Importance of return on capital

When it comes to active stock picking, the most enduring trigger is return on capital; when it comes to active stock picking, the most disregarded trigger is return on capital.

This is because an earning per share (EPS)-driven world would rather look at directly reported numbers in the quarterly performance, as the return on capital employed (ROCE) number needs to be calculated (what a pain). The latter becomes possible when the annual report comes in, by which time the stock would already have appreciated.

The result is when analysts cross-check earnings estimations with managements, they refer to basis-point differences in margins but never see a company through the ROCE prism.

The big question: What influences a high ROCE?

One, a comprehensive ROCE culture, which influences whether a company will acquire or prefer to build, whether a company will expand or buy back its shares. What sets ROCE-driven companies apart is not that they actually engage in this appraisal (this can be taught to class six students) but that they apply this principle, simplify the mechanics and trust it consistently across the organisation.

Two, when a company talks in terms of enhancing per-share value over grandiose pursuits of like 'we expect to be a $2-billion company by 2020'. The latter appears the usual thing to do but on that rare occasion when a chief executive officer says 'We seek to increase fivefold our per share value every five years', they would have me sit up and take shorthand.

Three, when companies delegate just about everything across their ranks except that one function that is sacred to their existence - returns, returns, returns - that continues to be controlled singularly by the management apex, in addition to the minimum acceptable post-tax return.

Four, a high capital return is also often considered the result of not being seduced into capital spending or acquisitions and only occasionally making that big move (when most observers are advising caution). Warren Buffett invested more than $15 billion within the first 25 days of the Lehman crisis unfolding, when everyone, including my mom-in-law, pronounced 'Careful!'

Five, when companies direct capital towards the best-return projects, strengthening their competitiveness. There will be more occasions of the company walking away from deals than engaging in these, drawing criticism from quarter-watchers.

Six, by staying flexible. When stock prices are high, the high-return companies either sell more stock or sell the business (most Indian managements nonchalantly say 'We don't look at our stock', forgetting the very reason they are in business); when stock prices are low, companies could buy their stock back, especially if this corporate action generates a return higher than what the business operations can generate. Alternatively, value-focused companies skip dividends completely if they feel their businesses generate higher returns (in India, the very announcement would trigger stock hammering on the grounds that the company would be suffering liquidity issues).

Sadly, this column is nearing its end but if you need to stretch your bandwidth on the subject, take The Outsiders by William Thorndike jr to bed - and enjoy the difference.

The author is a stock market writer, tracking corporate earnings and investor psychology to gauge where markets are not headed