A Look At Incremental ROCE

6th Jun '15 by Mark Carter

4 comments 4992 reads

Many investors focus on increases in earnings. Perhaps “focus” is the wrong word. It is more like “obsession”. There are commentators that point out, though, that it is not growth in earnings that is important, but return on capital. Growth in earnings achieved by investing below the cost of capital is actually value-destructive.

I would take the idea of ROCE (Return on Capital) one step further: it is not return on capital per se that is important, but return on INCREMENTAL capital. Ideally, what investors want, or at least should want, are high returns on incremental capital, the opportunities to deploy capital at those returns, and a reasonable share price in relation to earnings.

I am growing fonder of Stockopedia’s cashflow statements. They give your 6 year’s worth of data, and it really lays out nicely how cash came in, and where it went.

I think you can also use it to see what a company’s incremental returns have been.

Take a look at spreadbetters IGG (IG Group), for example. For 12 m/e 31-May-2009, it generated operating cashflow of 56.8m. For ye/ 31-May-2014, it was 134.4m. That’s an increase of 77.6m.

The cash used for investing activities during that period was 159.5m (58.1+2.48+25.4+7.14+66.4).

So the return on incremental capital has been around 48.7% (77.6/159.5). That is phenomenal. Revenues have compounded at a rate of 8.9%pa. It pays a generous 4.1% dividend yield. Admittedly, there may be unusual distortions in cashflow there; but still, the company seems to be doing all the right things.

Two other companies that I had thought of as being good-quality companies: DPLM (Diploma) and HLMA (Halma) also, as it turns out, have good incremental returns on capital. DPLM is 22.4%, and HLMA is 16.8%. I think these companies will surprise us positively by the length of their growth. Unfortunately, their valuations are fairly high.

On the other side of the coin, companies that have a high ROCE, but lagging operating cashflows, are AZN (AstraZeneca) and IMT (Imperial Tobacco).

AZN reports that its average ROCE is 21.6%. However, its ROCE starts at 31.0% and ends at 5.9%. Looking at the cashflow statement, I see that it had operating cashflows of $11739m for y/e 31-Dec-2009, decreasing to $7058m for y/e 31-Dec-2014. Cash invested during that period amounted to $11440m. At least so far, AZN has invested a lot of money with little to show for it. The company’s “patent cliff” is well-publicised, and the company seems to…

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iwright7

8th Jun '15

Mark,

It would be interesting to screen for incremental ROCE, but the Stocko selection criteria don't lend themselves to this. Perhaps ave 5Y ROCE of >40% (and 5Y ROE >20% to select additional historical quality) and then study the historical cashflow statements for those companies passing the screen.

Anyone any further screen selection ideas?

Mark Carter

5Y ROCE >40% seems too high to me. Maybe something like 15% or 20%.

Cashflows can be lumpy, so some judgement is required.

Some companies like Games Workshop (LON:GAW) have very high ROCE (29.4%); presumably due to little capital requirements and niche. Their operating cashflow is fairly stable, though. I think with companies like that all you can really expect to do is collect your dividend. What I really want is for a company to be able to increase its cashflows through investing, and I want it to be able to achieve high returns on that investment.

In addition to specifying ROCE, you might like to specify debt levels. Maybe you can restrict your selections to having Net Debt < 0; although that's likely to be somewhat over-restrictive. I'd be suspicious of companies that ostensibly have high ROCE, but employ mountains of debt. Companies with good returns on capital should disgorge cash, not groan under debt piles.

Charlie Munger has said that if you invest in a company with a ROE of 15%, and wait, you will grow rich. Implicit in that statement is that the company has low debt. I also think it is also beneficial that you see some growth potential in there, as evidenced by the cashflow statement.

Mark - Take you point about debt so have included it and dropped 5Y ROCE to >25% and 5Y ROE to >20% to allow for annual variance and it brings up some high class companies - 87 companies listed (including IGG) Buffet once commented that to achieve the best returns its worth investing in companies doing more or less the same thing 5+ years earlier, because they can build a fortress like franchise. Mungar and Buffet talk a lot of sense.

UK Value Investor

9th Jun '15

Excellent article Mark.

I think you're much less likely to go wrong looking at ROCE and cashflows than you are with EPS growth. I learned that lesson myself in 2014 and added ROCE into my valuation blender. I'm happy with the results so far, but even ROCE on its own can be misleading, and there is a place for sensible EPS analysis as well.

John

A look at incremental ROCE

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Mark Carter

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