ROCE: Anchor For A Strong Portfolio

The art of stock analysis has witnessed a significant evolution over the last century. Finance textbooks and investors from all over the world have emphasized the importance of different metrics in financial statement analysis at different points of time. However, the last 30 years have seen a large number of investors following the Warren Buffett school of thought. He mesmerized the investment community with the concept of ‘moat’. Moat, as he describes it, is a water body around a magnificent castle that is filled with dangerous creatures like piranhas, poisonous snakes, etc. which act as a deterrent for anybody who tries to attack the castle. Thus, he described a company that has a competitive advantage in running its business as having a ‘moat’. Return on capital employed (ROCE) serves as an important metric to measure whether a company has a competitive advantage.


ROCE is measured by the formula EBIT/capital employed (capital employed can be calculated as total assets – current liabilities). ROCE measures how effectively a company is able to deploy its capital, i.e. equity and debt, to generate returns for its capital providers. If the ROCE of a company is higher than its weighted average cost of capital, then the company has a strong and sustainable business. It means that a company can meet its obligations towards both its creditors and shareholders from its own business operations without the need for raising funds via equity or debt. If the ROCE is significantly higher than its cost of capital, the company can even fund its investments for growth on its own, resulting in a growth of earnings and the creation of shareholder value.

For example, if Company A has a 10% profit margin and Company B has a 20 per cent profit margin, Company B appears to be performing better. However, if Company B uses twice as much capital than Company A to earn a higher profit margin, it is actually a less financially efficient company as it is not making maximum use of its revenues. A higher ROCE indicates that a larger part of the company’s market value can be returned as profit to shareholders. As a general rule, a financially efficient company will have ROCE at least twice that of current interest rates.

ROCE is often considered a superior metric than ROE, which is measured as net profit/average shareholders’ equity. ROE is a metric that is prone to manipulation because if debt is added to the books, it reduces the equity on the balance sheet, thereby inflating the ROE, whereas ROCE already incorporates the effect of debt. Companies that have successfully managed to redeploy incremental capital at higher rates of return consistently over long periods of time have managed to create significant value for their respective shareholders. A company that reports a robust ROCE year after year means that the company is able to extract better returns than the opportunity cost of funds. However, ROCE is only one of the important metrics to consider before making investment decisions and should be combined with the likes of growth prospects, valuation comfort, etc.

Industries like FMCG, pharmaceuticals and IT have historically managed to clock higher amounts of ROCE over longer periods of time in India due to the secular demand for their products and the emergence of several household brands. However, despite these companies continuing to maintain high ROCEs, it is difficult for some of the larger companies to register sales and profit growth at the same pace as they did in the past. This is because these companies are very large in size and a large part of their market is already penetrated, thereby leaving little room for exponential growth. Companies like Colgate, Hindustan Unilever, Infosys and Wipro are examples of such companies. Thus, it is important to consider the company’s growth prospects along with ROCE.

Some of the industries such as manufacturing, infrastructure, power, real estate, etc are very capital-intensive industries. It is rare for these companies to post very high ROCEs over long periods of time. It is extremely important to gauge the stage of the business cycle before investing in such companies. Some of these companies can report high ROCEs intermittently, but this is often near the peak of their business cycles. Hence, just looking at the ROCE metric without considering the cyclicality and sustainability of earnings is unlikely to yield impressive results. Between 2003-08, infrastructure and real estate sectors outperformed the rest of the market by very large margins, despite having very low ROCEs as these companies were experiencing a cyclical upturn. In contrast, FMCG and IT stocks proved to be underperformers relatively, despite having high ROCEs. It was these stocks that stayed afloat after the financial crisis hit the markets in 2008 and many of the real estate and infrastructure stocks, which were till then the darlings of the stock market, crashed like a house of cards and perished.

It is believed that incremental return on capital employed serves as a superior measure to identify the wealth creators of the future. This is because higher returns on incremental capital deployed measures the impact of new capital allocation decisions taken by the company management. Investors should try to invest in companies that are expected to improve their ROCEs as compared to the past. 

A study by Edelweiss found that within the BSE-500 pack (ex-banks), 205 companies generated a ROCE > 20 per cent over FY08-FY12. Of these, only 107 were able to sustain an I-ROCE (incremental return on capital employed) of 20 per cent. These companies recorded an I-ROCE of 27 per cent (vs 11 per cent for BSE 500) and shareholder returns of 29 per cent CAGR (vs 18 per cent for BSE 500). For the period from FY12-16, the average market cap increased by 27 per cent CAGR (vs 15 per cent for BSE 500). This is illustrated in the image below. 



The correlation between high ROCEs and share prices can be back-tested for confirmation. For example, home appliance major TTK Prestige has managed to create humungous wealth for its investors. The company has maintained a ROCE of over 15 per cent throughout last 10 years. The company’s stock price has soared by a mind-boggling 8872.75 per cent during the same period. Similarly, Titan Company has also maintained a high ROCE over a long period of time and has delivered stellar returns of 2839 per cent over the last 10 years. Some other wealth creators can be found in the illustration below: 



We have already seen why ROCE is such an important metric to consider for investors. However, the ratio also has its limitations. The main drawback of ROCE is that it measures return against the book value of assets in the business. As these assets are depreciated over time, ROCE will be inflated even though the cash flow has remained the same. Hence, older businesses with depreciated assets will tend to have higher ROCEs than some newer, possibly better businesses.

It would have been wonderful if every company with high ROCE delivered the highest share price returns. This would make investing tremendously easy. However, this is not how things always play out in reality. It is observed that in good times all companies perform well, except those with the worst ROCEs. In the years FY10, FY15 and FY17, when the markets showed an extremely strong performance, it was not the companies with the highest ROCEs that have delivered the highest returns. However, the companies that had extremely poor ROCEs proved to be the biggest underperformers. In bad times, all companies, except the ones with high ROCEs, tend to underperform. In FY09, FY11, FY12, FY13, FY16 and FY18, the high ROCE companies witnessed significantly lower damage and even performed respectably. At the end of the financial year 2008, which was the year of the financial crisis, being invested in the companies with the lowest ROCEs would have earned a median return of -53 per cent as against earning a median return of -36 per cent for the highest ROCE companies.

Hence, the presence of high ROCE companies in investors’ portfolios should be not only for capital appreciation, but also for capital protection.



Conclusion It is crucial to keep an eye on ROCE during stages of investment ideation or implementation of a strategy, either for running a business or investing. It has been observed that organisations that have superior ROCEs as against industry peers over long periods of time end up creating significant shareholder value. However, the cyclicality of industry, changing business dynamics, growth prospects, valuation comfort, and several other important factors and metrics need to be considered along with ROCE. ‘Bottom-up’ stock picking over a long investment horizon can be extremely rewarding to shareholders as compared with the benchmark index.

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