Jon D. Shawn, 9th November 2018
This Magic Stock Ratio Will Find The Next Amazon
Investors don’t have an easy life. And nobody said that investing in stocks and making money is easy.
Good investors have to investigate a lot, look at many different numbers, calculate growth and do a cashflow analysis for every single stock they consider worth buying before making that final purchase decision.
But what if I tell you that there is one single ratio that you have to look up in order to invest on a level with Buffett, Lynch, Dalio & Co.
If there were only one ratio that I can look up for investing in stocks, it would definitely be: ROIC.
ROIC is the abbreviation for Return On Invested Capital.
"In the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return-even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result."
-Charlie Munger, Poor Charlie's Almanack
Only some of the great stocks you could have detected using only the ROIC (by the way: the link to the article containing a list of companies with top ROIC to invest in 2019 is below this article):
Texas Pacific Land Trust, Inc.
So, you certainly want to know how you could use this amazing ratio to beat the market consistently.
For that, we have to know what the ROIC tells us about a company.
“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.”
– Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter
Return On Capital Invested (ROIC) is a ratio of a company's After-tax Operating Income to the Capital Invested in the company.
ROIC basically computes the underlying return that a business earns on its investments in the business. So, a high ROIC (> 10%-20%) is great, because it triggers this chain reaction:
High ROIC > Very efficient management > High cashflows > High growth rates > Healthy Business > Higher Value > Stock soars
Great companies generate high returns on capital and they do so with consistency. Return on capital is so important because it is a key fundamental driver of valuation.
Businesses that can generate higher returns on capital can invest less in capital expenditures and thus generate more free cash. Since a stock’s value is the present value of future cash flows, this makes these businesses more valuable (i.e. the stock price soars).
Let‘s do a quick analysis of Apple, Inc. (AAPL) and Coca-Cola Co. (KO) and compare them. For that I look the ratios up on morningstar.com (or simply type in Google: X morningstar ratios (with X being the stock name)).
Here is the ROIC (7th row) of Apple over the last 10 years:
And here is the ROIC of Coca-Cola over the last 10 years:
So, the first thing I notice is that Apple's ROIC in the last decade was consistently over 20% (with only one year being slightly under that 20%).
This is a trait truly amazing companies have: consistent high ROIC.
And I think we don’t have to debate about whether Apple is a great company or not, being the most valuable company while growing at great rates.
Think about the quote from Charlie Munger at the beginning of this article.
When a company returns 20% every single year on their investments, the stock has to do the same sometimes.
Whether the price is high or low currently, it‘s almost inevitable.
As a simple rule of thumb for investing with the ROIC: The stock is a buy when the company has a consistently high ROIC (over 10%) over 3-10 years (depends on your investment philosophy (long-term, near-term or short-term?)).
Another thing you love to see is that the ROIC has grown over the last couple of years e.g. from -5% in 2010 to 23% in 2015 to 47% in 2018.
That is a great sign, especially useful when evaluating younger companies who didn’t have positive earnings 4 years ago etc.
And now when we look at Coca-Cola‘s ROIC over the past ten years we notice that the ROIC is currently at 4% (as of writing in November, 7th 2018).
Another thing that we notice is that the ROIC was 4 out of 10 years under 10% which doesn’t mean there is a consistency.
Furthermore, the ROIC peak is at around 26% (Apple‘s peak ROIC is 42% !).
At last we look on the growth of the ROIC and there appears to also be a key difference:
While Apple‘s ROIC was pretty solid and constant, the ROIC of Coca-Cola had been constant until 2011 and has been decreasing since then from 26% to 10% in 2014 to 4% in 2018.
So, solely based on the ROIC we would prefer the Apple stock in the last couple of years (I know that it is a bad example to compare a tech stock with Coca-Cola, but I just want you to understand the concept with this simple comparison).
Let‘s look what the Apple stock has been doing in the last 3 years and compare it to what the Coca-Cola stock has been doing in the last 3 years:
Apple stock went from 120$ to 201$ - return: 67.5% Coca-Cola stock went from 42$ to 48$ - return: 14%
So, we see it turns out it was a good idea to follow the ROIC method in this very simple example.
By the way with the ROIC method you could have detected Apple stock more than 8 years ago with much, much larger returns than the 67.5%.
You may are interested how this strategy worked for me in the last couple of years.
I personally invest with this ROIC strategy (+ looking at revenue growth and book value growth and a very short glance on the EPS growth).
So, I invested basically with these rule of thumb criterias:
1. Revenue should be the double of the revenue 3 years ago. (Sometimes I even invested in companies who didn’t fulfill that criteria) 2. Book value should be the double of the book value per share 3 years ago (Sometimes I even invested in companoes who didn’t fulfill that criteria) 3. Consistent (optimal: growing) ROIC over 10%-20% (this criteria is almost always a must) 4. Understand the core business model and how the company earns money (see Warren Buffett’s Circle Of Competence for more informations) (crucial!)
I have been investing with this strategy since 2014 and here are my returns:
|Year||My return||S&P500 index return|
|2018 (so far)||49%||6%|
As you see this strategy turned out to be very lucrative for me over the last couple of years.
Since 2014 I beat the index (sometimes by far).
Stocks (selected by the ROIC strategy) I hold during this time were stocks like
Amazon, Netflix, GoDaddy, Visa, Vertex Pharma, Idexx Laboratories, Apple, Microsoft, Micron Technology, Intel, Disney, Viacom, Softbank, Tencent, Google, Alibaba, Nvidia, Texas Pacific Land Trust, Novo Nordisk, Paycom, Comcast etc.
I hope this simple strategy will help you to invest in stocks with double-digit returns and beat the stock market regularly.
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