Return on Mental Capital

Thoughts on maximizing returns on research time

My next Flyover Stocks company profile will be published soon and I’m trying something new with this one. To date, I have focused exclusively on underfollowed SMID cap companies, but I want to expand the universe to include larger companies that emerged from “flyover country” and are still worth your time to research.

A few Flyover Stocks Hall of Fame members include Tractor Supply, Cintas, and Jack Henry - each of which I plan to profile in the coming year. Paid Flyover Stocks members get full access to these reports, which include moat, management, and valuation analysis and rankings. To get access to these reports and the archive of companies already profiled, please become a paid member today.

Thank you for your continued interest in Flyover Stocks!

---

In my university classes, I teach that a financial manager’s top responsibility is to maximize the market value of equity. This is done in part by allocating capital only toward projects that generate returns in excess of their cost of capital.

You wouldn’t borrow money at 8%, for example, to invest in a project returning 3%. You’d destroy value. Instead, you want to invest in projects that return well in excess of 8%.

We should think of our mental capital the same way. Like capital, it’s limited and shouldn’t be wasted on low return projects.

Before launching my own firm, I could dedicate all of my work time to company research. There were some benefits to this, but I often found myself quibbling over minutiae that had no bearing on what really mattered in my analysis.

Keeping up with analyst upgrades and downgrades, modeling metrics that had little impact on firm value, and scrolling through Twitter mentions of my companies had low return on mental capital (ROMC).

Some days, I would power off my laptop drained but unsure of what I actually accomplished. It was due to high turnover, but low-margin productivity.

My new time constraints have forced me to focus my research time and I find myself being more productive at the end of the day, despite fewer available hours.

In 2003, Robert Arnott and Cliff Asness wrote a paper called “Surprise! Higher Dividends = Higher Earnings Growth” that showed how companies with higher dividend payout ratios tended to have faster earnings growth than those that retained more of their earnings. This is the opposite of what you would expect.

One of their hypotheses was that firms that pay out a meaningful amount of capital each year have less “irresistible” surplus cash laying around to spend superfluously on “empire building.” Instead, the capital constraints might have led management teams toward more productive and thoughtful capital allocation.

Similarly, healthy time constraints might lead to higher ROMC due to the necessity of focusing only on what matters.

One of my favorite scenes from Sherlock Holmes stories is found in “A Study in Scarlett” where Holmes baffles Watson by telling him he is unaware of heliocentricity.

“You see,” he explained, “I consider that a man’s brain originally is like a little empty attic, and you have to stock it with such furniture as you choose. A fool takes in all the lumber of every sort that he comes across, so that the knowledge which might be useful to him gets crowded out, or at best is jumbled up with a lot of other things, so that he has a difficulty in laying his hands upon it. Now the skilful workman is very careful indeed as to what he takes into his brain-attic. He will have nothing but the tools which may help him in doing his work, but of these he has a large assortment, and all in the most perfect order. It is a mistake to think that that little room has elastic walls and can distend to any extent. Depend upon it there comes a time when for every addition of knowledge you forget something that you knew before. It is of the highest importance, therefore, not to have useless facts elbowing out the useful ones.”

“But the Solar System!” I protested.

“What the deuce is it to me?” he interrupted impatiently: “you say that we go round the sun. If we went round the moon it would not make a pennyworth of difference to me or to my work.”

Now, it’s hard to believe that Sherlock Holmes wouldn’t have known about heliocentricity, but his point remains true. Each of us has a different amount of mental capacity and ability to recall information, but each of us also has a limit to what we can keep in our “brain attic.” Bits of information with low ROMC should be kept out of it

Source: DALL-E, AI generated

Here are a few things that have helped me increase ROMC in my research:

Avoiding high news flow companies: Companies that are always in the news have a way of pulling our attention away from what matters. We don’t want to miss anything that might be important, so we must sift through a lot a noise in search of signal that probably isn’t there. Low news flow companies naturally have less distractions. This doesn’t mean that high news flow companies are never worth your time, but you need to develop a deep understanding of what really matters at the company and then intentionally avoid the daily noise.

Limiting information sources: I don’t have a Bloomberg or FactSet at my firm and have no intention of getting either anytime soon. Don’t get me wrong - they are both great at what they do and can have high ROI in certain cases, but I don’t miss them. Access to annual reports, filings, presentations, transcripts, and historical financials provide enough threads to pull on without flashing lights and real-time news flow.

Modeling what matters: When modeling a company, find two or three metrics that have a direct impact on earnings growth and return on invested capital and spend more time thinking about what they imply about the business in the coming years. For example, one of the key metrics for Costco is average executive member spending per year. Thinking about how the average executive member spends and how many non-executive members might convert to becoming executive members is a much better use of time than forecasting revenue per employee, for instance.

How have you streamlined your research process to improve ROMC? Please let me know in the comments below.

Stay patient, stay focused.

Todd

---

Todd Wenning is the founder of KNA Capital Management, LLC, an Ohio-registered investment advisor that manages a concentrated equity strategy and provides other investment-related services.

At the time of publication, Todd, his immediate family, and/or KNA Capital Management, LLC own shares of Costco and Jack Henry.

Please see important disclaimers.