Why This Metric Will Ensure You Pick Wonderful Stocks
Summary I will select stocks for my son’s portfolio using five simple questions that are based on a strategy that returned 850 percent in the past 20 years in a backtest. This article focuses on the first question: do the financial statements indicate the company will generate attractive returns on invested capital? I introduce a traffic light system that separates industries with great economics and high returns from poor industries using a dataset of 3000 companies. In the next several weeks I will elaborate on each of the five questions using numerous examples; in the coming months I will start selecting real stocks. What if the next time you buy a stock you can only look at one financial metric, which one would you choose? Although I admit this is a less than ideal situation as each (additional) financial metric gives you more clues about the prospects of a company, there is one metric that truly matters: the return on invested capital, or the ROIC. The ROIC measures the company makes on the capital that was put in the company by investors, the suppliers of debt and equity. At the end of the day, an investor cannot but do good, if he or she buys shares of a company that compounds returns at an attractive rate (of course the ‘pieces of the company’ must be bought at a reasonable price) In just a few minutes, I will use the ROIC metric to show in which sectors and subsectors in the stock markets investors should look for to find wonderful companies. But I first want to spend a few words on theory. There are probably more than a dozen ways to calculate the ROIC, but to me the most intuitive way is the calculation used by Columbia professor Bruce Greenwald. For the ‘return on’ part take the EBIT (earnings before interest and taxes) and subtract taxes. In the second step I need to define the variable ‘invested capital’. To get this figure Greenwald simple takes the number at the bottom of the balance sheet (“total assets”) and subtracts from that figure all the so called spontaneous liabilities. Spontaneous liabilities are defined as current liabilities that bear no interest like accounts payable and accrued expenses. CFO’s love these kind of liabilities as they are in a sense free capital and can therefore be subtracted from the balance sheet total to get the real amount of capital the company needs to generate earnings. Divide the first figure by the second figure et voila, you have the return on invested capital. For my son’s portfolio I will be looking for companies that have a long record, preferably 10 years, of a high and stable ROIC that is above a hurdle rate of at least 8 percent (WACC, weighted average cost of capital). Please read this previous article in which I explain a simple 5-question-investment-strategy to find stocks that are likely to yield above average returns. A back test of the strategy resulted in a staggering 850 percent return in 20 years. 5 questions that lead to above average returns Do the financial statements tell I deal with a company that has a moat? Do I understand qualitatively why the company has a moat? Can I buy the company at an attractive discount Does the company have a strong dividend track record? Does the company have a balance sheet I am uncomfortable with? The key takeaway of this article is that for my son’s portfolio, I only want to invest in wonderful companies that generate attractive returns on capital. This is far from easy. The graph below presents the five year average ROIC of the 3000 companies with the biggest market capitalization in both the United States and Europe. Graph: Generating attractive returns is not easy (click to enlarge) *Data from Bloomberg. Starting point was the 3000 largest companies in the United States and Europe. For 654 companies 5 year average data was not available. I also excluded dozen outliers. This results in a dataset of 2346 companies. Bad news.. Only 1327 of the 2346 companies – or about 60 percent – have a ROIC that is higher than 10 percent. Do you believe a hurdle rate of 10 percent is too ambitious in the current interest rate environment? Fair, but even if you assume a WACC of 8 or 6 percent the percentage companies that have a ROIC that is lower than the WACC is still respectively 45.8 and 32.1 percent. The empirical evidence is crystal clear: it is hard to earn returns that are significantly above a reasonable hurdle rate. A traffic light system to screen for wonderful companies As a deep value investor the only criterion to buy a stock is a low valuation compared to the company’s earning power. I did not mind in which industry the firm operated. Now I am shifting my investments from cigar butts to wonderful compounders, I must realize time is a scarce resource. It takes blood, sweat and tears to really understand the business model of a company and the economics of an industry. Therefore it makes sense to me to focus my investment research on companies in industries that are just by nature more likely to crank out attractive yields on capital; i.e. I should focus on the companies on the right side of the graph. Although there are examples of managers that operate extremely successfully in fiercely competitive sectors, I believe getting these companies on your radar is like finding a needle in a haystack. So, what should be the hunting ground of an investor that is looking for wonderful companies? I grouped the 3000 American and European champions in 10 industry segments and calculated the five year average ROIC of each industry using Bloomberg data. The results are presented in the graph below: Green, orange and red: A traffic light system for individual industries (click to enlarge) *Data from Bloomberg. Defined by the GICS-framework. I made a rough distinction between sectors that yield very attractive returns (green color), sectors that yield reasonable returns (orange color) and the ones that earn less than decent returns. The graph learns companies in the Health Care, Utilities, Financials and Energy sector yield returns below 10 percent on average . Most utility companies are regulated which entails they cannot set their own prices, energy companies are extremely capital intensive and in the end commodity businesses (oil and gas prices will make them look good or bad) and health care companies are dragged down by biotech companies that are asset light (barely capital invested) but loss making in the process of making a new medicine leading to extremely negative ROIC’s. In the Consumer staples, IT, Industrials, Consumer discretionary and Telecommunications sector the average return is above 10 percent. The problem with this analysis is that within each of these sectors, there is huge dispersion in returns due to different economics of industries in different subsectors. Therefore, I also calculated the calculated the average ROIC of (68) subsectors within sectors. I am fully aware this is a long list, but I believe it is of tremendous importance to find the right hunting ground. I have a copy of this list as a first check to see if a company I am interested in operates in a sector with favorable economics. Looking for great companies? Look at the