What moved Warren Buffett from “cigar butts” to high-quality businesses? It might have partially been Charlie Munger or even Phil Fisher with his “scuttlebutt method,” but it likely had something to do with the nature of superior return on invested capital (ROIC) as well. In particular, the fact that it is often a persistent source of value creation for asset owners. Many capitalists and analysts alike subscribe to the idea that intense competition gradually grinds return on invested capital down toward the cost of capital, eventually eliminating most economic value added by companies. But the reality is that high levels of return on invested capital are persistent on average, even over long periods of time, perhaps reflecting the dilution of competition as industries in major economies like the US have concentrated to near monopoly. Whatever the reason, superior return on invested capital is more likely to stick around than its value-driving companion, fleeting growth. The implications for value (and growth) investors are important, and one way to potentially benefit from this often misunderstood dynamic is to put superior return on invested capital at the base of an investment process. In this article, we will detail the long-term dynamics of return on invested capital and discuss how we construct our investment process largely around its roll in sustainable value creation.
ROIC is a core value driver in combination with growth
In part one and part two of this three-part series, we covered value creation and the fleeting nature of growth. If we glance again at the below graphic, it’s clear that return on invested capital deserves its turn as well. We also should not ignore a company’s ability to optimize capital structure and cost of capital (or generally the strength of the balance sheet). It’s key to remember that return on invested capital does not create value unless it is in excess of the cost of capital. In fact, growth is actually value destructive if return on invested capital is below the cost of capital. But this article is generally about constructing an investment process based on superior levels of return on invested capital, and so the discussion will assume an adequate spread above cost of capital.
Source: Valuation by McKinsey & Company
Let’s remember that it’s the long-term that matters
As owners of businesses, equity investors care about the long-term ability of a company to produce attractive cash returns. Next year’s results matter little compared to the trajectory of results over the next couple decades, or even indefinitely. So critically, it is the predictability or sustainability of growth and return on invested capital over long periods of time which is important, rather than their level over the next couple of years. This conclusion often clashes with what we see in the investment industry. Many “investors” focus on the next quarter rather than the next decade. And despite both growth and return on invested capital creating value, market participants are often focused more on growth than value creation, leading many to pay more for growth, but not necessarily for return on invested capital.
But which should investors be more focused on, growth or return on invested capital? The combination is what really counts, but with predictability and sustainability being so critical, we give the edge to return on invested capital, perhaps the opposite of how many market participants function today. We often hear investors discussing growth and how much should be paid for growth, but we rarely hear investors discussing return on invested capital despite its importance to value creation, perhaps because so many investors are focused on the short-term. But for long-term investors, the sustainability of growth and/or return on invested capital over many years is what really matters. Using the charts below from the book Valuation by McKinsey & Company, we will attempt to demonstrate that return on invested capital is reasonably predictable and more persistent than growth (on average) over long periods of time, and therefore an attractive metric to put at the core of a value investing process.
ROIC is persistent and reasonably predictable, providing a solid basis for an investment process
Contrary to what many analysts model, high growth rates decay quickly, often reaching the market average of around 5% in just a few years. But high levels of return on invested capital are different. While there is often some decay, superior levels of return are generally persistent over the very long-term.
Source: Valuation by McKinsey & Company
The capitalistic idea that returns on invested capital above the weighted average cost of capital will be competed away over reasonable periods of time simply does not hold on average. Capitalism is too imperfect currently for such an idealistic concept to be reflected in the real world. And the evidence in the above chart is proof that high levels of return on invested capital can, and in fact do tend to persist over the very long run. The median US company has produced a return on invested capital of about 10% over time, but companies with return levels above 15% clearly demonstrate that they can maintain those return rates well above the median, and certainly above the cost of capital. It seems fading return levels to the cost of capital over five to ten or even fifteen-year periods is potentially overconservative. All else being equal, these high return on invested capital companies deserve a meaningful and persistent valuation premium. Investors may want to consider the level and consistency of return on invested capital when making estimates, perhaps only fading consistently-high levels of ROIC to a defined premium over cost of capital, reflecting the historic realities demonstrated in the chart above.
Focusing on ROIC helps to play the odds when value investing
High return on invested capital is more persistent than high growth on average. Both generate value, but return on invested capital has a much more lasting impact and may therefore be a more important driver of valuations over long periods of time (despite many investors focusing on growth). Predicting sustained high growth requires incredible foresight as it goes against the odds. But as the graphic below demonstrates, you don’t have to be an expert to predict which companies will maintain high levels of return on invested capital, you just have to play the odds. Of companies with a return on invested capital in the range of 10-20% in 1995, 75% of them maintained that level of return (or higher) 10 years later. For companies with return levels greater than 20% in 1995, 67% percent still achieved such incredible levels of return a decade later, and 81% still had a return on invested capital above 10%. Do also note, if companies have low returns on invested capital, it is most likely that they stay low, indicating how difficult it may be to pick winners that will transition from relatively low to high return levels.
