I have written a lot about value investing and a lot about ratios. Let me write AGAIN about Return on Capital. I am assuming you all know what is ‘Return on Capital’.

Most investors, especially value investors , and old fashioned investors (like me) place a lot of importance on this number. A high ROCE is a very good starting point to consider buying a share. A low number and you will ignore this stock. For me the cut off is 13. Why 13? simply because that is the sensex return over the past 2-3 decades from the sensex. So if I can index my portfolio and get 13 I expect my investee companies to get more than that, right?

So Gillette with 48% stays in the portfolio with a permanent tag and the dividends from G go back to buying more of the same. That company knows how to use my money, and it does a better job than what I can do. Ever.

Cummins does a decent job with 18% Roce and so stays in the portfolio. When I am asked to buy Siemens I again go to the same ratio and find it at 16% and qualifying. In these cases, the dividends may or may not get invested in the same share (then PE comes into play too, but using PE is a different post).

“What we really want to do is buy a business that’s a great business, which means that business is going to earn a high return on capital employed for a very long period of time, and where we think the management will treat us right.” Warren Buffett 

This is very important for compounding – the dividends have to be reinvested especially if you are a young person not dependent on the dividend income for your day to day living. The higher the RoCE the better it is that they re-invest the surplus instead of paying a dividend (in one of the highest level of RoCE based investing, the Murugappa group gave a special dividend and a buy back of shares in Shanthi Gears, which is there big time in my portfolio – it has a poor Roce in recent times). However not all compounding companies can reinvest at the same or similar RoCE. However in case of Gillette I have such a huge margin that even if it drops from 48 to 17…I will still be holding it. Long term investors realize that current income of the company does not matter – so an increasing roce or a huge roce can (and does) act as a good call. If the company keeps the Roce high for a long time and keeps reinvesting the money, compounding will create wealth for you – apart from the PE going up constantly. You could make it better by reinvesting the dividends too.

“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

The market price of Gillette, Cummins, Shanthi Gears, and Siemens (the examples chosen at random) keeps fluctuating from time to time, but for the compounding investor – the single minded focus on dividends and reinvesting ensures that they are not carried away by the price (I just saw the price of Gillette now – I thought it was 5k it turned out to be close to 7k!). Shows my indifference to price – and why not? My cost is less than Rs. 70! Now you know why I call it the compounding machine (WBs words).

When I said old fashioned, it is because I believe that the value of a share CANNOT INCREASE more than the Future value of its Free cash flow. So I don’t understand valuation of loss making companies. I don’t simple. I need a big RoCe. Who else to quote?

“Over the long term, it’s hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you’re not going to make much different than a six percent return – even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you’ll end up with one hell of a result.” Charlie Munger

“The higher return a business can earn on its capital, the more cash it can produce, the more value is created. Over time, it is hard for investors to earn returns that are much higher than the underlying business’ return on invested capital.” Warren Buffett

It’s the reason Buffett and Munger steer well clear of businesses with low returns on capital.

It is not always possible to copy Buffett or Munger for everything, but this one is easy. Whatever ‘investment’ tip you get look at Roce. If if is more than say 15, go ahead seeing what the company does. If it is less than 15 – for the past few years, just don’t bother. The index beckons.