top of this list (click to enlarge) I am exaggerating when I say I only want to look at subsectors that yield returns above 10 percent, but since time is a valuable resource, I will spend most of my time in the most attractive corners of the stock market (the top of this list). Please look at this list to see the names of the companies that are part of each subsector. You could also use the list to find wonderful companies yourself. Please note I continue to use the traffic light system. This leads to interesting insights. The sector Consumer Discretionary might be a value creator on average (ROIC: 11 percent), but within this sector the subsector Automobiles is a pure value destroyer with an average ROIC of 3,1 percent. The automobile industry is very capital intensive and extremely competitive leading to low profitability. The finance industry is also fiercely competitive, but the subsector Capital Markets generates returns that are above a decent hurdle rate – think asset management firms such as Schroders ( OTCPK:SHNWY ) and Aberdeen ( OTCPK:ABDNF ) in Great Britain and credit rating agencies like Moody’s (NYSE: MCO ). These companies tend to have very sticky costumers that seem to swallow high tariffs for the services the company provides. You can dig a little deeper again and ascertain that within highly lucrative (value destroying) subsectors there are terrible (great) individual companies. Even the best industries include value destroying companies, while the worst industries have value creating companies. As mentioned before, however, I will look for companies in “green” sectors, in my quest for stocks for my son’s portfolio. Find companies that have their GROWING earnings protected by a moat A high ROIC is great. It is a strong signal a company has some sort of competitive advantage, which not only results in high (economic) profits but often also in stable and predictable financial results. A high (historical long term average) ROIC, however, does not have to entail that new capital investments- for instance investments out of retained earnings – generate the same lucrative returns. A dollar invested in a new Wal-Mart (NYSE: WMT ) store in Arkansas is very likely to be return enhancing for the group, but that same dollar invested in the international activities – where the competitive advantage of the company is much, much smaller – is very likely to destroy value ( read this ). When you invest in wonderful companies it is absolutely critical to find out if the CEO invests in the divisions of the company that have a moat. Clearly, Microsoft (NASDAQ: MSFT ) has a moat with respect to products like Windows and Office, but squandered money on game consoles (Xbox), and a long list of other investments and takeovers (to name a few internet ad bureau aQuantive, $6.3 billion which was completely written off, Skype, $8.5 billion and Yammer, $1.2 billion) I will be looking for companies that are able to grow their sales and earnings while maintaining an attractive ROIC. In general this kind of companies have business models that are scalable, such as the Zara and H&M stores of mother companies Inditex ( OTCPK:IDEXY ) (5 year average ROIC: 28 percent) and H&M ( OTCPK:HNNMY ). Due to huge economies of scale these companies can grow their number of stores and sales in a way that generates economic profits for shareholders. Next article The goal of this series of articles is to construct a value investing portfolio that will pay for my sons college tuition 20 years from now. I will use screens on my Bloomberg terminal to find high-ROIC-reasonable-growth-companies that trade at attractive prices. Filtering stock indices around the world on ROIC is a huge time saver to come to a short list of wonderful companies in a quick way. The most difficult part of stock selection, however, is the qualitative part: do I understand qualitatively why a company is able to generate returns of capital that are consistently above the WACC. This question will be the subject of my next article. Food for thought A wonderful company can reinvest the earnings it does not give back as dividends at a very attractive yield causing a snowball effect that results in very attractive returns for investors. A thing I would like to point out is that it is very reasonable to assume that most new (‘incremental’) investments will yield returns that are significantly lower than the average ROIC in the past years. Although Damudaran explains an interesting formula to estimate the so called marginal ROIC in this paper (for the connoisseur, please see page 51 ), the problem is that there are too much swings in both invested capital and operating income due to the economic fluctuations, accounting alterations and corporate events (think take-overs) to come up with a reasonable estimate. Therefore I use 5 or preferably 10 year ROIC-data to find out if the metric stays consistently above the WACC and combine this with data on (autonomous) sales growth. As mentioned before, calculating the ROIC is not an exact science. As a value investor I always try to be on the conservative side and be very careful to take ROIC, ROCE or ROI metrics that companies provide themselves, as they often use definitions that are very favorable to the company (and the bonuses of top management). When I use Bruce Greenwald’s ROIC method, I know I include goodwill and intangible assets in invested capital and make sure all the costs of doing business are included in operating income (including taxes!). It is beyond the scope of the article but I also correct for accounting that distorts the economic picture (I for instance try to capitalize R&D expenditures that are likely to result in future sales and profits) I am afraid I have to spend a few words on the cost of capital or WACC as well. It really saddens me a bit that I spent months and months during various university courses on complex mathematical models to measure this cost of capital. The honest truth, however, is that these models are elegant and neat in the academic world, but nothing short of useless in the real investment world because all the model assumptions are violated. During the Value Investing course I attended at Columbia, I learned to look at more qualitative things to estimate the return investors require. Greenwald, for instance, looks at the rate of return private equity firms promise to their investors. A private equity fund that invests in risky businesses like biotech should return at least 16 percent. If you assume 16 percent is enough for extremely risky investments, it makes sense to have a significantly lower required yield for a defensive company like Wal-Mart. Do note, even in the current interest rate environment I will never use a WACC that is below 7 percent. I can’t emphasize enough that calculating the ROIC and WACC is far from an exact science! I do believe, however, that investors can see very quickly whether company is likely to earn attractive returns using the ROIC calculations that are outlined in this article. In my next article I will take it one step further and look at qualitative factors that make a company wonderful. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.