3 Stellar Stocks Making All the Right Moves

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:

Company 2009 2010 2011
Coca-Cola (NYSE: KO  ) 20.3% 14.7% 14.5%
PepsiCo (NYSE: PEP  ) 21.9% 14.4% 13.4%

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.

Company 2009 2010 2011
Philip Morris International (NYSE: PM  ) 30.3% 34.5% 43.6%
Bridgepoint Education (NYSE: BPI  ) (215.3%) (591%) 187.3%
Boston Beer (NYSE: SAM  ) 23.7% 36.7% 34.3%

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.

Jim Royal, Ph.D., owns shares of Philip Morris. The Motley Fool owns shares of Coca-Cola, Boston Beer, Bridgepoint, and PepsiCo. Motley Fool newsletter services have recommended buying shares of Boston Beer, Philip Morris, PepsiCo, and Coca-Cola. Motley Fool newsletter services have recommended writing puts on Bridgepoint. Motley Fool newsletter services have recommended creating a diagonal call position in PepsiCo. Motley Fool newsletter services have recommended writing covered calls on Dell. The Motley Fool has a disclosure policy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (20) | Recommend This Article (59)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 13, 2012, at 5:57 PM, Lisbet565 wrote:

    What hypocrisy ! PM is routinely blasted for the product it sells; yet, scams like for-profit colleges, which swindle not only their students, who they pretend to "educate," but also we-the-taxpayers, who get stuck with the bill for all those billions in unpaid loans, yawn when chastised by our elected officials -- but are still allowed to belly up for public funding. The thought of investing in such scams -- or the likes of PM, for that matter -- turns my stomach.

  • Report this Comment On April 13, 2012, at 6:32 PM, Midas5280 wrote:

    For-profit education is worse than PM. At least we know how toxic cigarettes are to our health and longevity. For-profit education produces idiots who don't know what they don't know. These putrid "educational" entities simply produce a piece of paper for a certain sum which is usually high. Students end up with high debt and a piece of paper not recognized at legitimate schools, equating to them returning to one of these lovely fraudulent institutions for higher degrees and, of course, more piled-on debt. University of Phoenix, Westwood,etc., etc., are nothing more than a big scam. All they accomplish is further deterioriation of the U.S. via producing clowns jumping up and down stating they have a "degree". All fluff, no substance!

  • Report this Comment On April 13, 2012, at 8:55 PM, xetn wrote:

    Trying to compare the IRS to any "real" enterprise is completely idiotic. There is simply no comparison.

  • Report this Comment On April 13, 2012, at 10:10 PM, Rolin4ward wrote:

    I read that people illegally in this country don't pay around 240 billion dollars in taxes per year and yet the legal are squeezed by the IRS. Then instead of letting in people legally, there's the suggestion to legalize the sneaks that came in illegally when we already have enough crooks in this country. The IRS is more than willing to go after citizens but I don't see them supporting a controlled border so the citizens are all legal and paying taxes. So to say the IRS, or the government is getting more efficient brings up a lot of questions about how the country has been run. Now the the IRS is going to hire 4000 more agents to implement the fees for Obama care, attached to the legal citizens' taxes while nothing is done about the former. The IRS is becoming more efficient so they can pay the 4000 new employees. That's not saving, that's bait and switch.

  • Report this Comment On April 13, 2012, at 10:20 PM, Usnzth wrote:

    Wow, Jim. Judging by the previous responses, not a popular article.

    Personally, I love high yielding dividend stocks from a solid growth company, but I cannot justify investing in any of the above.

    One can make the arguement that people who purchase the products of the above companies deserve what they get, and that one might as well benefiit from their stupidity. But I don't want to build my wealth that way.

    That's my choice, and I'll stick with it.

  • Report this Comment On April 13, 2012, at 10:21 PM, WhyNot222 wrote:

    The job of MF is give advice on the potential for positive returns. If you want to be the social conscience, fine, but I don't want MF doing that. I want them to give advice without pontificating on whether I should smoke or go to for profit college. Maybe you need to re-evaluate whether this is the place for you?

  • Report this Comment On April 13, 2012, at 10:40 PM, Usnzth wrote:

    Nope. This is my place. I appreciate Jim's opinion, and your opinion, and I enjoy being able to express mine.

    A quick reread would show that there was no pontificating. I actually gave the other side's arguement without giving mine.

    What exactly stung you here?

  • Report this Comment On April 13, 2012, at 11:44 PM, bradeoneill wrote:

    i disagree with the post above that says for profit education is a scam. My wife attended one of the best medical schools in the country so I think i have seen a little bit of higher education, I attended a state school and then took some courses at the university of phoenix which were far superior to anything I received at the more traditional university. My instructors at University of Phoenix were working professionals and as such they had real world examples and our class projects were often centered around actual problems that needed solutions. In my class there were board members from a bank, business owners, and other people who were there for the education not kids sleeping off their hangovers in class.

  • Report this Comment On April 14, 2012, at 12:17 AM, TMFRoyal wrote:

    Yowza! Lots of excitement!

    One of the things that is often a powerful indicator of good returns is when investors vehemently hate a company (perhaps for a variety of reasons: its ubiquity, its monopoly, its sleaziness, etc). A few come to mind immediately: Goldman, Microsoft, Altria, McDonald's, etc. But what really makes them such a magnet for criticism and what they often have in common is their success (i.e. profitability).

