Stocks Living La Vida Loca

Big returns. That's what we want from our portfolios, right? So we should invest in companies that generate big returns and avoid ones that don't.

This is why return on invested capital (ROIC) is a crucial metric by which to measure any potential investment. After all, as shareholders, we supply the capital and demand the returns.

But don't take my word for it. Joel Greenblatt, a master investor at Gotham Capital, developed an entire strategy around companies that generate high ROIC, and he spelled out the strategy in his tome called The Little Book That Beats the Market. Given Joel's past performance generating mind-numbing returns -- 50% per year at Gotham Capital after expenses and before incentive fees -- if he says ROIC is important, ROIC must be important.

A definition
To make sure we're on the same page, here is how we'll define ROIC:

ROIC = net operating profits after taxes (NOPAT) / invested capital

To make the metric more useful in our quest for big returns, we break it down further.

ROIC = (NOPAT / sales) * (sales / capital)

NOPAT/sales measures how well sales turn into returns. Let's call this metric "margins."

Sales/capital measures how efficiently capital is turned into sales and is known as the asset turnover ratio or "capital velocity."

The players
Using the information above, we see there are four types of companies as listed in the matrix below.

We'll examine each of the four quadrants separately in this series to understand the characteristics that help them create or destroy value. Let's start with La Vida Loca.

The good life
Life is good for companies that generate big margins with high capital velocity. Typically, they are positioned well, have a competitive advantage, and generate huge returns.

Here are some examples from my La Vida Loca stock screen.

Data provided by Capital IQ, a division of Standard & Poor's.
*Coach first traded publicly on Oct. 5, 2000.

Clearly, these companies know how to generate great returns from the capital that shareholders provide. As such, long-term stock owners have reaped the rewards.

Price still matters
So we should just buy the companies with the highest returns on invested capital, right? I wish it were that easy.

There's a problem trying to live the good life: Everyone else wants to live it, too. So finding great companies like these when they are cheap is tough to do. The reason it's tough is that they are rarely cheap.

Warren Buffett continually cites Wrigley (NYSE:WWY) as a great company that he understands. Yet he has never found it cheap enough to warrant a substantial investment. Everyone recognizes that Wrigley is a great business generating great returns. So the stock price stays high.

Last year, Motley Fool Inside Value advisor/analyst Philip Durell recommended Intuit (NASDAQ:INTU), a company that came up in my La Vida Loca screen, at a very reasonable price. The maker of tax-preparation and other financial software generates a 17% margin with a capital velocity of 1.25 for an ROIC of almost 22% in 2005. No wonder that recommendation has outpaced the market, beating the market by 31%. And with its recent price decline following an earnings release, it may be an even better bargain today.

The Foolish bottom line
Companies that live La Vida Loca work hard to create wealth for shareholders. That's why Philip and the Inside Value team continuously search them out. And fortunately for Inside Value subscribers, he pounces on them only when the price is right. We'd love to show you the ones Philip has recommended so far. So come live la vida loca for 30 days with a free guest pass to Inside Value.

Up next: Speed Demons
Some companies create value by cranking out the sales.

Electronic Arts is a Motley Fool Stock Advisor recommendation.

David Meier does not own shares in any of the companies mentioned. Electronic. The Motley Fool has a disclosure policy.