Thursday, July 31, 2008

Revisiting Return on Invested Capital

As I mentioned in an earlier post ("From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula"), Return on Invested Capital (ROIC) is one of the two metrics that comprise Joel Greenblatt's Magic Formula.

A question raised on the Magic Formula Investing Yahoo! Message Board led to a discussion that highlighted the limitations of this metric. The question was why KSW, Inc. (Nasdaq: KSW), a micro cap HVAC contractor, was no longer on the Magic Formula list. One of the message board's moderators, Marsh Gerda (who also writes an MFI Diary blog) and I separately calculated the Magic Formula metrics to see if we could figure out why the company was no longer on the list.

Greenblatt's Formula for ROIC

Recall from the previous post on this that Greenblatt's formula for ROIC is EBIT1/(Net Working Capital + Net Fixed Assets).

My ROIC Calculation for KSW

KSW is a $29.4 million market cap company with no debt and $17.75 million in net cash on its balance sheet. Using the standard definition of Net Working Capital (Current Assets - Current Liabilities), I got an ROIC of 38% for KSW. Using that standard definition of Net Working Capital made intuitive sense to me, because it put KSW's excess cash in the denominator of the ROIC formula, so holding so much excess cash reduced the company's return on invested capital.

Marsh Gerda's ROIC Calculation for KSW

Marsh Gerda used Greenblatt's more idiosyncratic definition of Net Working Capital, which excludes a company's excess cash, to calculate KSW's ROIC. He got an ROIC of 1757% for KSW. It appears that he calculated this the right way (with respect to the Magic Formula method) and I calculated it the wrong way, by ignoring Greenblatt's different definition of Net Working Capital.

What The Numbers Mean

Theoretically, an ROIC of 1757% means that, for every additional dollar of capital a company invests in its business, it can earn $17.57 in earnings. In reality, of course, there are a couple of problems with this. First, if a company could really earn 1757% on its cash by investing that in its business, it wouldn't be holding most of its market cap in cash, where, presumably, it is earning less than 4% in annual interest. This would be a problem using my calculation of ROIC as well: 38% may be a lot less than 1757%, but it's still almost an order of magnitude more than the company can earn on its cash.

The second problem is that the amount of capital KSW can profitably reinvest in its business appears to be limited, for a few reasons:

- As an HVAC contractor, it requires little tangible capital, so it can't simply spend a lot of additional capital on new plant and equipment.
- Theoretically, it could use additional capital to expand into other cities (most of KSW's business is in NYC), but the commercial construction business is highly local: a contractor needs relationships with local developers, politicians, etc. (KSW could perhaps get around this by acquiring an HVAC contractor in a different city, but it may not have enough information about that city's construction industry to be an intelligent buyer, and it may not have enough cash to make a suitable acquisition).
- As a construction contractor, KSW probably has to pay up front for supplies and labor before it gets paid on a project. It make sense for the company to hold a certain amount of cash to cover these upfront costs, particularly when credit is less available, and more expensive (especially the sort of construction factoring the company would likely have to rely on).

Similar real-world constraints prevent other companies with theoretically high returns on invested capital from reinvesting most of their cash in their respective businesses. This frequent inability of profitable companies to invest most of their excess cash in their core businesses leads in some cases to the companies returning that cash to shareholders, via dividends or buybacks, and in other cases, to spending that cash on acquisitions (sometimes of businesses that are less profitable than the acquiring company's core business).

1Earnings before Interest and Taxes


Daniel said...

Interesting post. How did the company end up with so much cash in the first place--is it all retained cash flow from operations?

doofus said...

As you point out, even the incorrect lower figure of 38% is wildly beyond real-world expectations. Doesn't it call into question the validity of MFI, or at least some of the assumptions of the model?

DaveinHackensack said...


Just called the company and spoke to the CFO, Richard Lucas. He couldn't give me a precise breakdown offhand, but said that most of that cash was from retained cash flow from operations.

Also, after seeing this bit of the bio of KSW's CEO, Floyd Warkol on the company's website (my emphasis),

He founded his own mechanical contracting company, which was acquired in 1985 by JWP Inc., a NYSE company. At JWP, Mr. Warkol helped acquire over two dozen mechanical contractors throughout the United States

I asked the company's general counsel, James Oliviero, if the company was looking at acquisitions in other parts of the country. He said they were, and would consider one if it looked like a good deal and would be accretive to earnings.

