If you are interested in managing your own investments there is a definite chance that you have heard about the idea of factor returns.
Simply a lot of tests
Factors are simply certain ratios or indicators that have some statistical value in utility explaining investment returns.
Scientists found these factors by doing what is called regression analysis, which is nothing else that running a lot of tests which ended up with a list of ratios or indicators that have some value in determining stock returns.
Well known factors are
The well-known factors are price to book ratio, share price momentum and company size.
For example if you look at company size, research has shown that smaller companies usually lead to higher returns.
Is RoIC a factor you should use?
Another factor you can look at is return on invested capital (RoIC). This ratio is calculated by dividing the earnings a business derives from operations by the capital needed to run the operation.
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.
RoIC a quality ratio
As you can imagine RoIC is strongly correlated with the „quality“ of a business.
For example if you own a business that is protected against competitors and has loyal customers the higher the chance is that your capital will earn a high return.
High RoIC = a competitive advantage
In fact, Bruce Greenwald, in his great book „Competition Demystified“, named high RoIC 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 Economic Value Added (EVA). Using the EVA-methodology, managements can make investment decisions on the basis of prospective RoIC vs. underlying cost of capital.
RoIC in the Magic Formula
In the investing world, RoIC has found some recent importance due to the popularity of Joel Greenblatt’s Magic Formula. The New York Hedge Fund manager selects investments by buying companies that have the most attractive combination of value and quality.
As you can imagine, he uses RoIC to determine the quality of the company. The results of the Magic Formula are quite staggering and numerous studies have shown that the Magic Formula in fact works quite well.
To consider before you use RoIC
So would it be a good idea to just buy companies with high returns on capital or maybe take RoIC into consideration when selecting undervalued companies.
While we do believe that RoIC is something you should look at there are several things you need to think of before using it:
Incremental RoIC matters.
In the world of accounting, the balance sheet value of an asset is not necessarily equal to its replacement value (to say the least). Therefore, you might be tempted by a company that uses a long-depreciated asset to generate its profits.
Obviously, this increases RoIC but says nothing about incremental RoIC (increased profits / increased investment) as this will be lower because of higher amounts that need to be invested in the business.
Compare this business with an online platform that spent lots of money to build IT infrastructure that can be scaled so that all additional users lead to infinite incremental RoIC as no further investment is needed.
To make a long story short: focus on the capital needed to support the very 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.
Think twice about super-high RoIC.
To some businesses, RoIC just does not really matter.
Think of advertising agencies or investment banks – all they need are a couple of computers, some flipcharts and some tables (spare the billiard 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’s make a controversial point: most of these consulting-type businesses do not actually have a 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 to have 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 (before the financial crisis) comes to mind as the company’s consultants need no capital to operate but 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, as you already know the market normally assigns an ambitious multiple to these companies.
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 12 times earnings (USD 10m) for a business that returned more than USD 1 650m since he has bought it. Most of that is due to price increases – a great example of how to achieve high incremental RoIC.
Nevertheless, Buffett also says that he, unfortunately, cannot invest much more money into See’s, as there are no useful investment opportunities left in the business model.
Thus, always when you were lucky enough to buy a business that shows the characteristics described above you have an ever increasing reinvesting risk of the returns the business generates that lowers your return over time as you simply cannot find any other investments that are as good.
This is a relative long story to get to what we have found in our research.
There are better factors than qualityContrary to what you expect we have found that business quality to not be one of the best things to look for. Low valuation (by one or a few valuation ratios) and share price momentum is much more important.
We have not given up
We have however not given up on quality and continue to test and read investment studies related to RoIC and will definitely include it in our investment model (for the Quant Value newsletter) if it leads to higher returns.