ROIC

ROIC: How to Invest in Squirrels
by James Boric
The Rude Awakening
Wall Street, New York
Thursday, December 22, 2005

James Boric explains that the difference between a progressive company and a stodgy one is that the former has a high ROIC.

-------------------------

-------------------------

[Joel's Note: He may be a little bashful about me telling
you this, but ever since he returned from a value investing
conference in New York a month or so ago, James Boric has
been working like a exhaust fan in an airport smoker's
lounge. The man has simply not stopped. We don't mind so
much though...this is when he produces a flurry of quality
articles and insights for the rest of us.

Below, James shows you how to look for companies that make
sound investments themselves. Why would you invest in a
company that doesn't know where to put its own money? James
shows you what indicators to look for when choosing a
company with adequate adaptability, dexterous innovation
capacity and squirrel-like agility. Don't get caught with a
lethargic, stodgy company destined for the road kill heap.
Read on below for tips on how to avoid such a grizzly
fate...

--- Advertisement ---

TIME IS ALMOST UP!

The Reserve Doors are Open Again...For Now.

Have the greatest financial minds in the world working for
you...for 96% off.

The perfect investment is available to you again at a
special price, but ONLY until Jan 1, 2006.

Don't miss your opportunity to secure your own Agora
Financial Reserve membership.

http://www.isecureonline.com/Reports/AFR/WAFRF9B2/

-------------------------

How to Invest in Squirrels
By James Boric

For 26 years, the symbol for Ralph Wanger's small-cap Acorn Fund -- which averaged 17% from 1970 to 1996 -- was a squirrel. Seems odd at first. But after thinking about it, it makes perfect sense.

Squirrels, like good small-cap companies, are nimble, efficient and adaptable. They are quick to avoid danger. They can thrive in small niches that most don't even know to look in. And if they do get into trouble, they can outmaneuver their larger predators.

"You don't see many three-hundred-pound squirrels in the park," Wanger remarked in his classic book, A Zebra in Lion Country. Squirrels that are slow and overweight could not survive in the wild. And the same goes for over-leveraged  and stodgy companies (no matter what their market cap is). 

So how can you determine if a company is innovative and progessive, rather than stodgy
and fat?

ROIC: Explaining the ROIC

One of the best ways is to examine a company's return on invested capital (ROIC). This might sound a little complicated, but it can be worth the trouble. Few financial statistics provide a better glimpse into a company's long-term health than its ROIC.

A company's ROIC numerically answers questions like: Is it a good business? Is it innovative and progressive? Does it manage and invest its own capital to generate a high rate of return for its shareholders? Or does it waste its earnings on frivolous projects that yield very low (even negative) returns? For instance…

If a company spends $1 million to build a new manufacturing plant and is able to crank out $500,000 in new earnings, its ROIC is 50%. It spent $1 million in capital to increase its earning by 50%. That is a very effective use of company capital. In two years the new manufacturing plant would be paid off and the company's earnings will be much higher than they were before.

Conversely, if a rival company spends $1 million to open a similar manufacturing plant across town and only manages to eke out $25,000 in new earnings, its return on its investment would only be 2.5%. That's terrible. The company could have made more money by putting its $1 million in a safe CD or government bond! It wasted the shareholder's money.

As an investor, you want to invest in companies that generate a higher return on invested capital versus a lower ROIC. Those are companies that manage their business better than others in their group. And they also produce higher earnings than their peers.

So what's considered a "high" ROIC?

A recent study by Bin Jiang and Timothy Koller of McKinsey Global Institute found that from 1963-2004, the average ROIC for all publicly traded companies (excluding financial companies) with sales of at least $200 million was nearly10%. In other words, on average a company will earn 10% in every dollar it invests.

But that "average" return varies widely from industry to industry.

As you can see from the chart below, pharmaceutical companies tend to have a higher ROIC than utilities companies. Software companies have a higher ROIC than energy companies. And health care equipment companies tend to have a more robust ROIC than consumer service companies. So for the purposes of using ROIC as an investment tool (or screener), it is essential to compare individual companies to their peers versus the market in general. 

Another note from the McKinsey study (which you can also see from the graph above) is that the average ROIC (across all industries) over the last 10 years is higher than in the last 40 years. And the industries leading the way are the pharmaceutical/biotech, household and healthcare services industries. So it should come as no surprise that those industries have outperformed the overall market in 2005.

In the last 12 months, the biotech industry is up 24.12%, the household and personal products industry is up 2.23% and the healthcare industry is up 13.32%. Keep in mind that the S&P 500 is only up x.x% in the last 12 months. So by investing in the companies with rising ROIC, you would have outpaced the market xx times over.

ROIC: This Year's Performance

Meanwhile the consumers services, food, transportation and telecom services industries all have lower returns on invested capital compared to their 40-year averages. You want to guess how they performed this year?

Not too well.

The wholesale food industry is down 7.2%, the transportation industry is down 3.65% and the telecom industry is off 2.2%. Only the consumers services industry made a profit this year – rising 4.93%. The long-term investment results differ little from these short-term results. Low ROIC sectors perform worse than high-ROIC sectors.

Clearly, companies that earn a higher return on their own investments are companies you want to have in your portfolio. They are the ones that can adapt, innovate and manage their operations better than competitors.

So as we get ready to start a New Year, where are the best companies hiding right now?

To begin answering that question, I created a list of all the companies in the stock market with an ROIC of at least 30%. After excluding all financial companies (like the McKinsey study did), I came up with 165 companies.

Here are some observations I made after studying the list…

Of the 165 companies, seven were from the textile industry...seven were from the steel and oil industry…seven were from the oil and refining  industry...and 17 came from the business services and software services industries. So if you are looking for industries to focus on right now, those are four I would start with. 

And after drilling down even further, I noticed that…

- 87 of the 165 best-run companies on the market were small caps with a market cap of $1 billion or less
- 51 were mid-caps with a market cap between $1-5 billion
- And 27 were large caps with a market cap above $5 billion.

Translation: over half of the well-run, innovative and adaptable companies on the market right now are in the small-cap universe. They are everywhere – just like those wily squirrels that Wanger loved so much.

"A squirrel is…an interesting animal," said Wanger in a 2000 interview. "It's not the strongest or smartest animal in the forest, but it is a very successful animal. There are squirrels in every country, because they are adaptable and opportunistic. For a small-stock manager, that's a good symbol.

"Tigers are brave and beautiful, but they're nearly extinct. And bulls are strong and powerful, but they wind up as a beef patty between slices of bread. But squirrels are all over the place."

Invest in the squirrels. That's my advice.

The next company Chris has identified is right here for
you. WARNING: If you are looking for get rich quick
companies, don't bother with this one...this is a 10-year,
slow and steady burner:

Capital & Crisis – A Squirrel Investor's Delight
http://www.agora-inc.com/reports/FST/EFSTFB06

--- Advertisement ---

Better Than Options...

Far less risk
Unlimited profit potential
Greater probability for success on trades
$0 commissions
Greater liquidity (market is 10 times larger than stocks!)
Greater flexibility (buy or sell 24 hours/day)
No "time premium" which makes regular options so expensive
No Expiration Date
All while collecting interest on your trade!
World Renowned Currency Experts Are Ready to Reveal "The
Secrets of the Spot Market"...

http://www.isecureonline.com/reports/MTR/EMTRFC59/  

-------------------------

And the Markets...