The market flirted with corrections several times this quarter, but bounced back each time. Last week, Federal Reserve Chairman Ben Bernanke acknowledged that as economic conditions improved, he’d start tapering his bond-buying stimulus program. Markets tumbled on the news, but bounced back when the government released weaker than expected GDP data (markets ostensibly thinking this might prompt the Fed to continue stimulus a while longer). For those keeping score at home: the market meets the Fed’s upbeat economic projects with panic, and meets actual disappointing GDP data with cheer. This is exactly why short-term traders, and market prognosticators, perform so poorly over the long term. The market will respond in odd ways to similar events, and just when you think you spot a trend, it’ll flip itself around. The good news is that we don’t need to worry about what the market makes of the next macroeconomic event. I’ll maintain my focus on adding value to your portfolio, and we’ll dip back in with our cash whenever the market gives us a sizeable correction.
As I add value stocks to my watch list to take advantage of an upcoming soft spot in the market, I thought now might be a good time to review one of the more important metrics I use when valuing a company: Cash Return on Invested Capital (CROIC). CROIC tells the savvy investor how well a business uses its capital to generate cash.
The CROIC formula is straightforward: free cash flow / (total assets – excess cash).
CROIC helps investors find companies that do more with less. For example, suppose there are 10 companies in an industry and 9 out of 10 generate a CROIC score between 4-7% per year and one firm generates a cash return on invested capital of 15%. Nine of the above firms use $100 of capital and return $4-7 in free cash. The other firm returns $15 in cash for every $100 of invested capital.
CROIC is an excellent metric because it excludes unproductive cash. I tend to target companies that have favorable cash to debt ratios, because that gives them a ballast in troubled times. While that cash sits, it doesn’t add to the productivity of the company. So, if one simply looked at the return on assets, the number would be skewed by the cash on hand. CROIC, however, is not affected by the cash on hand.
Companies with a high CROIC are often targeted for buyouts, especially if the company has significant cash on hand. If a company has a high CROIC, an acquiring business would know that it would not need to keep a lot of money in the company to enjoy significant cash flow. It would enjoy a high return on investment. There is another metric – ROIC – which gives us a return based on earnings. I prefer, however, valuation metrics that are based on free cash flow rather than reported earnings (earnings can more easily hide a financial weakness at the company).
One of the more interesting features of CROIC is that it is an excellent tool for finding companies with good competitive moats. Economics tells us that a company cannot generate a high CROIC in a niche without a competitive advantage. Strong earnings almost always attract competition, which would normally chip away at the leader’s pricing power and margins. If a company sustains a high CROIC, it is a sign that company leadership has been able to maintain its competitive advantage.
I often look for improving CROIC over a three year time horizon. That, combined with a value stock, is often an indicator that the company was in trouble, but that management is turning the business around. Successful turnarounds are excellent investment opportunities. Of course, a high CROIC does us no good if we’re paying too much for it. CROIC is just one factor in my overall value analysis.
Using CROIC, and my other value metrics, I will continue to search for excellent opportunities during the market’s hot stretch, and we’ll be ready to strike as the market creates value opportunities.