Archived article

Please note that tax, investment, pension and ISA rules can change and the information and any views contained in this article may now be inaccurate.

We explain how to filter the market using a well-established formula
Thursday 30 Nov 2017 Author: Tom Sieber

A prospective investor should judge a company and its management on the ability to deliver shareholder value. But what do we mean by this term?

You might be tempted to look at growth in metrics such as pre-tax profit or earnings per share. A more refined measure, often employed by investment analysts and fund managers, is provided by return on capital employed (ROCE).

Investors can use this well-established formula to find the best companies on the stock market.

main1

In this article we look at how to calculate ROCE, why it matters and we explain situations when a high ROCE can be bad. We also highlight four examples of companies which we believe can offer a sustainably high ROCE over the long-term.

The importance of ‘WACC’

To truly generate shareholder value a company needs to be generating a return on capital employed which is consistently ahead of its weighted average cost of capital (WACC).

In a nutshell, it means making a larger return on the money spent to improve the business than the average cost of funding for that investment.

Fund manager Terry Smith is on record as saying he looks for a ROCE of at least 15% when deciding if a company is a suitable investment for his roster of collectives which includes the £10bn Fundsmith Equity (GB00B41YBW71) fund.

How to calculate ROCE

To fully define and outline how to calculate ROCE we should break it down into its two constituent parts: the return and the capital employed.

The return is usually defined as operating profit. The capital employed represents the amount of money required for a business to function. A widely used measure of this is shareholders’ funds plus debt liabilities.

Shareholders’ funds will typically be equivalent to a company’s total assets, which could be everything from factory equipment to a global brand, minus liabilities. Helpfully all these numbers can be found in a company’s accounts.

Let’s use Tesco’s (TSCO) accounts from the February 2017 financial year as an example. Shareholders’ funds could also be described as shareholders’ equity or in Tesco’s case, total equity.

main2

We’ve used the unadjusted operating profit figure for our calculations; other people like to strip out one-off items. Furthermore there are other ways in which to adjust the calculation methodology.

For example, Tesco’s website says its ROCE figure should be much higher at 8.1%. That’s partially because it calculates the figure by dividing return by the average of opening and closing capital employed.

Even if we do take 8.1% as the ‘true’ figure, it is still below the 15% ROCE figure desired by many investors. Tesco’s ROCE has actually been poor for some time. It fell from 14.5% in 2013 to 4% in 2015.

Tesco operates in a mature and highly competitive market with slim profit margins and has plenty of capital tied up in areas like supermarkets, stock and logistic facilities.

Which stock have high ROCE?

Firms with high ROCE will often include those with limited capital requirements to fund their future growth.

Good examples include an internet-based firm like Rightmove (RMV) or businesses like Domino’s Pizza (DOM) which see franchisees bear a significant brunt of the capital burden.

They often trade on high valuations but these are typically justified by the long-term returns enjoyed by shareholders.

When high ROCE is a bad sign

There are times when a high ROCE can be a worry. In a recent conversation with Shares, James Milne at Crux Asset Management said a ROCE out of step with the long-term average for a stock was a potential red flag.

A rising ROCE tells you two things about a company. Either the return is increasing faster than capital employed or the capital employed is being reduced.

The former might be achieved by a successful shift in strategy or entry into a new market. The latter can only really be achieved by cost cutting or, at the very least, scaling back investment in the business.

BlackRock fund manager Stuart Reeve, who helps look after the asset manager’s global income fund, comments: ‘A rising ROCE can be a bad sign if that rising ROCE is unstainable. This occurs when a company is growing returns on capital employed without reinvesting in the business.

‘The rising ROCE will only continue for so long, until heavy reinvestment is required, and the associated high costs consume free cash flow and can overwhelm dividend growth,’ adds Reeve.

‘For example, a company may be reducing costs to boost ROCE, but this cost reduction may be unsustainable, and heavy reinvestment may be required at some point in order to maintain competitive position or keep up with an evolving industry.’

Look for common characteristics

Even if a company is generating strong ROCE thanks to a rising return, this can attract competition as others look to get a piece of the action. It can put pressure on the price a company charges for its products and services as it reacts to the competitive threat.

To deliver sustainably high returns a business needs to operate in a market with strong barriers to entry or enjoy specific advantages like scale, a strong brand or patented technology.

Retailer WH Smith (SMWH) generates a high ROCE. According to financial information provider SharePad the 10-year average is 54.2% and in the latest financial year it posted a ROCE of 59.4%.

