If you buy Warren Buffett lore that you should only invest in companies that you’re happy to own forever, you want to make sure they’re up to it. One of the key things that Fundsmith Equity (B41YBW7) founder Terry Smith, and many other top investors, use to evaluate companies is a measure called return on capital employed, or ROCE for short. This looks at a company’s profitability compared to how much capital is invested in the business and is measured by profits divided by a company’s net assets, represented as a percentage.

This is one of Smith’s chief investment measurements used to decide if Fundsmith Equity will buy a share or not. The higher the figure, the better – it usually signals that a company has a competitive advantage over its rivals, as it can make more money from putting the same amount of capital to work.

There’s no hard and fast measuring stick but a useful rule of thumb is that mid-teens is decent, 20% is good, higher is exceptional.

Terry Smith’s  top investment measures 

- Gross profit margin

- Operating profit margin

- Return on capital employed

- Cash generation and conversion

- Financial stability

Better than average capital allocation is one of a chief executive’s most important jobs, and some do it well, most do not. Data from Sharepad shows that a little more than 10% of FTSE 350 companies (37 stocks) averaged ROCE of 20% or more over the past five years. The 20% benchmark is bettered by around one-in-five of S&P 500 companies (105), while only five of the Euronext 100 stocks qualify.

That means just over 15% (147 of 955 companies) of leading stocks across the UK, Europe and the US would qualify if investors demanded 20% average return on capital employed to merit further investigation. This should not be so surprising.

NEEDLE IN A HAYSTACK

Finding projects or investments capable of generating standout returns is tough. A CEO might be able to generate a decent profit by building a new factory or opening a new shop, say, but what really matters is how those return compares to the cost of the cash spent. The bigger that gap – or spread between return and cost – the more value has been added, and usually the firm’s stock is rewarded for that.

For example, let’s say that a firm wants a ‘spread – that’s the return minus the cost – of 10%. When interest rates were 1% (that’s the cost part), any spending that earned a return of 11% or more was golden. But with interest rates now north of 5%, projects must return 15% or more to make that 10% spread. And because opportunities like that are few and far between, only the very best CEOs and management teams can consistently invest in a way that delivers attractive spreads or returns.

The digital economy has moved the equation on from just factories and shops, but even investing in intellectual property – software, new customers etc. – the same rules apply.

On the face of it, there should be a correlation between above average ROCE and benchmark-beating share price returns, but does the data demonstrate this? Looking at the FTSE 350, the answer is a resounding... sometimes. Stripping out companies that do not have a five-year share price track record (they have not been listed that long), four of the top 10 ROCE performers have delivered double-digit share price returns, led by Games Workshop’s (GW) 26.5% average annual gain.

Yet Rightmove (RMV) and Plus500 (PLUS), which sit right at the top for ROCE five-year averages, have been barely positive, handing investors just 1.7% and 1.3% share price returns, on average, a year since 2018, albeit during a period when the benchmark FTSE 100 has gone basically sideways (up just 3.6% in five years).

WHAT THE US DATA TELLS US

Looking at US stocks on the S&P 500 index, the data also paints a patchy picture of above average ROCE as an indicator of better share price performance. Over the five years since 2018, the index has increased by just over 50%, from around 2,723 to the current 4,117, implying about 10% a year.

Of the top 50 average ROCE stocks over five years, 32 have returned more than the S&P 500 benchmark on an annualised basis, with 15 putting up impressive 20%-plus annualised share price returns. But that still leaves 18 of 50 top ROCE stocks doing worse than a simple index trackers for investors, with Philip Morris (PM:NYSE), MarketAxess (MKTX:NASDAQ), Best Buy (BBY:NYSE) and CH Robinson Worldwide (CHRW:NASDAQ) failing to average any positive returns at all.

What seems clear from the data is that while ROCE can be a very effective tool for whittling out stock investment options for investors to investigate further, it is an incomplete metric on its own.

DISCLAIMER: The author has a personal investment in Fundsmith Equity.

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