Investors love companies that generate high returns on capital. Companies that can do so sustainably are destined to grow shareholder value, as they can grow earnings while rewarding shareholders at the same time. But some companies that generate excess returns can be traps that can cost shareholders dearly! Only if the business falls within the investor's circle of competence can he ascertain whether the company can continue to generate high returns.
Consider Access Plans (APNC), a marketer of various consumer health and insurance products. The company has a book value of just $13 million, but it generates about $1 million in after-tax income per quarter.
As a result of the company's stellar returns, it trades at a market cap of $18 million. As such, if the earnings fall, investors have no downside protection in the form of assets, unlike the case in other companies we have discussed. If competition, attracted by these returns, is able to erode margins, the company's stock price will fall towards its book value.
At the same time, however, if the company is able to continue to generate such returns, shareholder gains will be enormous. Companies with sustainable competitive advantages trading at discounts are the ones off of which fortunes are made, as Warren Buffett and Philip Fisher can attest.
Therefore, the question comes down to whether the stellar returns on capital can be sustained. To answer this question with any reasonable level of confidence, the investor must understand the business. He must be able to determine the key success factors in selling these products, and what advantages Access Plans has which will allow them to continue to generate excess returns in the future. Without this understanding of the industry, the investor is just guessing, and is therefore at risk of violating the first two rules of value investing!
When a company's value based on its earnings is far higher than its book value, investors will end up paying too much for a company if they wrongly assume the strong returns on capital will continue to persist. Competition will reduce earnings to a normal level in time, unless the company has a competitive advantage. But only by understanding the company's business thoroughly can the investor determine if a competitive advantage exists.