Although these numbers are inflated by the fact the company leases a lot of its stores, these are exceptionally high figures for a company operating in a competitive industry like retail.

When you adjust for leases, the average ROCE over the past 10 years for WH Smith is much lower at 11.9%.

The company has recently been slashing costs in its high street operation as management have looked to manage a steady decline in sales.

In the last financial year, £12m worth of costs were taken out of the high street division and a further £18m of savings are targeted over the coming three years.

This reduced investment has had an impact. WH Smith has placed in the bottom five of the annual poll of best and worst shops by consumer champion Which? in each one of the last eight years.

Fans of the company would argue this is mitigated by the success of its travel division which benefits from its position in train stations and airports across the country. The division is also expanding internationally and its sales overtook the high street division for the first time in the year to 31 August 2017.

However, if the underinvested high street offering starts to damage the travel brand or if demand in this side of the business tails off for some over reason, then the company’s returns could come under threat.

main4

main10

InterContinental Hotels Group (IHG)

10-year average lease-adjusted ROCE: 22%

What does the company do?

Operates upwards of 5,200 hotels across the globe under several well-known brands including Holiday Inn and Crowne Plaza.

How does it achieve consistently high returns?

InterContinental only owns a handful of hotels and focuses instead on franchising and managing premises.

As well as generating premium margins, the asset light model also enables it to grow quickly with limited capital investment and to focus on building preferred brands based on guests’ needs, and on strong delivery systems, such as its branded hotel websites and call centres.

The company also has a strategy of developing its pipeline of new hotels from high growth markets.

Why are the high returns sustainable? 

The strength of its brands should help protect its robust returns. Holidaymakers and business travellers will often opt for a brand they know and trust. The diversified nature of its portfolio running from high end resorts to its budget Holiday Inn Express offering should also provide some resilience.

Micro Focus International (MCRO)

10-year average lease-adjusted ROCE: 32.4%

What does the company do?

It helps companies refresh and update their IT systems, often bringing out-of-date infrastructure up to speed to cope with challenges like cloud computing, e-commerce and mobile applications.

How does it achieve consistently high returns?

Micro Focus is very efficient at managing its portfolio of products, bringing in new lines and boosting operating efficiency.

The company has a large installed base of customers whose subscription payments account for more than 40% of revenue, with upwards of 50% coming from subsequent maintenance fees.

Why are the high returns sustainable? 

It has a wealth of experience and expertise in core computing languages like COBOL, Linux and open source SUSE.

Management have taken on a big challenge with the $8.8bn merger of Hewlett Packard Enterprise Services and will be looking to bring margins for this business in the low to mid-20s up to speed with the mid-40s consistently achieved by Micro Focus.

Spirax-Sarco Engineering (SPX)

10-year average lease-adjusted ROCE: 23.4%

What does the company do?

Spirax has two divisions: its steam specialities business (75%) and WatsonMarlow unit (25%). The former manufactures steam control products and serves industries as diverse as food and oil. The latter is a leader in the supply of peristaltic pumps.

How does it achieve consistently high returns?

The company invests heavily in product development and employs more than 1,500 sales and service engineers with strong expertise.

Although it manufactures leading products, steam at high temperatures and high pressure means products often have to be replaced. Spirax sells a significant volume of replacements on its large installed base of equipment. Around 50% of its sales come from this avenue.

Why are the high returns sustainable?

The company has a high-quality earnings profile. No one industry represents more than 20% of its sales and no individual customer accounts for more than 1% of sales.

There is a good balance between higher growth markets and those which are more defensive. The ‘spares and repairs’ element of the business should also help protect its returns going forward.

Victrex (VCT)

10-year average lease-adjusted ROCE: 29.1%

What does the company do?

It is a specialty chemical company with a 70% market share in the supply of polyether ether ketone or PEEK resin.

This super-strong, heat resistant and lightweight plastic is used as an alternative or replacement for metal in areas like transport, the industrial sector, electronics and medical devices.

How does it achieve consistently high returns?

The firm not only makes PEEK resin, it also has the capability of manufacturing finished and semi-finished products for its customers.

This added value allows it to charge a premium price, particularly given its materials and products often deliver higher performance and greater efficiency than the alternatives.

Why are the high returns sustainable? 

Internal estimates suggest if producers of materials running from medical implants to oil equipment substituted its materials with PEEK in their supply chain its market would increase seven-fold.

The company has already invested heavily in extra production capacity and product innovation. It now ‘faces an end-market environment that is near universally positive for volumes’, according to investment bank Berenberg. (TS)

 

‹ Previous2017-11-30Next ›