Is This Shipper Worth Its Salt?

Return on invested capital is one of my very 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 Frontline (NYSE: FRO  ) .

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 Frontline, a tanker company that ships both crude oil and dry cargo, stacks up by this measurement. 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 Frontline

2005

2006

2007

2008

2009

TTM

11.7%

10.2%

6.4%

12.2%

4%

4%

What can we conclude? Frontline's ROIC moves around a bit, although its standard deviation is just 3.8 percentage points (versus 5 percentage points for competitor DryShips (Nasdaq: DRYS  ) ). Frontline is a solid shipper, and its results are surprisingly stable for this volatile industry. Speaking of the industry, for comparison, Teekay (NYSE: TK  ) , another shipper – mostly focused on the petroleum end -- sports a reasonably stable ROIC, yet its returns are lower. Meanwhile, Overseas Shipping Group (NYSE: OSG  ) has delivered a steadily declining ROIC, albeit with less leverage than either Teekay or Frontline. Ships Finance (NYSE: SFL  ) , meanwhile, has used comparable leverage to deliver a low-for-the-industry ROE in recent years, and its ROIC hasn't crested 6% in recent history.

Returning to Frontline, I'd like to note three things: First, Frontline will suffer as the global economy suffers – you can see it in the results above. Second, this industry is bracing for an influx of new double-hulled vessels, which will mean more transport supply in aggregate, even if many are replacing retired single-hulled models. Third – and the kicker – is that Frontline's ROE ran as high as 122% during this same time period. Watching ROE alone might have given you the wrong idea about this stock, which gets about 80% of its capital from debt. With a yield near 11%, Frontline looks attractive, but until the economy picks back up, I'd say it's best purchased for yield.

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


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