Source: Valuation by McKinsey & Company
Our conclusion is that return on invested capital is a critical driver of valuation over time and is also persistent and reasonably predictable for high-quality companies. An investment process based on high levels of return on invested capital automatically builds in a level of humility, as it is simply playing the odds rather than requiring a rare level of financial foresight. Common sense also tells us that high levels of value creation protect against bankruptcy and permanent loss of capital, which in turn makes investment decisions easier in times of crisis. It also generally supports self-funding, helping to avoid capital shortages when funding is scarce. And higher-ROIC companies can distribute more of each earnings dollar to shareholders, all else being equal. Of course, it is only the basis for a deeper level of research to understand the sources of return on invested capital, potential growth and valuation. But we believe it helps our investment process tilt the odds in favor of superior investment outcomes.
We put superior return on invested capital at the core of our investment process, generally looking for double-digit return on invested capital over a decade or more, although optimally focusing on levels of 15% or greater.
ROIC’s roll in value creation and investing may become more important
We might also point out that return on invested capital persistence may very well be set to increase. The recent and dramatic concentration of most industries in the US has led to more and more oligopoly or even monopoly type systems which tend to support persistent and high levels of return on invested capital. They may also serve to dampen growth for some companies or industries, meaning return on invested capital’s roll in value creation may become even more crucial in the years ahead. For additional reading on industry concentration and its impacts on economic and political structures, we recommend reading Jonathan Tepper’s The Myth of Capitalism and Tim Wu’s The Curse of Bigness, but readers can also review our recent articles touching on the subject with company examples such as Thor Industries (THO) and H&R Block (HRB). It is a fascinating topic which is likely to become one of the most critical political issues in coming years, also due to its relationship with wealth inequality.
Real world examples of ROIC (and growth) in action - from our holdings
Roche: Roche is a core long-term holding in our portfolios, providing us with exposure to leading biologic therapeutics with a focus on oncology and a stable diagnostics business. The firm’s fundamental profile is exceptionally strong, characterized by dominant positions and high barriers to entry related to patents, technical know-how, and innovation potential, including research and development spend few companies can match. The firm’s cash flow generation is high and stable, which bodes well for the safety of the dividend and its growth over time. While not necessarily a high growth company, the overall strength, quality and stability through the cycle certainly earn the company’s position as a core investment.
Source: Thomson Reuters Eikon
We have written about Roche’s return on invested capital and dividend profiles in the past, and the graphic above demonstrates that the company easily passes our hurdle for double-digit ROIC or better over the past decade. As expressed in this article, the only-reasonable growth levels may not support a premium valuation, but the exceptional ROIC profile certainly does according to our process.
Cognizant Technology Solutions: Cognizant is a leading provider of Information Technology (IT) services - including technology consulting, application development, systems integration, business process services, cloud services, and more traditional IT outsourcing services. Investing in the technology sector is often a difficult endeavor for conservative, long-term investors due to its inherently fast-moving and ever-changing competitive environment. Having said that, we believe that IT consulting and services firms such as Cognizant deserve some attention, as they stand to benefit from the increasing digitization of the business world, without bearing the risk of being tied to any specific technology platform. In this space, Cognizant stands out as a company that has a clear focus on delivering the best level of service to its clients over the long term. This is reflected in its corporate strategy, capital allocation decisions, and various other aspects of how it runs the business. It has clearly been a successful approach, as evidenced by significant market share gains over the past 2 decades and independent client satisfaction surveys.
Source: Thomson Reuters Eikon
While the company might not appear as ‘cheap’ at first glance, understanding the drivers of value creation leads one to look through the prism of return on invested capital and growth. Cognizant’s long-term track record clearly shows that the company consistently earns about twice its cost of capital and grows much faster than the market. We think it can maintain market-beating earnings growth over the next decade, but exercise our usual caution when deciding how much to pay for potential growth.
Summarizing the key elements of effective long-term value investing
Growth and return on invested capital (in relation to cost of capital) drive value. Predicting growth and return on invested capital over long periods of time is critical to estimating value and therefore determining an attractive price to pay to own a business. Above-average growth is often fleeting and therefore difficult to foretell over long periods of time, indicating that investors should be cautious when paying premium valuations for continuing high growth rates. Above-average return on invested capital is often persistent, and due to its persistence, investors can reasonably predict that it will continue to drive value over the long term and deserve a premium valuation. Ultimately, superior return on invested capital supplies an attractive base to begin in-depth fundamental research.
There are many paths that can lead investors to superior investment results. As value investors, we seek to understand the core drivers of value creation, growth and return on invested capital. While both may be predictable, the averages show that high growth is predictably fleeting while high return on invested capital is predictably persistent. We search for both, but seek to put the odds in our favor by being cautious to project high growth rates while demanding an attractive return on invested capital that we determine is sustainable.
Disclosure: I am/we are long CTSH, RHHBY, THO, HRB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed to or by the author. This article does not constitute investment advice.