Top 10 Posts of 2019 #8 – High ROIC Key To Survival
I know you’re likely busy winding down for the end of the year. Spending time with family and friends. Getting ready for 2020. Wrapping up last minute things before taking a break for the holiday. To celebrate the end of the year, I want to share the top 10 posts of 2019 starting today to end the decade and the year, with some valuable things you can learn from over the holiday season, and begin 2020 with some great knowledge, info, and momentum.
These posts were voted on by you with your views/listens/watches. These top 10 blog posts are the top 10 posts of 2019 that are most viewed/listened to/watched videos/podcasts/blog posts of this year.
A few days ago I showed you post #10 – Analyzing The Louis Vuitton Buyout of Tiffany Part 1
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Then we went to post #9 – ROIC and Why It Matters.
Let’s get to it
In today’s top 10 posts of 2019 #8, we talk about ROIC, again. This time, why a High ROIC is Key To Survival.
I hope you enjoy and learn a ton from these top 10 posts of 2019 over the coming 10 business days.
Thanks so much for being a part of this value investing journey.
Jason Rivera
On this top 10 posts of 2019 #8, we look into the gradual shift in focus to ROIC (Return on Invested Capital) by CEOs and corporations that creates more opportunities for stockholders / investors.
The Hottest Metric in Finance
In 2016, the Wall Street Journal dubbed ROIC as “The Hottest Metric in Finance”.
In his 2018 letter to shareholders, J.P. Morgan Chase (JPM) CEO, Jamie Dimon pointed out ROIC “as a key driver of value.”
Studies on ROIC in 2016 also found that the percentage of companies that tied executive pay to capital allocation measures like ROIC rose from 21% to 30%.
In recent years, ROIC has become a common word in corporate America.
CEOs are beginning to care about ROIC because Institutional Investors care.
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They should, because a higher ROIC means higher value creation within a company.
The higher value creation within a company means higher share prices and bonuses in time.
I am convinced that companies that are ignoring this key driver of long-term value creation, will be punished by shareholders and the market in time.
Why?
Because over time, companies that ignore ROIC – and keeping it high and raising it over time – will continue to destroy the value within the company and shareholder capital.
Companies that focus on ROIC can survive well during any business environment – including a recession – because they’re always focused on creating value within the company.
GE and its capital allocation decisions
Case in point, GE lost over $160 billion – or roughly half its market value – by making poor capital allocation decisions and not focusing on ROIC.
In 2016 alone, then GE CEO Jeffrey Immelt spent $22 billion on stock buybacks while the company was overvalued.
I know these buybacks destroyed value within the company because GEs ROIC dropped from 4% in 2016 to -12.5% in the TTM period.
The reason GE managers approved these measures is because they don’t know anything about proper capital allocation…
And, because the buybacks allowed them to earn their bonuses in 2016…
On the other hand, GM – while facing serious issues in their business – focused on making ROIC a priority over “accounting earnings.”
Accounting earnings are not real-world earnings or returns – they simply show up on the income statement.
Any time you see net income or EBITDA or adjusted EBITDA in a financial report, think accounting – i.e. not real-world capital.
This is why I focus on Operating Income, or EBIT, Free Cash Flow, and Owner’s Earnings.
These are “true”, real-world economics the company produces from its operations and assets.
Not only are these better metrics to value and evaluate a business from but they’re also harder to manipulate than net income as well.
GM and its focus to ROIC
By focusing on ROIC, GM sold off underperforming segments. They used that capital to invest in higher return assets so it could invest in its future.
This decision to focus on the growth of ROIC instead of growth in accounting earnings turned the company around.
Since 2017, GM’s ROIC rose from 3% to 6% now – a full 9 percentage point increase.
GM is now thriving and creating value. Meanwhile, GE recently replaced its CEO and half its board. This happens after GE lost $160 billion in market cap by destroying value.
GM is focused on proper capital allocation, while GE is focused on generating bonuses for executives.
Conclusion: Stockholders Can Profit from ROIC
I HIGHLY RECOMMEND THIS DECISION TO FOCUS ON ROIC
Companies having an ROIC over 10% for a sustained period is one of the main hurdles I look for a potential investment to break.
Why?
I estimate that over the long term – think 5 to 10 years – far fewer than 5% of companies in the world can reach this high threshold.
If they can, this is one sign it may be one of the best run companies in the world, and I may consider investing in them.
If they can do this, they’re focused on the long-term health of the company. Focused on proper capital allocation. Focused on growing the internal value of the company well over time.
Almost all companies say they focus on these things, very few follow through with their actions.
ROIC as a competite advantage
Companies that focus on growing ROIC can be a massive competitive advantage for investors, as well as CEOs.
Companies and CEOs that focus on ROIC and proper capital allocation, are shown in studies to have an output more than 20X returns on investments over time. They, at the same time, execute their strategies well.
Meaning in time, this is a 20X increase in the value of the company. Great for both the CEO and shareholders.
ROIC is one of the main metrics I focus on when evaluating a public or private company investment…
It’s so important that I also recommend and implement focus on this metric to every company we advise on capital allocation.
Your thoughts…
What are your thoughts on capital allocation and ROIC? What do you think about our top 10 posts of 2019 #8? I would love to hear them in the comments below.
For more information on how we can help you and your business with proper capital allocation – including implementing a real-world focus on ROIC, go here.
In tomorrow’s top blog posts of 2019, we get to #7 on our top 10 posts of 2019. We will go behind the scenes of a $6.2 million deal.
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