Manager Insight

Jeff Hyrich favours companies that reinvest in their businesses.
By Michael Ryval | 01/06/17

High return on capital is one of the most important attributes associated with strong investment returns, says Jeff Hyrich, lead manager of the $2.2-billion Trimark Global Endeavour. But this valuation should not be considered in isolation, he adds.

About the Author
Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

"We want to own companies with high returns on capital. But it's only one metric, because we also look at competitive positioning, quality of management, growth opportunities, and the availability to reinvest back in the business," says Hyrich, a vice-president at Trimark Investments, a unit of Toronto-based Invesco Canada Ltd. "We also want to buy them at reasonable valuations. There are a bunch of things that we look for, but return on capital is number one."

As a rule, Hyrich seeks companies that have a return on capital exceeding 15%. Indeed, the average of the 35 companies in the portfolio is more than 20%. "When a company reinvests back in the business at that rate of return, it facilitates better growth."

Take, for instance, a long-term holding in  Ross Stores Inc. (ROST), a leading U.S discount-clothing retailer. Established in California in the early 1980s with six stores, it has grown to a nation-wide chain with 1,561 outlets.

"It has a return on equity (ROE) north of 40% and a return on capital (ROC) of about 60%," says Hyrich, who works alongside Erin Greenfield. "They can keep putting new capital in the business and consistently generate a 40%-plus rate of return. At that rate, they should be able to double the store base to 3,000 over the next 10 to 12 years."

Hyrich joined the Trimark team in 1999, and three years later became manager of Trimark Global Endeavour. He became the lead manager in 2007 of the fund, whose Morningstar Analyst Rating is Silver. He tends to focus on companies with at least a five-year track record, although most have a much longer history. To identify attractive companies, he screens for metrics such as earnings growth, profit margins, the pattern of free cash flow, return on capital and balance-sheet strength.

While Ross Stores is the proverbial jewel in the crown since its scores very high in Hyrich's estimation, he will still consider a company that may not tick all the boxes but has a very low price-earnings multiple.

One example is Hyundai Mobis Co. Ltd., an aftermarket auto-parts supplier for Kia and Hyundai vehicles that is a unit of Hyundai Motor Group, based in South Korea. Hyrich regards the stock as if it were a growth annuity because the parent company has steadily gained market share globally.

"Return on equity has probably been 15%, far lower than Ross Stores' 40%. On a valuation basis, Hyundai Mobis trades at about eight times earnings versus Ross at about 18 times," says Hyrich,

He notes that Hyundai Mobis has expanded into parts manufacturing and also owns a 21% stake in its parent company. "There's a great example where the ROE ticks the box, but it doesn't get three ticks, because of its lower ROE. But the valuation is more than reflected in its P/E of eight."

The average ROE in Hyrich's portfolio is 20.7%, far superior to the 13.1% for the benchmark MSCI All Country World Mid-Cap Index. On a long-term debt-to-capital basis, the fund's ratio is 24.9%, indicative of greater balance-sheet strength versus 35.5% for the benchmark. "Even though my companies are generating a 60% higher ROE, they are doing it with 30% less financial leverage," Hyrich says. "One of my sayings is, 'It's hard to go bankrupt, if you have no debt.'"

While some companies return capital to shareholders in the form of dividends, or buybacks, Hyrich tends to prefer companies that reinvest their earnings. "If you have the ability to reinvest back in your business at a great rate of return, that's excellent," says Hyrich. "A lot of businesses are mature, or have no real ability to reinvest back in their business. They have very limited growth opportunities."

Hyrich is not a fan of companies that use their capital to make acquisitions, since they may turn out to add little or no value and end up with a write-off. But he tempers this view if the company is big enough and diversified enough to withstand a foray into another line of business. One example is  Microsoft Corp. (MSFT), which acquired the handset business from Nokia Corp., and within a couple of years wrote off the investment.

"Ninety percent of the time I love what they do at Microsoft," says Hyrich. "Fortunately, Microsoft is higher today than what it was after the Nokia deal. You have to look at the big picture."

One of the new names in the Morningstar 4-star-rated Trimark Global Endeavour is  Polaris Industries Inc. (PII), whose shares declined significantly when demand for its all-terrain vehicles (ATV) fell due to weakness in some end markets where oil drilling was down. "I thought, 'ATVs sales in these markets account for only 8% of revenues, but the stock is down 60%,' and yet, here's a business that has a 50% ROE," says Hyrich, noting that the company has a dominant market share in ATV manufacturing.

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