Before I deliver on this article's title of three must-have stocks, I want to tell you a story that is sure to enflame you. It's a story of what well-managed organizations do right.
The IRS recently conducted an audit of its own operations for the year 2006, the most recent data available. It discovered that taxes were underpaid by 17% -- a whopping $450 billion. For context, that $450 billion is enough to cover that year's deficit of $248 billion and still have plenty left over.
So the IRS took a reasonable step: It invested money to conduct audits and other enforcement measures. The result? It collected about $65 billion and reduced the final non-compliance rate to 14%.
That additional $65 billion was a great return on the IRS's total 2006 budget of some $10 billion, which goes to all manner of operations, not just enforcement efforts. Clearly enforcement provides a substantial return on investment. In fact, the IRS estimates that enforcement efforts yield more than 10 times their investment -- and sometimes more than 20 times!
In business, a smart executive who could achieve those returns would quickly allocate more capital, build that division of the organization, and vastly improve profitability. But while the IRS has been allocating more resources to enforcement, the U.S. Congress actually reduced the IRS budget by about $300 million this year, meaning the IRS collected significantly less money.
This is a great lesson for businesses and investors.
A tale of two stocks
If that Congressional decision makes no sense to you, then you're intuitively grasping the concept of return on invested capital, or ROIC. Good businesses allocate capital to where they see high returns. So when investing, focus on companies that have high and sustained returns on invested capital, since high ROIC usually means these businesses have a competitive advantage. It's a technique that Warren Buffett uses, and it's relatively simple to figure, as I explain here. The formula is:
ROIC = net operating profit after taxes / invested capital
A company's ROIC shows the percentage it's earning on the money invested in its business. The higher the ROIC, the better. Some businesses, such as Dell in the 1990s, actually receive money before they have to pay suppliers, so they could run with little or even negative capital -- an enviable position.
Take a look at how the ROIC of two megacaps has fared over the last few years:
Source: S&P Capital IQ.
Coke and Pepsi are two outstanding businesses, yet their returns have dwindled. For years they focused heavily on running their soda syrup business. These core franchises required little capital to maintain, and Coke and Pepsi could earn excellent returns.
But in 2010, each decided to buy previously spun-off bottling operations, because they were running out of growth opportunities. Bottling requires much more capital, and you can see that in the declining ROIC numbers above. In the case of these soda giants, decreasing ROIC reflects the lack of stellar investment opportunities, rather than a deteriorating business.
But shouldn't we look for businesses that are continuing to find great opportunities? Absolutely!
About those three stocks...
Below I highlight three stocks that show substantial ROIC and have the ability to grow it in the future. Included are one rock-solid blue chip and two small caps, which I've included because they are little-known and can continue to grow for years.
Philip Morris International
Source: S&P Capital IQ.
Philip Morris shows the kind of ROIC growth that you rarely see in a company of its size ($150 billion market cap). It operates exclusively outside of the U.S. and is able to capitalize on its many high-power tobacco brands, with seven of the top 15 names, including top-seller Marlboro. It generated an operating margin of 43% last year -- enough to make even the best software companies blush. Using its huge cash flow, Philip Morris buys back shares generously, with $16 billion in repurchases over the last three years. It also offers a dividend yield of 3.5%, which the company is eager to boost. Last year that meant a 20% bump to the payout, and I expect to see more gains this year. For all its prowess, it still trades at a reasonable 16.5 times 2012 earnings.
When you look at Bridgepoint's ROIC, don't let those negatives flummox you. They're actually a good thing. They show that the company had negative invested capital in its business, and even when it did require capital in 2011, this $1.1 billion online educator still has very enviable numbers. Its online focus -- and therefore low capital investment -- helps the company churn out buckets of cash. The company has responded quickly to new regulations on for-profit educators, and those new regs don't seem to be hurting profitability too much. The company trades at a rock-bottom eight times 2012 earnings -- tremendously cheap -- and yet its earnings are growing. The company has also shown it can allocate capital through stock repurchases, but it's still sitting on nearly $300 million in cash and no debt.
You may already be familiar with Boston Beer and its Sam Adams brand, but it's still a small cap with room to run. Boston Beer pioneered our love affair with craft beer and is America's largest independent brewery. Craft beer is the place to be. In fact, craft sales have been soaring at 10% to 12% annually, while the total beer market has stagnated. The company has pushed sales 12% higher on average over the last half-decade, translating into nearly 30% annual gains in net income. And it still has just 1% of the beer market. Oh, and the slight downturn in ROIC last year? That's because the company invested in product quality with its "Freshest Beer" program, a long-term investment that I'm happy the company is making.
Foolish bottom line
So when looking for great long-term stocks, focus on return on invested capital, like Warren Buffett. If you like small caps such as Boston Beer and Bridgepoint Education that have room to run and rising ROIC, then you'll want to see the rock star company in our special free report called "The Motley Fool's Top Stock for 2012." The report highlights a business that is revolutionizing commerce in Latin America, and you can get instant access by clicking here to download it now.