    Thanks for the comments!

    Foolish best,

    Jim

  • Report this Comment On April 14, 2012, at 1:12 AM, john795806 wrote:

    Personally, I thought it was a great article, all-around. Too bad about the off comments on the IRS: they are there to do THEIR job, not lobby for border enforcement, Rolin4ward. If it was their job, I'm sure they would be out finding ways to get illegal immigrants to pay more taxes. Fact is, if we are serious about reducing our deficit, we should give them more money, not less.

    As for the other companies, as a former addict to cigarettes, I'll pass on PM--but that's just because thinking of them makes my lungs ache. I appreciate the discussion around Bridgepoint Eduction...anyone want to throw in something about Boston Beer and other companies whose products promote alcoholism? Geez....if in addition you are concerned about global warming in our industrialized society, about 90% of the companies on the stock market should be out of some people's "social concern" portfolios.

  • Report this Comment On April 14, 2012, at 2:43 AM, desertcounselor wrote:

    I appreciate the above comments. There are corporations which we can almost universally say should not be doing what they are doing in poisoning or killing people. Mostly, we can keep our opinions to ourselves, but PM is one which nearly everyone can agree is a villain. As for Bridgepoint Education - I am not familiar with them, but it does seem to me as a former teacher that any corporation which amasses such high profits - derived from students - is not helping the social fabric. But I reserve my scorn for those who support the purposeful causing of addiction around the world.

  • Report this Comment On April 14, 2012, at 7:35 AM, wjcoffman wrote:

    Villian? Really? Don't buy cigarettes! I'm no fan as I've lost at least one family member to the effects of smoking and another is a militant smoker (you're not going to tell me to quit - I'll show you by smoking 3 packs a day!).

    Yeah, I'm going to wage a campaign against YUM because I can't put down the Ruffles. Villlians of my expanding waist line.

    We see plenty of companies cease to exist because people stop buying their products (Polaroid comes to mind). Why not a tobacco company?

  • Report this Comment On April 14, 2012, at 4:35 PM, crca99 wrote:

    About the calculation..."relatively simple to figure"....not for me. I've never understood where to find invested capital on an annual report, and is net operating profit different from net profit?

  • Report this Comment On April 14, 2012, at 4:47 PM, crca99 wrote:

    ROIC = ((1 - t)(EBIT)) / ((A - cash) - (non-interest-bearing current liabilities)).

    It's the non-interest bearing current liabilities that snags me up the most.

  • Report this Comment On April 16, 2012, at 11:30 AM, mpheckel wrote:

    crca99, you've gotten me part way there. Now just two little items: I know the more traditional definition, but in your formula what's t and A? Thanks!

  • Report this Comment On April 16, 2012, at 12:32 PM, mrbillCZ wrote:

    Personally, I choose to invest in companies that will not inflate health care costs, but that is my decision, not that of MF. However, after watching the politico with for-profit schools (and actually teaching for one), I was intrigued with Barron's artcile this week on student debt. Worth a read.

    As for the craft beer....all over that although stock a bit pricey.

  • Report this Comment On April 20, 2012, at 12:07 PM, Gottamouthoff wrote:

    I think even community colleges take as much as they can for the possible oppertunity to learn. You really have to be prepared to work hard to get your money's worth. It;s not high school. The teachers there will not babysit you. The money and effort is up to the student. You have to know up front that money and effort should be spent for filling a need for pay should be your goal. Satisfaction is having a rewarding career.

  • Report this Comment On April 20, 2012, at 4:27 PM, WineHouse wrote:

    In response to bradeoneill : I think you're confused. At the very least, you seem to have "for-profit" confused with "private." Most high-quality private colleges, universities and medical schools are non-profit, even though they're "private."

    If your wife attended "one of the best medical schools in the country," I think it's safe to say that it was definitely NOT a "for-profit" institution. It was likely a private medical school (such as Harvard, Yale, Stanford, Albert Einstein, NYU, University of Chicago, Northwestern, University of Pennsylvania; etc., to name a few) as opposed to a public (state-supported) medical school (examples: the New York State University medical schools at StonyBrook, "Downstate" (Brooklyn), or Buffalo; the University of California medical schools at San Francisco, Los Angeles or San Diego; the Pennsylvania State University School of Medicine at Hershey; or the University of Michigan medical school at Ann Arbor).

    Most "for profit" medical schools are outside the US (e.g., the medical school in Grenada is for-profit).

  • Report this Comment On April 21, 2012, at 12:07 PM, StupidityExpert wrote:

    Stop wasting our time!

    This is not a forum for social commentary. Many of us share your frustrations, but lets not vent them here.

    Let's just talk about good investing.

    Suggestions to the offended: If you are successful, perhaps you can just send your gains to the counter-culture venue of choice?

    SE

  • Report this Comment On April 25, 2012, at 9:28 PM, bradeoneill wrote:

    winehouse- My wife's school was a not for profit, what i was trying to convey was that I have seen some very good schools up close and in my opinion the education at the University of Phoenix was very good. It was targeted and relevant, unlike a lot of the classes your average undergrad stumbles through on their way through the traditional university.

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