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.
