Doug Goodwille from Kayne Anderson speaks to Drew Meredith from The Inside Network on market thinkers.
While a surging gold price is on hold as the world adjusts to a Trump presidency, all the factors that saw its price rise more than 50 per during his first term in office – trade disputes, fiscal deficits and geopolitical tensions – are almost certainly guaranteed the second time around.
The only ratio you need to know for picking stocks
If it wasn’t clear in 2019, it must be clear now; value investing is dead.
Looking solely at the performance of the growth heavy Nasdaq versus the S&P 500, the difference is stark. Nimble, fast growing, technology-enabled companies with growing addressable markets are the clear leaders and winners post COVID-19. The Nasdaq is up 22% in 2020 and the S&P500 just 2%.
In a world where value is dead and growth stocks have sent market price-earnings multiples to mulit-decade highs, there must be a better way to assess and identify opportunities. Return on invested capital may be the solution.
Return on invested capital is a straightforward ratio commonly used to assess how efficienctly a company is at allocating the capital that you provide as a shareholder into profitable investments.
Put even more simply, how well is the management of say Boral Ltd (ASX:BLD) using its shareholder capital to generate returns (not pay dividends).
In my view, it is one of the most pure and useful financial ratios going around. If you compare the return on invested capital or ROIC of a business, with its weighted average cost of capital or WACC, you can quickly tell whether that company is generating positive returns from your investment, or simply wasting money. We will cover the WACC at a later date, but as a short introduct, it represents the cost of both the debt and equity of a business, the fomer determined by interest rates and the latter by how difficult it is to raise capital.
The ratio for ROIC is simple, but the devil is in the detail:
Net Operating Profit After Tax
Invested Capital
Or going one step further:
Net Operating Profit After Tax
Debt + Equity but excluding non interest bearing liabilities like tax payable
Net operating profit requires you to add back the cost of debt before applying this figure to ensure a comparable result.
Many analysts and managers preferred to use the more readily available EBIT figure, being Earnings Before Interest and Tax. However, as usual it is important to adjust for any ‘one-off’ or ‘extraodinary’ items that management have sought to exclude from the normal operating profit, if they are in fact due to poor decisions in the past.
Interesting, the ROIC is most useful for companies making signficant and regular investments, whether in the form of IT, manufacturing or other capacity. It is less relevant for companies that effectively act as pass through entities for dividends.
In simple terms, investors should seek companies who are generating an ROIC that exceeds their WACC by at least 2%. Anything under this, suggests they are destroying rather than adding value.
ROIC can also be used to identify value traps, particularly pertitent at this point in time. For instance, if a company has a low P/E it may traditionally be considered as a buying opportunity. Yet if that same company has a weak ROIC than the P/E is likely lower for good reason.
