Read a discussion online. Decided it was useful enough to tidy up and share with you guys.
Qn: Is there any reason for investing in low ROIC companies?
• ROIC creates value for shareholders
• Growth destroy value if ROIC is lower than Cost of capital
• Why would anyone invest in companies with mediocre ROIC?
1. Leverage improves return to equity
If a firm is leveraged, it might have a high ROE despite a low ROIC. Of course, one has to be aware of the risk involved when investing in such a firm.
2. ROIC may improve
One reason is if you think ROIC will improve. A company where management acknowledges and is actively working to resolve inefficiencies could present a very nice opportunity. If you consider a company with 5% margins, a 10% decrease in expenses could more than double their earnings.
3. The reason for high ROIC matters
You also have to look at competition. Companies with very few good competitors can have very high ROIC. If there are few competitors because it is a difficult industry to break into, that may be safe-ish. However, if it is simply a new industry or one which competitors are still working on getting into, that ROIC may be at risk since competitors will eventually take market share and drive prices/ROIC down. In an industry which already has low ROIC, this is less of a concern because new businesses will only be able to drive down prices if they are more efficient, which is unlikely if they are small/growing.
4. Price determines if it’s worth it
A company with a low ROIC still has value, and sometimes the market price of its stock is significantly below that value. If you can buy at a big discount to value, and then sell in a year or 2 at some time close to fair value, you can generate significant returns on your invested capital. This is traditional value investing.
That isn't my approach to investing. I much prefer to invest in high ROIC companies, but I have several professional investor friends, who following the more traditional value approach and have terrific long term results.
If you own an investment for less than 5 years, the change in how the market values the earnings or assets of the company is generally the primary determinate of your investment return, hence the need to buy when the price is really cheap.
5. Long term investors should hold companies with high ROIC
If you own an investment for the long-term, as I prefer to do, then your investment return is primarily a function of changes in company value, which in turn is a function of ROIC, hence the need to focus on companies with a high ROIC.
Certainly, you are missing all sorts of investing opportunities. But, that is not the point. The goal is to be right on the investments that you do make. There are lots of different ways to make money, even as a value oriented investor. Your goal ought to be to figure out which approach works fits you, and which you can do well, and focus on that.
6. Take into account revision to mean
Reversion to the mean - over time most companies see their returns on capital move towards the cost. The issue with a business currently earning high returns on capital is that the market will usually price the business accordingly (i.e. on a high multiple of current earnings). This creates problems when (most) companies see their high returns revert to the mean (cost) resulting a double whammy where growth slows and the multiple contracts.
The opposite is true with companies currently earning low returns on capital. They tend to be overly discounted by the market, but on average, their returns improve over time towards the cost - resulting in improved earnings growth and an expansion in multiple. This is a long winded way of explaining the value premium.
Everyone wants to be the next Buffett and buy a great company at a fair price and let the business compound away at high rates for many years, resulting in one of the best investment track records of all time. The trick is, most businesses can't sustain a ROIC much in excess of their cost of capital for a long time. Harder still, every person in the market is looking for these opportunities. Therefore, your job as an analyst is to find those truly special companies that can sustain abnormal returns (extremely difficult) or look for companies that have been overly discounted by the market, with room for improvement (still difficult, but arguably easier because at least the odds are on your side)