Return on Invested Capital: Adding a Grain of Salt

I typically don’t post on the more theoretical aspects of value investing, but wanted to make an exception for a quick rant related to Return on Invested Capital (ROIC). 

Follow any number of financial blogs and you might be tempted to say that ROIC has developed a cult following. It is spoken of in hushed tones, as the holy grail of investing (after all, Buffett endorses it, right?). It has been referred to as the key to finding “moats” (a concept itself so overused as to have lost all meaning); a guide to companies with high and sustainable profits. 

Now don’t get me wrong - I’m as big a fan of a high ROIC company as the next guy. Who doesn't like to find a company that makes lots of money on very little investment? And when I've gone back and looked at the best performing stocks of the past 10, 20, and 30 years, high (and almost more importantly consistent) ROIC, while not universal, had a clear correlation among the top performers.

Where my issue with the ROIC zealots lies is in the interpretation of the output. Like almost every financial metric, ROIC suffers from the garbage in, garbage out limitation. It’s a snapshot in time indicator, and, for the better or worse, encumbered by the rules of GAAP accounting.

Perhaps I should use an example. My feeble brain needs simple examples, and since I’m a bit of a farmer at heart, lets talk about a farm consisting of 1 acre. The farm has no other assets (all machinery is rented, etc.), and no liabilities.

In my neck of the woods, that one acre would cost you $1,000. In that respect, your invested capital would be $1K.

Now just ballparking some figures here, but we can average 50 bushel winter wheat on that land once every two years (we have to let the land lie “fallow” every other year to catch up). So at $5.80/bu., we get revenue of $290. Knock off $170 for operating expenses, and you get operating income of $120 on your one acre. But remember, we have to divide that by two since the above numbers are for a two year operating cycle. Annually, our operating income averages $60/yr. Take away 30% for taxes, and we’re left with $42/yr.

We can quibble about my numbers (and argue about the economics of farming) some other time, but my main point is that the ROIC of my 1 acre farm is 4.2%.

Let’s assume now that you bought that 1 acre 15 years ago. Back then, you would have paid $400 for the land. The farm has no need to retain earnings (which, if I’m analyzing the business, is its core advantage, but that’s a topic for another day), so over the past 15 years all income has been paid out as dividends. 

In this scenario, your “invested capital” is $400, and the ROIC is now 10.5%. Exact same business. Exact same economics. Yet, one has a much higher ROIC just due to semantics.

My point is that, while high (and consistent) ROIC is important, it’s a starting point, and in many cases a misleading one. Age of assets, cash levels, dividends, share buybacks, goodwill, intangibles, financing arrangements, depreciation, amortization, tax structure, type of assets, structure of competitors, industry dynamics, and a host of other line items need to be looked at before dismissing a stock as . . . shudder . . . low ROIC.

This is closely related to a developing investment theme that overpaying for a high ROIC company is somehow okay. The future earnings power of that business will bail you out no matter what you pay, so who care about current price. 

Can this (mathematically) happen? Absolutely. But it’s a slippery slope from that thought back to the “nifty-fifty” of the 1960s or the tech bubble of the 1990s. In both instances, and increasingly among ROIC aficionados, an infinite future earnings stream discounted back (at any discount rate) is still infinite, so it doesn't matter what you pay for a stock today. At the risk of stating the obvious, this is a mistake. (Read about the St. Petersburg Paradox, which is also discussed in the excellent Fortune’s Formula).

And while both Charlie Munger and Warren Buffet espouse the benefits of investing in high ROIC companies, I can find no evidence in the writings of either gentlemen that overpaying for anything is ever a good idea. In other words, finding high ROIC companies may be a good investment strategy, but it should never be confused with a “margin of safety.” ROIC is about the future (i.e. competitive advantage), while margin of safety is a fallback for being wrong about the future. Confusing the two as one in the same is a dangerous shortcut.

Bottom line, don’t let someone convince you to pay three times capital for “farm #2” above (the one with invested capital of $400) when you can get farm #1 at $1,000.

As the saying goes . . . Price is Paramount.


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