He also confirmed a couple other points I made in the post: that since the contracting business is based on local relationships, acquisitions are the only effective way to expand in other cities, and that they use some of the cash on hand to pay their up front costs on projects (there's usually a 60 day lag before they get paid). He also said that the company had never borrowed money.

DaveinHackensack said...



I'm not sure the 38% is "wildly beyond real world expectations". It's conceivable that they could, over time, get that sort of return on investment in an acquisition, for example. It's clear that they can't get that return right now, otherwise, they would invest some of their cash to take advantage of that higher return. There are other sorts of companies that can generate even higher returns on invested capital in the real world, e.g., software companies and drug companies (because the costs of the second copy of software and the second pill are so low).

Good question re this and the validity of MFI. I should have addressed this specifically in the post. I think the ROIC metric -- and MFI in general -- has the same limitations of other "rules-based" value investing strategies: it crunches numbers, without considering the meaning of those numbers in the specific context of each company. I'm sure Greenblatt is aware of these limitations, and feels that the system will, over time, produce good results because, more often than not, the rough metrics of ROIC and earnings yield will effectively capture the good companies that are currently cheap (they'll capture some duds as well, but he figures the system works more often than not).

Whether this will be true going forward, remains to be seen, but the broader lesson I take from this is that any sort of screen based on fundamental metrics such as ROIC should only be used as a starting point for further, qualitative research. It is possible, as I've written previously, that a simple rules-based system like MFI might produce good results in a market facing some macro trend economic tailwinds (e.g., Brazil or Australia), but for U.S. stocks now, I would only use it as a starting point for further research.

Marsh_Gerda said...

I think an important point is being missed. JG only uses the ROIC that he calculates to rank the companies regarding their efficiency in returns on capital... in other words trying to decide if it is a "good business". Since that is the purpose, excess cash should be excluded. A company like KSW requires very little capital to run its business... no plant, no major inventory, limited property... those features rightly give it a high ranking on the good business scale.

It is of course foolish to think that for each additional $ of capital that they could increase income by $100. BUT, if KSW got a chance to expand their business, say open in another city... it would require minimal capital, and that is what JG is driving at.

I think the way JG handles Excess cash is what differentiates his approach from everyone else.


DaveinHackensack said...
This comment has been removed by the author.
Lincoln Minor said...

If I understand it correctly...

A 100% ROIC means that for every dollar of invested capital, the company earns one dollar of EBIT (not $100).

Thus, a 30% ROIC earns $0.30 EBIT for each $1 of invested capital. And a 1,757% ROIC earns $17.57 for each $1 of invested capital (not $1,757).

DaveinHackensack said...

Good catch, Lincoln Minor. I'll edit the post accordingly.

DaveinHackensack said...


Thanks for your comments.

What you are describing is closer to Buffett's idea of the benefits of a business that requires low amounts of tangible capital (e.g., See's Candies -- Al and I discussed this on the message board). Buffett came to like those sorts of businesses because he realized they require relatively little future investment of capital to maintain the operation.

Greenblatt explicitly makes a different point in TLBTBTM: he describes ROIC as a measure of how a company can profitably reinvest its earnings in its business (the gum store analogy in the book). Unlike Buffett's emphasis on companies with relatively low amounts of tangible capital, the MFI system occasionally picks up companies that have significant amounts of tangible capital (e.g., miners such as Teck Cominco or Hudbay Minerals, etc. when commodity prices are high).

"It is of course foolish to think that for each additional $ of capital that they could increase income by $100."

As Lincoln Minor pointed out, a 100% ROIC means that they could increase income by $1 for every $1 invested in the business.

You're right that the way Greenblatt handles net cash is different, but his way essentially rewards companies for holding a lot of net cash. As George Peng pointed out on the message board, most analysts consider significant amounts of net cash to be a drag on returns. As I mentioned in this post, when a company is holding onto significant amounts of net cash it suggests that the company may not really have such high returns on invested capital -- otherwise it would invest its cash to take advantage of those high returns (granted, even a company with truly high ROIC can probably only profitably invest its cash occasionally, as suitable opportunities appear).

Mikes said...

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