Earning good returns long term

RECENT news about private hospital operator Life Healthcare’s international investments has created negative sentiment about the company’s ability to allocate capital wisely. Ruan Stander explains why Allan Gray believes this creates the potential for long-term investors to earn attractive returns.

Life Healthcare has fallen out of favour with the market, but is this negativity over-exaggerated? The company has spent the past eight years diversifying from its South African hospitals by acquiring hospital groups in India, Poland and the UK, so far with mixed results.

In a bad scenario, where the Indian business is worth only half of the current share price, the latest acquisition in the UK is worth 50 percent of the price paid, and Polish hospitals are worthless, the company would lose around 10 percent of its value. However, using the cash flow plus growth analysis below, the company still generates a return of 16 percent per annum. In a good scenario we believe Life Healthcare will deliver a return of 18 percent annum, with substantial upside from the removal of negative sentiment.

Opportunity

A long-term investor needs to carefully consider three things when evaluating an opportunity:

1. What rate of growth can a business achieve organically?

2. How much cash is generated after spending capital to achieve organic growth?

3. Does the management team manage excess cash wisely?

By way of example, let’s say a company with a share price of R100: 1. Grows at 9 percent per annum. 2. While generating R3 of free cash flow for shareholders.

3. Distributes all the free cash flow to shareholders in dividends.

The outcome for shareholders is a total return of 12 percent per annum that is calculated as a 3 percent dvidend yield plus a 9 percent capital gain, assuming that the valuation multiple stays the same.

This is roughly in line with the dividend yield, earnings’ growth and total return generated by the South African stock market (ignoring the change in valuation multiple) over the past 20 years. Now let’s consider the prospects for Life Healthcare using this framework.

Non-negotiable expense

Healthcare costs grow faster than the economy in most societies these days for various reasons: ageing populations require more healthcare, innovation increases the variety of treatments available and, importantly, healthcare is a non-negotiable expense since you only get to live once. On the other hand, increasing costs attract the attention of regulators (and politicians), so hospitals need to do their best to control costs and price increases.

If one assumes 6 percent price inflation, 3 percent volume growth (lower than 3.6 percent before) and 1 percent from operating more efficiently, the South African business could grow profits at 10 percent per annum going forward. Cash generation: 6.6 percent yield in SA.

Double-entry book keeping was an important financial innovation, but unfortunately some of its benefits come at a cost. One of the costs of an internally consistent accounting system is that accounting earnings almost never accurately reflect the cash a company generates for shareholders.