Is STEC Worth Its Salt?

Return on invested capital is one of my favorite metrics. In this article, I'll show how you can use it to find stocks to buy, stocks to watch, and stocks to avoid, starting with STEC (Nasdaq: STEC  ) .

Beware ROE
You've probably heard of return on equity, a favorite of Warren Buffett. It measures net income (the "return") relative to the equity capital a business has raised and built. A higher ROE signals a more efficient business.

But ROE can be gamed. Because debt is cheaper than equity financing, a management team whose bonuses depend on ROE targets may be tempted to lever up, increasing risk, just to juice net income and ROE.

Return on invested capital -- which is like a return on debt and equity -- catches this. ("RODE" would have been a catchy acronym, no?) To find ROIC, simply divide a company's after-tax operating profit by the sum of its debt and equity. Because it includes debt, ROIC is harder to fudge than ROE. Studies also indicate that watching ROIC can improve your returns.

Why ROIC reigns supreme
Michael Mauboussin -- the chief smart dude at Legg Mason Capital Management -- divided stocks into quintiles by ROIC in 1997, then tracked them through 2006. The lowest 1997 quintile ended up performing worst, unsurprisingly. But the stocks with the highest starting ROIC didn't perform the best, with annual returns of less than 6%, mainly because they fell out of the top quintile along the way.

Two investing secrets emerge from the nuances of Mauboussin's findings:

1. If you find a rising ROIC, you could have a winner
Companies that started 1997 in the lowest or second-lowest ROIC buckets, but finished 2006 in the highest or second-highest, delivered returns of 14% annually.

2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance
Companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually.

Will our next contestant come on down?
Let's see how STEC, a well-regarded computer storage maker that predominantly sells to businesses -- EMC (NYSE: EMC  ) is a big customer, for instance -- versus directly to end users. We'll be using numbers from Capital IQ (a division of Standard & Poor's). For most moderate-risk companies, I consider anything greater than 9% to be a decent ROIC; more than 12% is even better. The higher the risk, the higher the ROIC you'll need to be content.

ROIC for STEC

2005

2006

2007

2008

2009

TTM

1.6%

12.6%

2.4%

1.9%

25.2%

14.6%

What can we conclude? STEC has had its ups and downs – reflected in an ROIC standard deviation of 9.5 percentage points. But while analysts had cut forecasts for STEC earlier this year, the company still boasts strong sales and profit growth by most standards. And note that with debt-free STEC, ROIC is closer to ROE than with most companies. If business IT spending keeps up, there's a good chance that STEC's returns will, too.

James Early owns no stocks mentioned in this article. You can investigate his Motley Fool Income Investor newsletter free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On August 24, 2010, at 12:25 PM, flashfinancials wrote:

    Many of the comments in this article are self-fulfilling...i.e. it is not helpful to an investor to know that "companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually"...hmm...pretty hard to tell from 1997 vantage point WHICH companies would remain in the top 1 or 2 quintile! Let's see, the crystal ball says...

    Countering that, the author points out that the stocks with the highest ROIC did NOT perform well.

    ROIC is a measure of earnings vs. invested capital. It is not a measure of fair market valuation...i.e. the stock price. I would venture a guess that the market valuation of the top quintile companies in 1997 was overheated, and they did not perform to the high expectations already built into their stock price in 1997.

    Very hard to argue ROIC as a standalone stock screen when it does not even consider the current stock price. It's like looking at a car and deciding to purchase strictly on mpg or other metric, without considering the price of the car. ROIC is a measure of what the company did with early investors money. A good ROIC does say good things about the business, but does not say whether you, as today's investor, are getting a good deal or paying a high price.

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