor for valuation screening. The first attribute is measurability. ROIC can be measured relatively easily using readily available historical financial data from a standardized database such as Compustat. The second attribute, automation, is closely related to measurability. ROIC can be compiled in an automated fashion across a large universe of companies, which provides the efficiency needed for a screening tool. The third key attribute is fundamental insight. Viewing valuation through an ROIC lens not only results in a high quality screen, but ROIC itself

    provides fundamental insight about the type and quality of business being studied. The fourth key attribute is cross-factor correlation. ROIC provides some incremental information about other valuation drivers. An example is a companys growth rate. The sustainable growth formula holds that without raising additional capital, a firm cannot grow faster than its ROIC, reduced by the amount of profits returned to capital providers through buybacks, dividends, and debt service. ROIC effectively acts as a cap on a firms growth rate, and therefore ROIC and growth are somewhat correlated. The final attribute of ROIC that makes it a strong factor for screening is efficacy. As we demonstrate in a later section with our backtest results, ROIC has proven empirically to be strongly correlated with valuation, and stock selection based on discrepancies between a firms ROIC-based warranted valuation and market valuation yields positive alpha over time.

    The other Miller and Modigliani valuation drivers, while important to our overall fundamental process, fail in one or more of the key attributes that make ROIC a viable screening factor.

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    For financial professional use only. Do not distribute to the public.

    Why Focus on ROIC?

    WACC and competitive advantage period suffer from measurability and automation difficulties. NOPAT, while measurable, suffers automation difficulties as normalization of earnings is often necessary on an industry-by-industry basis, and industries change over time. Although academics have proposed several models of WACC estimation, including the Capital Asset Pricing Model (CAPM), these models have difficulty measuring the equity risk premium and therefore result in limited efficacy.

    The competitive advantage period is not a directly observable data item; it must be subjectively judged by the fundamental analyst and therefore suffers from measurability and automation difficulties.

    The following chart in Table 1 compares the various Miller-Modigliani drivers and confirms our hypothesis of ROIC as an effective initial screen.

    The last Miller and Modigliani valuation driver to

    TABLE 1: ROIC VERSUS OTHER VALUATION DRIVERS

    ROIC

    NOPAT

    GROWTH

    WACC

    CAP

    Return on invested capitalNormalized net operating profit after taxReinvestment rate Weighted average cost of capitalCompetitive advantage period