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).