How do you decide what to buy?
I get the question a lot, and I think it's a good one. The answer depends on things like how long I'm planning to hold a stock, whether I see it as a value or a growth play, and where the momentum is in the market.
If I'm looking for a long-term investment, I don't start with any of the usual measures, such as price-to-earnings ratios, P/E-to-growth ratios, earnings growth rates, or price-to-book or price-to-sales ratios.
I start with ROIC, short for return on invested capital. I don't think there's a single number that tells investors more about whether they want to buy and hold a stock. It's also a good basis for lots of other investment decisions, such as whether a company acquisition is a good deal for shareholders. (For more on that, see my column of Feb. 25.)
Return on invested capital tells investors how good a job a company is doing at investing its money in profitable opportunities and how good the company is at finding those opportunities. Crucially for long-term investors, it also indicates how good a job the company is doing at compounding investors' money through the rate of return the company gets on reinvested profits. (ROIC isn't the most common of financial measures, but you can find an example of it here.)
You should own shares of a company with a high ROIC for the same reason you should put your cash in a savings account that pays a high rate of compound interest.
Let me explain how this works and show you how powerful it is by looking at one of the best ROIC stories in Jubak's Picks, McDonald's (MCD, news, msgs). (See my most recent update on the Golden Arches.)
McDonald's is almost the perfect ROIC long-term holding:
- The company throws off a ton of cash. For example, in 2008, cash flow from operations came to $5.9 billion. It was $4.9 billion in 2007 and $4.3 billion in both 2006 and 2005.
- The company has found opportunities to invest a huge hunk of this cash flow. In 2008, the company recorded $2.1 billion in capital spending. In 2007, that figure was $1.9 billion; in 2006, it was $1.7 billion.
- It gets a huge return on this invested capital. The company's most recent return on invested capital was 19.1%. That's just a little bit better than your bank gives you on your savings account, right?
- The company looks to have lots of opportunities for investing its capital in the years ahead. Capital spending in 2010 is projected to increase to $2.4 billion from its $2.1 billion outlay in 2009. The company has ambitious programs to expand into China, refurbish existing restaurants and add items to its menus.
OK, McDonald's isn't perfect for a long-term investor. From that point of view, it distributes too much cash to shareholders in the form of dividends. A 3.4% dividend is nice, but I sure can't find anyplace to invest it and get a 19.1% return. I can easily fix that problem by reinvesting my dividends, though.
A bigger issue is the huge amount of money that the company has spent on stock buybacks: $11.6 billion over the past five years, according to Morningstar. Add the dividends paid out during that period to the buybacks, and it comes to about $20 billion. That's more than the company's cash flow from operations after capital spending (known as free cash flow). That means McDonald's has been borrowing during this period so it can pay out this cash and keep investing in its business.
That's not a huge problem when interest rates are so low and when the company's balance sheet is so strong, but some conservative bone in my body doesn't like the idea of borrowing money just to pay it out again.
You know the saying "The perfect is the enemy of the good"? Well, it applies in spades to stocks. Investors don't need to find the perfect stock, just the better stock.
So compare McDonald's with two of its restaurant peers:
It beats Burger King (BKC, news, msgs) hands down. Cash flow from operations for Burger King in 2009 was just $311 million, and capital spending was only $204 million. And the company earned an ROIC of 9% in 2009. Not bad, but not even half as good as McDonald's 19.1%.
Continued: You've got to do your own math
