Going back to my discussion on CROIC, the best way to find a good investment is to find a company that puts up high cash returns on invested capital for a very long period of time.
In competitive industries, the long-run return on capital should be really close to zero. If you’re in a very competitive market like…say, lawn mowing, you’re not going to earn very impressive returns on capital. You’ll earn impressive returns on time, but that’s not a business, that’s a job. I don’t want to invest in a job. You and I likely have enough to do already. We need returns from capital, not returns from labor.
Here’s a graphic I stole from one of the best finance books of all time, the McKinsey & Company’s Valuation: Measuring and Managing the Value of Companies, 5th Edition. (I really hope this is a textbook for a future finance class, partially because I already own it, and also because it’s awesome.)
The chart shows the return on invested capital for various industries. The points on each line are the bottom quartile, median, and top quartile return on invested capital.
If you’ve read this blog for some time, you know that airlines are crappy businesses. No surprise, they lag in ROIC returns. They have the lowest returns on invested capital. That won’t stop efficient market hypothesizers from calling them good investments at any price, however, mostly because EMHers lack in a fundamental understanding of where investment returns come from. But I digress…
ROIC vs. CROIC
First things first, notice that the chart shows the earnings return on invested capital, or how much in earnings various sectors report relative to how much invested capital they have in the business. Earnings return on invested capital is vastly different from cash return on invested capital.
It’s important to understand that earnings return on invested capital is not cash return on invested capital.
Think about it like this: you buy an airplane for $50 million. Over the next 20 years, you make $2.5 million in earnings per year from the airplane. You have a ROIC consistent with airlines as a whole of 5%.
Did you really make a 5% return? NO! Here’s why: to replace that airplane purchased 20 years ago at $50 million, you’ll likely have to pay $75 million or more for a new one. Inflation sucks!
So while your reported earnings are impressive, your reported earnings account for depreciation on a $50 million airplane. However, when that airplane is fully depreciated and you have to replace it, you’re going to have to replace it at a price of way more than $50 million – say, $75 million. So the actual cash earnings are much lower than $2.5 million each year. In fact, if you had to replace the airplane for $75 million, CROIC would be half the 5% ROIC, so 2.5% per year.
This effect also exists in railroads. Railroads generate a decent ROIC, but their real earnings (cash) is usually half that of reported earnings because installing new rails in 2012 costs more than rails installed in 1980, for example.
Use this Chart as a Guide
The chart above makes for a great guide in finding businesses that can provide for a long-run return on capital in excess of the stock market as a whole. Software is a fantastic business, for example, because it requires no real capital investment. It’s difficult to predict, so I avoid it. Utilities make for a very low return business because they require huge amounts of capital. They’re generally good predictable investments, though, because regulation keeps away competitors. Without regulation, they’d be just as poor investments as airlines.
I like restaurants, because they provide for excellent ROIC which often corresponds to great CROIC, because there isn’t much capex necessary with a restaurant that franchises its model (McDonald’s) or a company that leases its stores rather than buying them (Chipotle.)
In the long-run, companies that can generate the highest CROIC and trade at the lowest multiples of book value will provide the best performance relative to other investments. Think about it like you own the whole business. You’d much prefer to invest in a company that can turn $1 into $20 in earnings over the next 30 years than a company that turns $1 into $2 of earnings in the next 30 years. You’ll compound your money with the former far faster than the latter.
ROIC is a good guideline. Those with the highest ROIC are more likely to have high CROIC, and thus more likely to make you wealthy.