Apple and Nike show that stock performance is linked to how CEOs invest money

Published: Oct 23, 2017 8:40 a.m. ET

A measure called return on corporate capital is revealing — and there’s a free investor tool for research

Ever since stocks were first bought and sold, investors have sought to find company metrics that would separate the winners from the losers.

Sales growth, earnings growth, earnings per share — even CEO pay.

Now it turns out that companies that are good at deploying capital to produce quality goods and services represent lower risk and a higher likelihood of long-term stock gains.

We examined this phenomenon two years ago, tying high returns on invested capital (ROIC) to excellent stock performance over very long periods. The data were provided by FactSet, which defines ROIC as a company’s net income divided by total invested capital (total shareholders’ equity and long-term debt). The idea of ROIC is to measure how efficiently a company’s managers use the money they have raised.

At that time, Gary Lutin, a former investment banker at Lutin & Co. who oversees the Shareholder Forum in New York, said long-term investors who wanted to invest some of their money in individual stocks also needed to think about the products and services being sold by the companies and consider whether they would remain competitive for up to 20 years.

Lutin & Co. invests only in non-publicly-traded companies, so as not to interfere with Lutin’s work at the Shareholder Forum, which works to provide “fair access to information that can be relied upon by both corporate and investor decision-makers,” and receives financial support from professional investors.

Free data

The Shareholder Forum on Oct. 20 rolled out a new calculation called return on corporate capital (ROCC). That can be useful for investors because the data are available for free and are calculated in a uniform manner using GAAP (generally accepted accounting principles) data from SEC (Securities and Exchange Commission) filings.

Definitions of ROIC vary, and some companies even calculate ROIC using adjusted earnings numbers. But ROCC is calculated the same way for every company, using annual data: Net income plus interest expense and income taxes, divided by the ending balance of total assets less total liabilities other than interest-bearing debt.

The idea is that if a company consistently generates high returns on corporate capital, good things will eventually happen. A focus on the company’s main business, rather than financial engineering through share buybacks or on adjusted earnings figures, means real profits are rolling in at high levels relative to investment. That eventually can be expected to support higher share prices, as the profits feed organic expansion, acquisitions or other things that are good for shareholders.

The example of Valeant

Evan Tindell, chief investment officer of hedge fund Bireme Capital, said ROCC enables investors to “look at the absolutely unadjusted figures.”

He cited Valeant Pharmaceuticals International Inc. VRX as a company that “consistently” focuses on adjusted figures in its earnings releases. For example, Valeant reported a GAAP net loss of $38 million for the second quarter, but adjusted earnings of $362 million, after making adjustments for amortization, asset impairments restructuring and other times. Wall Street analysts’ estimates are based on projected adjusted earnings per share.

Valeant’s average ROCC over the past five fiscal years has been 1.8%, compared with 8.7% for its industry group, according the “real” GAAP numbers used by the Shareholder Forum.

In an interview on Oct. 17, Lutin pointed out that ROCC comparisons are a sound foundation for analysis but should be considered only the starting point. Some companies, such as Amazon.com Inc. AMZN will be “spending what could be booked as profits today in their development of goods and services to make bigger profits tomorrow,” he said

Amazon’s average ROCC over the past five years is 4.9%. That looks like a low figure, but for investors, the Amazon story has been about rapid sales growth, dominance in internet retail and expansion into new areas of business. The low ROCC and the stock’s high price-to-earnings ratio — 125.7 times consensus 2018 earnings estimates — may mean this type of valuation will eventually become unsustainable.

You can read more about ROCC and review numbers for companies at the Shareholder Forum’s website.

You can also use the tool here:

All you have to do is enter a company’s ticker and you will see its average ROCC for the past five fiscal years. If you enter the ticker for 3M Inc. MMM for example, you can see the company’s average ROCC is 26.2%.

The ROCC tool uses Standard Industrial Classification (SIC) from companies’ SEC filings to determine industry groups. These company-specified classifications are not always the best reflection of their current business, so you may have to make your own comparisons of companies in similar industries. For example, with 3M, you can see its ROCC greatly exceeds that of its industry group. The problem is that the industry group is “surgical and medical instruments,” when this industry represents only one of 3M’s five industry groups.

If we look at the S&P 500’s industrial sector, there are seven companies that FactSet classifies as industrial conglomerates. Here are the five-year average ROCC figures for the group, along with their five-year total returns:

You can see that for this industry group, the one with the best ROCC over the past five years didn’t have the best total return. But General Electric Co. GE which had the lowest ROCC, had the worst-performing stock by far.

John Maynard Keynes famously described the stock market as a beauty contest in his 1936 book, “The General Theory of Employment, Interest and Money” to explain price fluctuations in equity markets. What he meant was that investors were trying to determine which stocks would be most attractive to other investors.

“Speculating on what other people will find beautiful is a fool’s game,” Lutin said. “It’s a lot easier, and a whole lot safer, to pick a company that generates good returns by producing goods and services. A sound business foundation is also likely to continue its value a lot longer than today’s beauty.

”Here are five-year average returns on corporate capital for the 30 companies that make up the Dow Jones Industrial Average DJIA :

The ROCC number for DowDuPont Inc. DWDP  is actually for the “old” Du Pont, which was merged with Dow Chemical on Sept. 1. Dow’s five-year average ROCC was 11.1%.

From the ROCC figures for J.P. Morgan Chase & Co. JPM  and Goldman Sachs Group Inc. GS you can see that ROCC comparisons should only be made within comparable industry groups.

Philip van Doorn

Philip van Doorn covers various investment and industry topics. He has previously worked as a senior analyst at TheStreet.com. He also has experience in community banking and as a credit analyst at the Federal Home Loan Bank of New York.