- Charles Munger
“A company must necessarily achieve investment returns (note I say “investment,” not “investor”) that track similarly to its return on capital. No business scheme can achieve great investment returns if it cannot achieve great returns on capital.”
- Nintai Partners Annual Report 2007
Over the past decade, I have written extensively on our core strategies at Nintai Investments when looking for - and investing in - companies to add to our portfolios. Most of the qualifications we look for, such as no short or long-term debt, pale in their long-term impact compared to a company’s return on invested capital (ROIC). Distilled to its essence, ROIC is simply a measurement of how well a company uses its capital to generate profit. Comparing ROIC to a company’s weighted average cost of capital (WACC) can give an investor a quick and powerful tool for understanding whether the company can generate value for shareholders over the long term. It stands to reason that a company whose cost of capital is greater than its return on capital will not generate adequate returns (if any) to its investors. Conversely, as Charlie Munger states in the quote above, companies that can generate high ROIC over extended periods will likely (all other things being equal) help an investor outperform the general markets. The key attributes here are two-fold. First, the company must maintain a high ROIC over the same extended period as the investor holds it. High ROIC doesn’t help an investor in the short term. As we say (all too often) to our investors, we prefer portfolio-holding management to do the heavy lifting.
To simplify the impact of ROIC versus WACC, let’s use our standby business - Sally’s Lemonade Stand - to put this statement to the test.
ROIC versus WACC: A Working Example
Imagine Sally has decided to expand her lemonade stand with the onset of the summer season. She has decided to invest in her business to allow for sales (and therefore production) to double. To do this, she will borrow from the venerated Bank of Dad $25 to buy additional raw materials and supplies. Taking on this debt will allow us to calculate her weighted average cost of capital. At the end of the year, we can calculate her return on this invested capital. The question we will look to answer is whether Sally was able to generate a higher return on invested capital versus her average cost of
capital. More simply, was borrowing the money a wise business decision that added to the value of her business?
To calculate the return on invested capital, we divide net operating profit after tax (NOPAT) by invested capital. To make this case as easy as possible, let’s assume Sally’s stand pays no taxes, and her NOPAT was $1.65 for the period in question (let’s face it, there isn’t much money in lemonade stands!). The invested capital was the $25.00 in debt from the Bank of Dad at an interest rate of 10%.
The first thing that stands out is that Sally generated a lower return on invested capital in 2022. Even borrowing the $25.00 to boost her production ability and sales (and driving up total invested, her operating income dropped significantly. Second, with the assumption of the new loan from the Bank of Dad, she carries considerably more debt on her balance sheet.
Calculating the weighted average cost of capital is achieved through the following formula.
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Here’s a breakdown of this formula’s components: E: Market value of firm’s equity, D: Market value of firm’s debt, V: Total value of capital (equity + debt), E/V: Percentage of capital that’s equity, D/V: Percentage of capital that’s debt, Re: Required rate of return, Rd: Cost of debt, T: Tax rate.
I should point out that this formula is not required for a small, privately held 8-year-old’s lemonade stand. Instead, it’s safe to say we can use the interest rate on the debt (there is no equity) as the cost of capital. So, let’s say the WACC of Sally’s lemonade stand is 10% (the rate charged by the Bank of Dad).
If we look at Sally’s return on invested capital of 8.37% in 2022 versus the WACC of 10%, we can estimate that the future returns of the stand are muted as they exist today. Over the long term, we can’t say we’d be excited about investing in Sally’s lemonade stand!
Why Return on Invested Capital Matters
I’ve written many times that a company that achieves high returns on invested capital over a decade or two is of immediate interest to Nintai Investments. A company that can achieve such results along with a significantly lower weighted average cost of capital is of even greater interest. So, why is that? A company that achieves higher ROIC than WACC over the long term is far more likely to generate greater returns than a company that does not. This is for several reasons. First, the company likely has a wide and deep competitive moat. Second, the company consistently finds opportunities to allocate capital that generates outstanding returns on that capital. Third, management has shown a propensity to focus on lines of business, business operations, and business strategies that generate exceptional returns over the long term. All three of these suggest an investment opportunity that an investor could hold for a decade or two, allowing management and the business to outperform the general markets. Let’s break down each of these three reasons in more detail.
High ROIC Suggests a Deep Moat
As with nearly anything in life, success breeds imitators and competitors. If there is one salient fact in a capitalistic system, something that makes money will always find someone who wants to copy that success. A company that generates high returns on invested capital demonstrates the ability to hold such competition at bay. The longer it can do this, the greater the return to its shareholders. At Nintai, we look for companies with at least a decade of high ROIC and the ability to continue generating such returns for at least a few decades. This can be achieved in many ways – patents protecting intellectual property, difficulty in replacement, or pricing advantages. The list goes on.
However it is achieved, investors must deeply understand the investment’s ecosystem, including industry trends, competition, technology development, customer demands, etc.
High ROIC Suggests Profitable Investment Opportunities
To generate a high return on its capital, a company doesn’t need to have just a profitable business model. To maintain high ROIC, the company must have opportunities to invest its capital in perpetuating equally high returns. This type of “virtuous cycle” signifies a business operating an outstanding model and one that provides an excellent future of profitable growth. The ability to avoid value-destroying acquisitions, paying considerable fees to investment bankers, and the agony of integrating new businesses greatly reduce risks for any management team and its shareholders. At Nintai, we love companies that can quietly grow their business by seeding growth with free cash flow. It's even better when that capital can provide outstanding returns on that capital. Such investments rarely come along, but when they are found, we will wait a decade, if necessary, to purchase them at the right price.
High ROIC Suggests an Outstanding Management Team
Anyone who has run a business with a shrewd set of investors will know that the most important thing an executive can do (besides being ethical and honest) is to be a wise steward of the company’s capital. Part of that is focusing on generating high returns on invested capital. The ability to achieve high returns on invested capital over the long term (here we mean a decade or longer) helps identify a management team that understands their business model, the, their markets and competition, and critical drivers of their business operations. Finding individuals who can achieve this isn't easy. At Nintai, we look to partner with such management and, as we say all too often, allow them to do the heavy lifting.
I became a senior executive when my partners and I created our first business in 1996. New to the business world, I must confess, I knew nearly nothing about running a business or my fiduciary responsibilities to our shareholders. Fortunately, we had an outstanding Board of veteran business executives who patiently guided us through starting up, growing, and eventually selling our company. In my first meeting with our Board chairman, he told me the most important thing I would ever do would be to allocate capital. His lessons about business decisions, key measures, and outcomes of capital allocation made me a far better business owner and, eventually, an asset manager. When investigating a potential investment, always look for managers who understand that capital allocation will be the hardest (and most vital) aspect of their role as CEO. Companies led by individuals with this skill will significantly increase your chances of outperforming the broader markets.
We hope everyone is having a wonderful holiday season and look forward to your thoughts and comments.