Two Types of Investments and Thoughts on ROC

Posted on Posted in Investment Philosophy, Portfolio Management

I wanted to post a follow up to my Friday post on my investment checklist. I got a lot of feedback and had a few follow up email conversations with readers who had questions and comments. Some wondered about the metrics used to check asset investments or financials (obviously EV/EBIT is not important there). I also had a question about ROC and why such an importance on it. There were some good questions and also some good advice/feedback. Thanks for that.

First off, the checklist is just a simple tool I use that provides me with, well… a checklist… of the things that are usually important to me when looking at an investment. It’s not an all-encompassing “green light or red light” tool that just spits out a simple yes or no answer. It’s just a tool to help me organize my thoughts. I am not a systematic investor, so I don’t have simple yes or no answers. I do love simplicity though, and the checklist simplifies my thought process.

But I thought it would be helpful to comment on the fact that I break down my general investments into two main groups:

  • Earnings Based Investments
  • Asset Based Investments

From these main groups, there are also four subcategories of investments that I use to categorize the stocks I own:

  • Compounders (Earnings Based)
  • Cheap and Good (Earnings Based)
  • Cheap (Asset Based)
  • Special Situations (Depends-could be either or a combination of both)

The checklist has some items that are applicable to earnings based investments, and others that might be more relevant to asset based investments. I first talk about the three risk factors being Valuation risk, Leverage risk, and Business risk. These are important when considering both categories (earnings and assets). But then I mention EV/EBIT and ROC being two most important things to consider. Let me make some brief comments on these.

The thing to remember here is the big picture. When you make an investment, you’re buying a piece of a business. You want to buy the business cheap relative to assets or earnings. But you would also prefer that the business is also a good business. Some value investors are asset based investors exclusively (Walter Schloss was a great example). These investors sometimes say they don’t care about earnings, but I think this is an exaggeration. In an ideal world, every rational investor (asset or earnings based) would prefer to buy a great business at an extremely low price. The reason asset based investors buy mediocre (or sometimes even poor) businesses is not because they have a penchant for bad businesses, it’s because those are the businesses that are cheapest, and despite their mediocre quality, offer very attractive potential returns.

Thoughts on ROC: Why is it Important?

So if we all would prefer good businesses, it makes sense to come up with a quick way to evaluate the quality of the business. The easiest thing for me to do is check return on capital. Here is where the confusion understandably sets in. Just because I said it was one of the most important things doesn’t mean I need high ROC in order to buy the stock. I just said I want to look at it first. If it’s low, or non-existent, as is the case with many asset investments, at least I know what type of business I’m dealing with.

A great piece I recently read that also discusses ROC and why it might be an overrated metric is: The Perils of ROC Investing. Also, you can check out Dr. Wes Gray’s and Toby Carlisle’s research on ROC and why simple valuation metrics (even absent of good ROC) still produces attractive results: This is a great writeup by Carlisle on his excellent Greenbackd blog.

So valuation is most important. But don’t neglect quality just because the ROC metric doesn’t test well in backtest. In real life, a company is in business to produce real cash returns on the assets it has. It’s not in business to get sold to another buyer. It might do that, but that isn’t (in most cases) the reason its in business. So if it’s in business to make a return on the assets it has, we should consider and evaluate the ability of the company to do just that: and the quick and dirty way to do that is measure ROA or ROC.

I think investors that caution against using ROC are simply trying to say that it’s easy like a great business that produces high returns. And because it’s easy to like that business, it’s easy to overpay for that business. The point is don’t overpay for high ROC. (This is much different than not caring about ROC altogether).

This post got really long so I decided to break it into two parts. I’ll post the second part tomorrow which will briefly summarize what we discussed regarding the checklist, and how I run through it quickly when evaluating investment opportunities. 

2 thoughts on “Two Types of Investments and Thoughts on ROC

  1. Nifty little checklist John. A general question for you:

    As most great investors often say “you should be adequately rewarded for taking the risk”, so would it not make sense to measure Return on Risk, rather than Return on Capital (because risk can often exceed maximum capital outlay).
    To counter that, Nassim Taleb says “risk is in the future, not in the past”, so how does one measure return on risk then?

    1. Hi Switesh. You may already understand this, but just to make sure we are on the same page: Return on capital is a fundamental metric that I use to evaluate the quality of the business. When I say return on capital, I’m not referring to my investment capital, I’m referring to the returns that the business generates on its own invested capital. ROC can be measured in a variety of ways, but it’s very basically the amount of money a company makes in profit divided by the amount of equity and debt the company uses to achieve those profits. For example, let’s say a company has $1 million of net fixed assets (buildings, real estate, equipment, etc… or PPE in GAAP accounting language) and $200,000 in net working capital (current assets less current liabilities)… in this example, the business has $1.2 million of capital invested. Let’s say the company has no debt and made $120,000 last year. In this example, it acheived a return on capital of 10% ($120,000 divided by $1.2 million). I’m oversimplifying to make sure the concept is understood for you or any other readers who aren’t familiar with ROC.

      In this example, ROC and ROE are equal, because there is no debt. If this company took out a mortgage of $800,000 on their $1 million of fixed assets, their equity would go down to $400,000, but their capital would remain the same ($400K equity plus $800K debt). So their return on capital is the same at 12%, but their return on equity is now 30% ($120,000 divided by $400,000). So I like to use ROC rather than ROE because ROC generally factors in debt, and levels the playing field between leveraged and unleveraged companies to determine how efficient they are.

      Anyhow, read The Little Book that beats the Market or Buffett’s letters for more on ROC.

      Risk is a completely different animal and is more subjective. I’m guessing when you say return on risk, you’re asking about my estimate of the risk involved in each investment I make. Risk is obviously a key thing to consider, and I think about it first and foremost. But one way to consider risk is to evaluate the quality and valuation of the business you’re looking at.

      In the example above, if you were going to buy that pizza restaurant, you’d want to know how much you would have to pay (valuation), and you’d also want to know things like how stable the business is, what is the history of sales and profits, what is the surrounding area look like, what is the condition and age of the equipment, etc… You’d want to evaluate the business risk, you’d want to know the valuation (how much do I have to pay to get the $120,000 in earnings), and you’d want to know how much debt the business has (leverage risk).

      So those are the three areas I focus on when looking at risk (business, valuation, leverage).

      Hope this helps… and thanks for reading. If I totally misinterpreted your question/comment, let me know. Thanks!

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