Finding the Best Returns on Capital

For the investor with limited resources, success not only depends on how many rocks she turns over, but also the probability that those rocks reveal treasures. Better to flip a hundred rocks at Sutter’s Mill than a million at the Hudson River.

Of course, one must mine the terrain that she commands. Following Buffett’s advice, one should always begin within her circle of competence. But when opportunity arises, how and where should the circle expand?

One useful place to begin are those industries with high returns on capital. Over at Prof. Damodaran’s homepage, his data shows that a handful of industries show consistent and significant advantages for invested dollars. As of January 2009, the 34 publicly-traded businesses that provide educational services offered an average 47% return on capital. More dismally, the 144 REITs returned an average of 8.5%.

Of course, broad macro considerations likely skew some of these data. 2008 was a year with an excess of housing supply–hence homebuilders and manufactured housing had fewer profitable avenues to deploy cash. 2008 also saw record prices for oil, and oil service companies received more and better bids for work than in past years. Perhaps their 20.5% ROC represents an interim high mark.

Unfortunately, going through these data ultimately reveals that my current competencies do not lie in today’s most profitable industries–educational services, computer peripherals (33% ROC), and tobacco (32.6%). Looks like I need to enroll at Strayer, take up smoking, and study the engineering of peripherals.

Comments

[G. Rae MacA...:]

Great article -short & sweet & insightful. I would counter one point, however, ROC is not the best tool to compare REIT returns. REITs are highly-levered so ROE represents a much better metric. Over the long, long term, commercial real estate values tend to rise roughly with inflation, thus one shouldn't expect ROC to exceed 5,6 or 7% (or 8.5% as your analysis reveals)...however, on properties that are 60-75% levered (or 90% levered -in some cases) at the property level (often with non-property-specific corporate debt layered on), the ROE will be considerably higher. Employing vast amounts of leverage add risk (especially for those buying at the top of the market with very little equity) but there is a reason why buyers utilize little equity and why lenders are happy to oblige -because of the slow, yet steady, inflationary rise in the income generated by good properties and the corresponding rise in their respective values. With Gov't bonds where they are at today, and with mortgage insurance available on apartment loans, Apartment REITs (for example) are locking-in mortgages sometimes at under 3%, generating yields of 5-7%+ and all that residual yield after debt service goes to the equity holders...

May 21 09:08 AM