ROIC, the underrated factor

Jan Mohr 29 Feb 2012

If you happen to be interested in asset management, chances are that you have heard about the concept of factor returns. It’s actually all about certain variables that have some statistical utility to explain stock returns. Scientists found out about these factors by doing a so-called regression, did a lot of testing, and ended up with a list of characteristics that determine stock returns. The well-known factors are P/B-ratio, momentum, and size. Taking the latter as an example, ceteris paribus, a stock is expected to perform the better, the smaller its market capitalization is. There has been an endless academic debate on whether these factor returns are just compensation for risk or offer investors the chance to seize mispricing. More details on the factor debate here.

At this point, however, I would like to bring to your attention a return factor that might not have caught your attention before return on invested capital (RoIC). This number puts into context the earnings a business derives from operations with the capital needed to keep operations. The RoIC number is actually a little more complex to calculate than the return on assets. You only consider the capital that is either equity or an interest-bearing liability. Moreover, you do not consider investment assets like excess cash because this is deemed not necessary to keep up operations. At the end of the day, RoIC is just an expression of the old economic idea to generate the most output with the least input.

Generally, RoIC is strongly correlated with the „quality“ of a business model. This is intuitive: the better a business is protected against competitors, and the more loyal its customers are, the better the chance that your capital earns a high return. In fact, Bruce Greenwald, in his great book „Competition Demystified“, named high RoICs as a good indicator that a business has a durable competitive advantage. RoIC also found the way into other ground-breaking finance concepts like Stern Steward’s EVA. Using the EVA methodology, managements can make investment decisions based on prospective RoIC vs. the underlying cost of capital. Since its launch, EVA has been implemented in many companies.

In the investing world, RoIC has found some more recent prominence with the great popularity of Joel Greenblatt’s Magic Formula. The New York Hedge Fund manager selected stocks by buying the ones that have the most attractive combination of value and quality. As you can imagine, he uses RoIC as a proxy for quality. The results of the Magic Formula are quite staggering, and numerous studies have shown that the Magic Formula, in fact, works quite well.

So would it be a good concept to just buy stocks with high returns on capital or maybe consider RoIC when selecting value stocks? While I do utterly believe that RoIC is of the highest importance for the smart investor, there are several caveats I would like to remind you of:

1. Incremental RoIC matter.

In the world of accounting, the balance sheet value of an asset does not necessarily equate to its replacement value (to say the least). Therefore, you might run into a company that still uses a long-depreciated asset to generate earnings. Obviously, this pumps up RoIC and says nothing about incremental RoIC. On the other hand, think about an online platform that spent lots of money to build an IT backbone but can now scale this platform so that all additional users present infinite incremental RoIC. To make a long story short: focus on the capital needed to support the next dollar of earnings. More often than not, this is closely correlated with the total RoIC, but sometimes it is not. Don’t get fooled.

2. Think twice about super-high RoICs

To some businesses, RoIC just does not really matter. Think advertising agencies or investment banks- all they need are a couple of computers, some flipcharts, and some tables (spare the billard table). RoIC is incredibly high at these types of businesses. The problem is: they oftentimes do not really need you, the stockholder, as a provider of capital. They are really people businesses that are just the sum of the professionals working there and should be held as partnerships. Let me make a controversial point: most of these consulting-type businesses do not actually have value on the institution level. With all their contacts and expertise, the partners obviously are of great value, but the name they operate under hardly has any value. However, when you confront the rare situation of having a capital-light consultancy company with a very substantial reason to operate as an organization, a superb investment chance might be at hand. Moody’s (pre-financial crisis) comes to mind as the company’s consultants need no capital to operate. However, the regulator still demands the work to be done in the name of Moody‘s and not in the name of the single financial analyst. Other businesses like that are certification companies like Bureau Vertias or SGS. Unfortunately, I tell you no secret here, and the market normally assigns an ambitious multiple to these companies.

3. Incremental RoIC is of limited value without CAPEX opportunities.

Warren Buffett’s investment in See’s Candies was probably one of the best he has ever made. He paid something like eight-times earnings / USD 10 mln for a business that drove home a cumulated 1.650 mln after Buffett bought it. Most of that is due to increased pricing- a great example of achieving high incremental RoICs. Nevertheless, Buffett also states that he cannot invest much more money into See’s, as there are no useful investment opportunities left in the business model. Hence, always when you were lucky enough to buy a business that shows the characteristics described in 1. or 2., you were also facing an ever-increasing reinvesting risk dragging on your IRR. If you are Warren Buffett, this is not really a risk as you can also compound huge amounts of money at high rates (side note: this is, in my opinion, one of the least appreciated facts about Buffett: he kept on warning that his alpha will fade but it did so only very, very slowly and arguably not at all on a risk-adjusted basis!). The best that can happen to you is buying an attractively priced business with high RoICs that can reinvest free cash-flows at high RoICs. If you found a good one that I might not know- please tell me.

Keeping these three aspects in mind, the best is still in front of you. Maybe I am completely off, and this is stupid (likely, as I have no idea of central bank policies), but something tells me that if a market completely ignores a EUR 500 bln cash infusion by the ECB, we could be at the eve of inflation. Laugh at me because I get transmission mechanisms wrong; laugh at me because the deflating debt bubble is much more likely to cause deflation- but accept my point that inflation is at least not a remote risk.

Studies have shown that stocks can be a (relatively) good investment during inflationary times, but the results are still somewhat sobering. How come? A big aspect of why stocks perform less than expected during inflationary times is the companies‘ need to reinvest into their businesses- which can get quite expensive when prices for investment goods increase. The answer would be to focus on businesses that do not have to invest much when earnings grow. Stay away from high working capital needs. Stay away from huge factories that have to be replaced.

And what’s the method to find out?

Let incremental RoIC be your guide.