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 La-Z-Boy
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 five groups 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 La-Z-Boy, which makes the eponymous chairs and other furnishings, 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. La-Z-Boy's ROIC:
|
2006 |
2007 |
2008 |
2009 |
2010 (through April) |
|---|---|---|---|---|
|
3.9% |
4% |
-0.1% |
-3.6% |
7.4% |
What can we conclude? La-Z-Boy's results aren't great, but they're also not as bad as we might expect for a furniture company battling a horrific housing downturn. In this case, also note that La-Z-Boy's ROE in its fiscal 2009 was minus 33%, according to the computer-driven formula. But the net income it uses incorporates some one-time charges that ROIC avoids. In reality, it's usually best to neither ignore nor fully incorporate one-offs.
Of course, La-Z-Boy isn't the only furniture company in town. Ethan Allen -- a tiny company based in Connecticut -- sported ROICs in the teens until this past year -- and still pays a 1.4% dividend. If you're like me, you sleep on a Tempur-Pedic bed -- a memory foam based on a technology NASA developed in the 1960s and later released to the public. Anyway, Tempur-Pedic, a stronger and more recession-resistant business, boasts ROIC generally above 20% during the trailing five years. Going upstream takes us to Leggett & Platt, a maker of innumerable fixtures and furnishing components. It sports ROICs from 5.4% to 8.6% -- very steady, but nothing to write home about. And on the downstream end, furniture peddler Pier 1 Imports, to its credit, has at last climbed into positive ROIC territory after years of operating losses.
In the end, as I'm sure you know, for La-Z-Boy, much will depend on the future of housing. If you're in the market for an erstwhile dividend stock that may rebound, it could be the ticket, but I'd advise proceeding slowly until its numbers improve.
