The Long-Term and Return on Capital Employed [ROCE]

Dear Investor,

The Long-Term and Return on Capital Employed [ROCE]

I have yet to meet a fundamentals-based investor who doesn’t claim to be a “long-term investor”. It reminds me of the famous studies that reported around 80% of US drivers ranked themselves as above average. While not doubting the sincerity of the self-reporters, this fact sheds light on the difficulty of human beings in self-rating their own behaviors.

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After starting Somar Capital, I provided advice to many other investors that were starting new funds. They all reported to be long-term investors, and that their backers were patient long-term financiers. Unfortunately, most of these funds ended up closing, with very few making it past the two-year mark.

Which begs the question: what is the long-term? At Somar we look for the timeline where a business fully replaces its invested capital. It varies by industry but in general it would be around 10 years. That is, after 10 years, close to 100% of the company’s capital employed in productive assets has been fully amortized and re-invested. Why is this important? Because in the period beyond 10 years, the major drivers of investment success are: a) the attractiveness of the business operations; and b) the ability of the management team to efficiently allocate the capital.

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Somar measures the attractiveness of the business operations, through the business Return on Capital Employed [ROCE]. We calculate it as the ratio of operating profits after tax to the equity plus net debt invested in the business. A business is attractive if it can return 30% or more per year on its capital. Think of it as a machine that produces annual net cash flow equal to 30% of the cost of building it. These superior businesses tend to be rare. In addition, entrepreneurs and competitors see the opportunity and try to get a piece of these profits. Therefore, Somar spends a lot of time studying how sustainable these returns will be, and how can the company protect its franchise from existing and would-be competitors. Unique networks, brands, proprietary technology, scale economies, are a few of the ways companies use to protect their superior economics.

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As importantly, Somar tracks the management team’s ability to deftly allocate capital at attractive returns. Our leading indicator here is the Return on Incremental Capital Invested. Somar estimates the returns obtained from the investment of additional capital over the previous 2 to 3 years by current management. There are three possible outcomes from this analysis:

• Returns on incremental capital invested are similar to the average ROCE for the company as a whole. This means that management is keeping the business’ historical attractiveness. Normally a good sign, especially if management is careful to return the excess cash to shareholders through either dividends or stock buybacks (assuming the stock price is trading below inherent value).

• Returns on incremental capital invested are higher than the historical ROCE. A very bullish sign, that management is finding superior ways of deploying capital than they have been historically. This may signal an improvement in the economics of the base business and / or the investment of attractive adjacent businesses.

• Returns on incremental capital invested are below the historical ROCE. This raises alarm bells that either the company’s base business is losing to its competitors, or the management team allocation is careless and not focused on the shareholders’ interests. If sustained, this trend means that the business’ future will be less profitable than its past.

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A quick example shows how useful this process is. While looking at clothing retailing, twenty years ago I found a man’s clothing company that had strong growth, a small footprint, and high (20%+) returns on invested capital. Their offer was branded, differentiated and very popular. The management team embarked on an aggressive expansion plan to open the stores throughout the whole country. However, my analysis showed that the new stores were coming with a lower (10%) return on incremental capital invested. I raised the issue with management who assured me their higher scale would provide procurement savings that would restore the return on capital to the historical 20%+ range.

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However, the following year, the returns of the new stores came even lower at 3% to 5%. This showed that management had lost discipline in their capital allocation plans and were prioritizing empire building. I stepped aside. A few years later, during the Great Recession the company filed for bankruptcy.

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Just like every great champion knows: you are only as good as in your last game. Management teams are only as good as their recent capital allocation decisions. Somar tracks these carefully and uses them to inform our investment, selling and short decisions.

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We hope you are having a good return from Summer. We look forward to continuing to hear from you in the weeks and months ahead.

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Sincerely,

Pedro Ramos