Published on May 25, 2023
What drives return on invested capital (ROIC), and why should this metric matter to a long-term investor? We believe that understanding a company and its industry structure is imperative to determining the trajectory of ROIC, which dictates whether a company will generate attractive returns over time.
With all the noise we face daily as investors, it is sometimes difficult to focus on what really matters to driving future returns. Turn on a financial news network, and you are likely to hear talking heads obsess about arcane metrics one quarter to the next, recent macroeconomic trends, or even what today’s stock price movements portend for the future. Some investors focus on revenues, profits, free cash flow, and how a company’s competitive positioning will shape these measures over time. But, in our view, even these considerations need more refinement.
We believe that return on invested capital and its trajectory are key to understanding future free cash flow generation and should be a critical concept for every long-term investor. Put simply, return on invested capital, or ROIC, is a measure of the after-tax profits a business generates annually relative to the capital required to run that business.1 Warren Buffett’s legendary partner, Charlie Munger, succinctly described the importance of ROIC at a talk he gave at USC in 1994:
“Over 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 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return — even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive-looking price, you'll end up with one hell of a result."
In other words, over the long term, ROIC drives shareholder returns. Buying a high ROIC business at a low valuation can help boost that return, especially in the near-term.
ROIC Trajectory is Critical
One potential shortcoming of focusing on historical ROIC is that a business generating high returns today may generate incrementally weaker returns in the future. As a result, profits and free cash flow — and ultimately shareholder returns — will suffer. Therefore, it is critical to take a view on future returns on capital (also known as returns on incremental invested capital). A company that is dramatically improving its returns on capital over time can generate improved growth, profitability, and free cash flow, while a business sporting sky-high returns on capital today that are set to decline may well see stagnant or declining revenue, profits, and free cash flow.
A great example of a business that enjoyed solid historical returns on capital that ultimately deteriorated is AT&T Inc. Back in 1998, the company generated a respectable ROIC of 16%, per Bloomberg. Over the three years spanning 2020 to 2022, AT&T’s ROIC collapsed to an average of just 1%, per Bloomberg. The cause of this decline was twofold in our view: systematically poor capital allocation leading to M&A that was often erratic and value destructive, plus a wireless industry that coalesced into a highly competitive national market of price takers always willing to sacrifice price for incremental volume. This unhealthy combination led AT&T to ultimately cut its sacred dividend in 2022, in a remarkable admission that its strategy had been failing. Not surprisingly, shareholder returns from 1998 to 2022 dramatically lagged the broader market.
A counterexample is Old Dominion Freight Line, Inc., a company we hold in client portfolios. Back in 1998, Old Dominion generated an ROIC of just 8%, half of that of AT&T’s ROIC that same year. However, over the subsequent 24 years, Old Dominion’s ROIC steadily improved and clocked in at a very impressive 33% in 2022, per Bloomberg. The company’s returns on capital improved for several reasons. First, management undertook a brilliant change in strategy in the early 2000s, focused on continuously investing in additional capacity to its less-than-truckload network. This allowed them to ensure best-in-class service that would enable higher pricing and profitable growth, which allowed future investment in capacity that further improved service, creating a virtuous cycle of continuous improvement. In addition, the industry had consolidated such that just ten players controlled 82% of the North American less-than-truckload industry as of 2021, creating a more rational marketplace that optimizes price over volume, enabling higher industry profitability.2 As one would expect, shareholder returns at Old Dominion from 1998 to 2022 significantly outperformed the broader market.
Quality Growth Companies
We think of businesses that have high and stable ROIC or materially improving ROIC as Quality Growth companies. As reflected in the Old Dominion example, these businesses can reinvest capital at incrementally attractive rates of return to drive future revenue, profit, and free cash flow growth.
If the future trajectory of ROIC is so important, what steps can we take to identify companies seeing stable or improving ROIC? We think that understanding a company’s competitive advantage and its industry structure are critical to assessing the future path of ROIC. Therefore, we spend the vast majority of our research efforts attempting to understand these issues.
We seek companies that are protected from competition due to any number of factors, from network effects to regulatory barriers to scale advantages to unique brands. Often these companies enjoy significant and/or improving pricing power, see attractive and/or improving gross margins, and can manage capital investment in a highly efficient and/or improving manner. They also tend to operate in consolidated markets with stable and growing demand due to secular tailwinds. Thoughtful capital allocation is also critical, as many of these businesses generate enormous amounts of cash that can be used to further strengthen operations and reward shareholders; conversely, directing significant capital towards poor dealmaking can impair returns. Examining how management has historically allocated resources and researching how management is incentivized going forward can help inform our view on capital allocation in the future.
By building a portfolio of Quality Growth companies purchased at attractive valuations, we seek to capture the magic that Charlie Munger touched on nearly 30 years ago in his talk at USC. We believe a concentrated basket of businesses with solid and/or improving ROIC held for the long term should generate attractive shareholder returns for portfolios and benefit clients for years to come.
1 Note that there are multiple definitions for ROIC. We tend to look at both tangible ROIC, as discussed by Warren Buffett in his 1983 annual letter, and the classic textbook definition of ROIC.
2 SEC, Old Dominion Freight Line, page 2.
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