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.

Final Thoughts

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.

SEC, Old Dominion Freight Line, page 2.

Nael Fakhry

Co-Chief Investment Officer – Core Equity

Core Equity Composite (as of 12/31/23)

In our Core Equity accounts Osterweis has the discretion to decrease or increase equity exposure in an effort to reduce risk.

  QTD YTD 1 YR 3 YR 5 YR 7 YR 10 YR 15 YR 20 YR INCEP
(1/1/1993)
Core Equity Composite (gross) 13.59% 22.16% 22.16% 5.13% 13.73% 10.93% 8.57% 11.55% 9.33% 11.25%
Core Equity Composite (net) 13.30 20.97 20.97 4.11 12.62 9.84 7.49 10.45 8.22 10.10
S&P 500 Index 11.69 26.29 26.29 10.00 15.69 13.42 12.03 13.97 9.69 10.15
Swipe Table for Full Data

Past performance does not guarantee future results.

Rates of return for periods greater than one year are annualized. The information given for these composites is historic and should not be taken as an indication of future performance. Performance returns are presented both before and after the deduction of advisory fees. Account returns are calculated monthly, using a time weighted return method. Account returns reflect the reinvestment of dividends and other income and the deduction of brokerage fees and other commissions, if any, but do not reflect the deduction of certain other expenses such as custodial fees. Monthly composite returns are calculated by weighting account returns by beginning market value. Net returns reflect the deduction of actual advisory fees, which may vary between accounts due to portfolio size, client type, or other factors. From 1/1/2021 onward, net returns also reflect mutual fund fee waivers in certain periods.

The Standard & Poor’s 500 Index (S&P 500) is an unmanaged index and is widely regarded as the standard for measuring U.S. stock market performance. This index does not incur expenses and is not available for investment. Index returns reflect the reinvestment of dividends. The S&P 500 Index data are provided for comparison of the composite’s performance to the performance of the stock market in general. The S&P 500 Index performance is not, however, directly comparable to the composites’ performance because accounts in the composites generally invest by using a portfolio of 30-40 stocks and the S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring U.S. stock market performance.

The fee schedule is as follows: 1.25% on the first $10 million, 1.00% on the next $15 million up to $25 million, and 0.75% in excess of $25 million. A discounted rate is available for tax-free institutions, eleemosynary accounts and large institutions.

Clients invested in separately managed core equity accounts are subject to various risks including potential loss of principal, general market risk, small and medium-sized company risk, foreign securities and emerging markets risk and default risk. For a complete discussion of the risks involved, please see our Form ADV Brochure and refer to Item 8.

The Core Equity Composite includes all fee-paying separately managed accounts that are predominantly invested in equity securities, and for which OCM has the discretion to increase and decrease equity exposure in an effort to reduce risk. The non-equity portion of the account may be invested in cash equivalents, fixed income securities, or mutual funds. Individual account performance will vary from the composite performance due to differences in individual holdings, cash flows, etc.

References to specific companies, market sectors, or investment themes herein do not constitute recommendations to buy or sell any particular securities.

There can be no assurance that any specific security, strategy, or product referenced directly or indirectly in this commentary will be profitable in the future or suitable for your financial circumstances. Due to various factors, including changes to market conditions and/or applicable laws, this content may no longer reflect our current advice or opinion. You should not assume any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Osterweis Capital Management.

Holdings and sector allocations may change at any time due to ongoing portfolio management. You can view complete holdings for a representative account for the Osterweis Core Equity strategy as of the most recent quarter end here.

As of 3/31/2023, the Osterweis Core Equity strategy did not have an investment in AT&T.

Opinions expressed are those of the author, are subject to change at any time, are not guaranteed and should not be considered investment advice.

Mutual fund investing involves risk. Principal loss is possible.

Diversification does not assure a profit, nor does it protect against a loss in a declining market.

Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.