ROCE: The Most Critical Indicator
Pulak Prasad of Nalanda Capital in his celebrated book - "What I learnt about investing from Darwin", explains through the work of Russian geneticists Dmitri Belyaev and Lyudmila Trut how investors can identify strong businesses with multiple good traits through homing one key trait which when selected brings other favorable qualities along with it.
The Russian scientists spent almost 60 years studying the behavior of wild silver foxes and how the cultivation of tameness as a behaviorial trait through generations of foxes created domesticated pet dog like characteristics in them. This one trait of tameness when cultivated led to other positive traits of domesticated animals in wild silver foxes like tail wagging, sloppy ears, light colored hair. The writer draws comparison in the investing world to the metric of historical ROCE which is the single most critical metric to identify high quality businesses which have good cashflows and top management quality.
WHAT IS ROCE ?
Return on Capital Employed = Operating Profits/ Total Capital Employed
Operating Profits or EBIT is used to ensure that the metric does not get convoluted by taxes and only profit from operations are considered to zero in on the company's efficiency
Total Capital Employed = Net Working Capital (excluding excess cash) + Fixed Assets
This metric ensures that even companies with lower margins but higher ROCE can sustain itself and maintain a good growth on topline while accumulating FCFs.
An important concept to consider here is the reinvestment rate that is required to ensure that the revenue growth is met. This reinvestment is the NOPAT that is put back into the business to ensure the requisite growth continues.
Reinvestment Rate = Growth/ROCE
For a company growing at 10% annual sales growth, 15% margin and 25% ROCE with 30% taxes- it will still end up accumulating cash reserves of ~20% of overall sales in 5 years due to high FCFs post. In similar vein, a company with a similar growth rate and margin structire but with a ROCE of 12% will have negative cash reserves in 5 years
Examples of companies like CostCo , Havells justify this theory.
The challenges of this approach are missing out on future strong performers that would have been excluded in the list due to historical values. Howver, the metric does tend to help us shortlist companies versus trying to analyse a managment quality through very subjectve means. This aporoach also does not guarantee future performances ut it does serve as a good starting point.
