Decoding Investing Success — The Power of Return on Capital (ROC)
What makes a good company? Is it the one your friends and family rave about, or is it simply gross profit and revenue growth? At its core, a good company is defined by its ability to achieve high rates of return on capital (ROC) while maintaining a sustainable competitive advantage.
A company with a high ROC can reinvest its earnings back into its business, generating high rates of return. If reinvestment opportunities are limited, the company can return capital to shareholders or pursue acquisitions.
Over the very long term an investors returns will be equal to the growth of the business and cash returned (dividends and buybacks) to shareholders. The overall under or over valuation of the company at the buy and sell will have less and less effect the longer the investment time horizon. What this means is that companies with high ROC will need less capital to grow and all else equal will deliver superior investment returns.
For instance, if a company is valued at 10x earnings and has an ROC of 50% and reinvests all its earnings, its earnings will grow by 50%. Providing a return of 50%. Conversely, if it can reinvest only 10% of its earnings, the growth drops to 5%, although 90% can be returned to shareholders. Providing a return of 14%. High ROC companies often struggle to reinvest a significant portion of their earnings due to limited opportunities.
So what if a company can reinvest at a high rate of return? This matters because for every dollar that is reinvested at above market rates will provide the equity holder with value creation. Using the above example, a company valued at 10x earnings and ROC of 10%, the return is 10% in both scenarios. There is no value creation regardless if the money is distributed to shareholders or invested back into the business.
What if said company is valued at 10x earnings but has a ROC of 5%? If the company reinvests all earnings back into the company the investor return would be 5%. If the company reinvested 10% of its earnings the investors return would be 9.5%! Value is being destroyed by reinvesting into the business! Investors would be better off if earnings would be distributed back to shareholders and not reinvested into the business!
Note: The above examples are simplified for illustrative purposes and do not take taxes into account.
To calculate ROC, we use the formula:
It’s essential to back out excess cash and non-core short-term investments from the numerator (capital). Often a high quality company will have a substantial cash balance that is not needed for the business. Additionally, EBIT (Earnings Before Interest and Tax) should be normalized to exclude non-cash charges like goodwill amortization while including those that impact economic reality, such as stock compensation. For cyclical businesses, normalizing EBIT over a full cycle is crucial. Calculating ROC can sometimes be more art than science, requiring careful adjustments, but therein lies the opportunity to identify undervalued companies.
Why not use return on equity (ROE) instead? ROC normalizes the capital structures of different companies and across industries. A company with a high ROE might be relying heavily on debt, making ROC a more reliable metric for comparison. For some companies and investment opportunities ROC may not be an appropriate metric for business quality. Financial companies (e.g. banks and insurance) are a notable exception in that ROC is not appropriate and requires different but similar metrics.
A key caveat is that a company must possess a competitive advantage to sustain its high ROC. Without it, competitors will enter the market, driving ROC down to mediocre levels. Companies that consistently achieve high ROC over multiple cycles are more likely to have a genuine competitive edge.
So long as a business achieves and can continue to achieve high ROC there is little benefit in quibbling over slightly higher or lower ROC. Other factors such as reinvestment opportunities and future growth prospects become important considerations an investor needs to consider. ROC should be used as a gauge to indicate the overall quality and comparison of a business, not as a precise measurement.
Let’s compare two companies: Alphabet and General Motors, using 2023 annual report numbers. Alphabet has $229.8 billion in capital and $85.7 billion in EBIT, yielding an ROC of 37.3%. After adjusting for excess cash and marketable securities, its ROC jumps to 73.6%. In contrast, General Motors has $57.5 billion in capital and $9.3 billion in EBIT, resulting in a mediocre ROC of 16.1%.
Without knowing about either business or industries we can see Alphabet has a much higher ROC than GM and is a much better business. Alphabet is able to reinvest into its business and achieve much better returns than GM on its invested capital.
If we look into these businesses a little more we will find out that Alphabet (and especially their search business) is one the best businesses in the world at the moment. So much so that governments around the world have argued and continue to argue Alphabet is a monopoly. Alphabet dominates the segments in which they operate and are able to earn enormous amounts of money while employing relatively little capital clearly exhibiting a competitive advantage.
On the other hand GM (and other automotive OEM e.g. Ford and Stellantis) are generally bad businesses and at best are mediocre businesses. They require enormous amounts of capital to constantly be invented in the business in order to stay relevant. They face fierce competition globally from different automotive OEMs such as Ford, Stellantis, Toyota, and Tesla. Nevermind, the labor and regulatory issues that beset the industry. The 16.1% ROC we calculated for GM is likely too high given their need to constantly keep investing capital into the business to stay relevant (i.e. EBIT should be adjusted lower). It’s not a leap that reinvesting earning back into the business will earn a mediocre rate of return.
A good company is defined by its ability to achieve high rates of return on capital (ROC) while maintaining a competitive advantage. As illustrated by the contrasting examples of Alphabet and General Motors. While ROC is a crucial indicator of a company's quality, it's also essential to consider future growth prospects. Ultimately, focusing on companies with sustainable competitive advantages and robust ROC can guide investors in making informed decisions and understanding the true value of businesses.
This is great and all so we should just buy the companies with the highest ROC and best growth prospects? Not necessarily, we need to pay extremely close attention to the price we are paying for the value we are getting. Price is what you pay and value is what you get. In a future article we will discuss the paramount importance of valuation.
ColdBerry Capital is a global value investment fund whose investment philosophy is inspired by Warren Buffett and Charlie Munger. To find out more you can contact us here.
Notes
Financials were taken from Alphabet and GM’s most recent 10k
Disclaimer
The article expressed above contains forward-looking statements and is intended for informational purposes; it is not a recommendation to buy, sell, hold, or otherwise trade the securities of the referenced issuer. The authors/their affiliates do not hold a position with the issuer such as employment, directorship, or consultancy. The authors/their affiliates does not currently own a position in the referenced issuer's securities; however, that position may change at any time and without notice.
