Wednesday, March 25, 2015

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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Nate Tobik said...

Excellent post!

This new buy ROIC at any price doesn't look much different from the standard buy and hold blue chips at any price that's been popular forever.

Spike said...

Thanks Nate!

@kevin_holloway said...

Good post. I was hoping you would go more in depth on the accounting aspects of ROIC and how it can be over/understated. I've often wondered about this. Is return on incremental invested capital more relevant?

Spike said...

Kevin: Thank you for the comment. I think that ROIC can be over/understated in a myriad of ways. Both the numerator (net income) and the denominator (invested capital) can be influenced by a variety of factors. For myself personally, I am usually substituting some form of cash flow (usually my own estimate of FCF) in for net income to avoid some of the biases associated with GAAP EPS. For capital, a huge goodwill stockpile may be lowering ROIC for some businesses, and should be adjusted out, but for others who need to keep acquiring to keep the business rolling (some tech business for example), I don't adjust out much goodwill. Likewise, how recently have the assets on the balance sheet been marked-to-market. If the company overpaid for a hard asset (hopefully before we bought!) ROIC may be penalized due to this bloated capital base (I'm thinking of a miner or maybe an sand/gravel company here).

I do personally look at return on marginal capital, but I use that more as a judge of management capability / capital allocation skill than I do the overall business (i.e. is management reinvesting the funds profitability and consistently). It often seems like ROMIC is too volatile year-to-year to get a good feel for the business on a longer term basis.

Overall, my thoughts on ROIC are that it takes more than a quick glance and a formula to get a comfort level with a business. True ROIC can only be found by digging into the numbers and thinking critically about the prospects of the company. What is right for one business is not right for another company.

Of course, these are just my thoughts as I try to figure out how to use ROIC better in my own analysis. I would love to hear your (and others) thoughts on the subject.

bjdubbs said...

What about just return on tangible capital? Look at how much working capital and pp&e the business employes, and compare with the smoothed earnings for the last three years (or something like that). In your farm example, you look at market value (because that's the opportunity cost). Nice site, btw. Added to the rotation.

Spike said...


Thanks for reading the post. I do like the idea of using return on tangible capital and a 3yr smoothed EPS number to get a lay of the land with a company, but would still argue that even those adjustments won't be a one size fits all screen. The intangibles of some companies are very real, and need to be included in capital in my opinion. For others, none of the intangibles are real.

In the farm example you are exactly right that I used market value (I hadn't though of it as opportunity cost yet, but I like that - I think there's more too that and I need to ponder on it). But for a company that had just purchased the assets (the 1 acre), its ROIC is going to be unjustly punished vs. the neighbor across the fence who has owned the land for 15 years. Yet for all intents, their businesses are identical.

Maybe all I'm trying to come up with here is the same as what Joel Greenblatt has already done with his "Magic Formula" - ROIC needs to be looked at in comparison to what you are paying (earnings yield in his case).

Thanks again for the comment.

bjdubbs said...

A search for Greenblatt ROIC turns up this:

"Return on Capital: EBIT/(Net Working Capital + Net PPE – Excess Cash)"

So basically he defines the C in ROIC as tangible capital. The only way to measure intangibles is through earnings.