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How I pick shares- Part 4 (Return on Capital)

The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.
- Warren Buffett

Apologies first to regular readers* for the delay between publishing part 3 and this part 4 of How I pick Shares- I'm not entirely sure where the last month has gone? Perhaps the sheer novelty of being able to escape the house finally has started to eat up time that I previously had? I even went to Wales to see family last weekend! Anyway I'm sorry- normal posting every other week is being resumed.

Many years ago, I remember my father teaching me a valuable lesson about buying things for the house. He recalled that when he and my mother were first married that they had very little money indeed. My mother had won a Bride of the Year competition (!) and part of the winnings was a deposit on a new home. So beyond their wildest dreams, they shared a lovely new home, but hardly had a stick of furniture to put into it. 

My father adopted a policy of buying either very cheap items on the basis that if they broke or failed, the cost would not be significant or quality that would last them many many years. His advice to me was to avoid the mistake that many consumers make and buy the middle brand, that turns out to be not especially great and more costly in the long run than quality.

I have found this approach to be relatively true. For example, I have found that it pays to buy quality in relation to white goods and computers. On the white goods front all my appliances are from a certain German company (and they almost never fail or are repairable) and on the computer front I am writing this on my iMac which is in its tenth year. Although it cost me £900 at the outset, I found with a £50 memory upgrade at year 5, that the machine still continues to run as fast and reliably as it did in 2011. On the other hand, I do love Chrome Books which don't tend to last more than 5 years but are usually not more than £250. A marriage of "quality" and "value".

I do find that this approach translates well to shares. I think the natural instinct of most who are new to the game is to either jump on eye-wateringly expensive shares and ride them higher (see Tesla- TSLA as the current hot stock) or to bag shares which appear to be absurdly under-valued. Now in the case of the latter, instincts do sometimes do come good. I wrote a month ago about how I saw intrinsic value in RockRose Energy (RRE) but of course didn't actually buy any. Well done to all those that were holders and saw a one day rise of 64% as they announced that the company was to be sold (to someone who presumably had recognised something of their true value). However for every RRE that prove to be a spectacular firework, there are many that continue to lie in their bonfire night boxes untouched and eventually unsellable as they become tired old stories and are thrown out.

So whilst I do like the strategy of deep value investing and do deploy it, for me it is a riskier and longer term play than swinging to the other end of the scale and buying quality. I have written much about Warren Buffett, who (along with his compatriot Charlie Munger)  remains one of the shrewdest investors still alive today. He is also one of the wealthiest.  Buffett's story is quite simple. Having been raised on the wisdom of Ben Graham (of whom I wrote about here), Buffett departed from the "deep-value" approach espoused by Graham and moved more into looking for quality in the 1960's. Buffett 's quote above summarises his approach The ideal business is one that earns very high returns on capital and that keeps using lots of capital at those high returns. That becomes a compounding machine.

My own investment journey has been influenced by Joel Greenblatt (who wrote The Little Book that (still) Beats the Market) from the USA and two great British investors- Phil Oakley who wrote How to Pick Quality Shares and fund manager Mark Slater who can be found here who has followed and developed the great principles set out by his father Jim Slater in The Zulu Principle. All of these follow the following principles to a greater or lesser degree:

1. The great value of Return on Capital Employed (ROCE)
2. Maintenance of a good profit margin and
3. The importance of free cash flow.

I've got to the point now that, unless I am concentrating entirely on the deep value play (and there are one or two in the present market which I feel offer deep value plays) I am absolutely fixated as a starting point on Return on Capital Employed. For me that is the first marker of quality.  Stockopedia defines it thus, The Return on Capital Employed, or ROCE measures how effectively a company uses its total capital employed to generate income. It is calculated as the Operating Income divided by the Capital Employed.  Operating Income can also be described as Earning Before Interest & Tax (EBIT). Capital Employed is simply Total Assets minus Total Current Liabilities.

The measure may be summarised very simply- how efficiently is a company generating profits from its capital?

In many ways it should be the most basic measure of quality. Any business that exists needs capital- money invested by (usually) its founding shareholders plus often some bank debt. A business is a good business if it manages to generate a good return from that capital. A business becomes a great business if it consistently generates a good return from the returns previously made on its capital. That is the essence of the Buffett quote- such businesses then become compounding machines.

For example a services business generating say a 30% profit annually might use some of its profits to go out and buy another services business, paying for it over several years. It is using its own profits to acquire more profits in the future.  As it adds more businesses, in theory its costs base should decrease as it is able to streamline, thereby generating further profit margins for the enlarged business.

Return on Capital Employed should however never be regarded in isolation. The two other principles- namely maintenance of a good profit margin and free cash flow should also follow immediately on. The prime reason being is that quality, profitable businesses do fail from time to time. If they maintain a good profit margin then a drop in that profitability won't kill them. However and crucially if they can maintain a good level of free cashflow then they will always have the money to pay their creditors (notably HMRC in the UK or the IRS in the USA and the banks) so there is a much lower likelihood that they will run out of money and become insolvent. A further good reason is that if a business is maintaining a good margin and is throwing off a lot of cash, this will give them the firewpower to grow more rapidly and more profitably than their competitors.

So when looking for companies to invest in, ROCE should be high on your checklist. I've always been a big fan of screening for such companies and the tools that (paid for) Stockopedia and Sharepad offer will help you do this. However all listed companies publish their results freely and it is not difficult to find the figures  that you need to calculate ROCE from within the accounts.

Of course Quality usually does come at a price. Opportunities do come up from time to time- like in March 2009 or March 2020 to pick up Quality at Bargain Basement prices- however in such times you have to be brave, as volatility is scary. Most of the time you have to pay up for quality and these are often not shares which shift up quickly in the near term. However for the longer term investor who takes time to understand a company properly, holding a decent number of shares in a quality outfit can be tremendously rewarding financially.

*As ever this is published subject my usual disclaimer

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