Seeking the Best Returns on Capital

For the investor with limited resources, success not only depends on how many rocks she turns over, but also the probability that those rocks reveal treasures.  Better to flip a hundred rocks at Sutter’s Mill than a million at the Hudson River.

Of course, one must mine the terrain that she commands.  Following Buffett’s advice, one should always begin within her circle of competence.  But when opportunity arises, how and where should the circle expand?

One useful place to begin are those industries with high returns on capital.*  Over at Prof. Damodaran’s homepage, his data shows that a handful of industries show consistent and significant advantages for invested dollars.  As of January 2009, the 34 publicly-traded businesses that provide educational services offered an average 47% return on capital.  More dismally, the 144 REITs returned an average of 8.5%.

Of course, broad macro considerations likely skew some of these data.  2008 was a year with an excess of housing supply–hence homebuilders and manufactured housing had fewer profitable avenues to deploy cash.  2008 also saw record prices for oil, and oil service companies received more and better bids for work than in past years.   Perhaps then their 20.5% ROC represents an interim high mark.

Unfortunately, going through these data ultimately reveals that my current competencies do not lie in today’s most profitable industries–educational services, computer peripherals (33% ROC), and tobacco (32.6%).  Looks like I need to enroll at Strayer, take up smoking, and study the engineering of peripherals.

* For Damodaran, return on capital is “estimated by dividing the after-tax operating income by the book value of invested capital. We use the cumulated values for both variables, for the sector, to estimate the sector ROC.”  Or, ROC = EBIT (1-tax rate) / (BV of Debt + BV of Equity-Cash).

Disclosure: None

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4 responses to “Seeking the Best Returns on Capital

  1. ROC is meaningless if price paid is not taken into consideration… A point I am sure that you are aware of, but I still feel like I need to bring up.

  2. I agree–for an investment, price paid is key.

    As a tool for assessing businesses, I like ROC as a signal of a business’ moat. If you’re spending a lot of capital every year, there is an increased risk for allocation mistakes. As Buffett mused in 1987, “the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.”

  3. Pingback: Weekly Dividend Investing Roundup - May 23, 2009 | The Dividend Guy Blog

  4. Good idea but, as you suggested, one needs to look at multi-year numbers or take an average of the last 10 years or something. As Jeff pointed out, price is also very important.

    I generally look at ROE, which doesn’t discount debt like ROC, and it’s really important to understand that high ROE (or ROC) is often due to macro issues. For instance, many cyclicals, such as oil&gas, coal mining, railroads, homebuilders, and so on, would have shown high numbers a few years ago, whereas they are lower now. Macro investors bet on these numbers if they have an underlying thesis for believing the numbers will remain high; but value investors need to be careful.

    However, if high ROE (or ROC) is retained for a long period of time, it likely, as you suggest, implies a moat.

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