In his latest interview with the RWH Podcast, renowned investor Terry Smith reinforced a principle that too many investors ignore: return on capital employed (ROCE).
As legendary investor Warren Buffett stated in his 1979 annual report, ROCE is “the single most important measure of performance.” Terry Smith, one of today’s most respected fund managers, echoes this sentiment, arguing that investors often overlook this fundamental metric.
“If you invest with me, you want to know what return you’re going to get,” Smith explains. “If you’re going to put your money in the bank, you want to know what return you’re going to get. If you’re going to buy a bond, you want to know what interest rate yield you’re going to get. In other words, when people invest in companies, they ignore that.”
But ignoring ROCE comes at a cost. Investors who fail to analyze a company’s return on its own capital risk buying into businesses that generate lower and lower returns, despite appearing to show earnings growth. “I’ll generate earnings growth for you at lower and lower returns, which plenty of companies have done over time,” Smith warns. “See Tesco for details, right? It’s like, oh, it’s a disaster, right?”
Beyond ROCE, other key financial indicators provide insight into a company’s strength. Gross margins, for example, reveal pricing power and brand strength. “Companies take in components, ingredients, services, labor, and they put a markup on it, right?” Smith notes. “The size of that tells you a lot of things. It tells you about their pricing power, their brand strength. It tells you about the defenses against inflation.”
Cash conversion is another crucial factor. The percentage of profits that materialize as cash determines a company’s ability to pay dividends and reinvest in itself. “There are companies that make more than 100% of profits in cash, usually by the method of paying people more slowly than they get paid. And that’s beneficial fairly obviously, because cash is the only thing in the end you can pay the dividend with.”
However, understanding financial metrics alone isn’t enough. Smith emphasizes the need to dig deeper into a company’s operations and leadership. “Do they have brands? Do they have control of distribution? Do they have intellectual property? Do they have an installed base of software or equipment that they service and sell spares and so on and upgrades to? How do they do this?”
Management’s decision-making process is particularly revealing. “Every year you have this company that produces this return, these profits and cash flows arrive, right? How do you decide whether to give it back in a dividend? Buy back shares? Invest in the business? Or buy things, right?”
Unfortunately, many executives prioritize acquisitions over stock buybacks, even when their own company is undervalued. “I’ve met managers who say, ‘My stock’s undervalued.’ Ah, now you’re busy acquiring things, buying lots of things. Why don’t you buy your own stock? ‘What? Well, why would I do that? I’d shrink.'”
The irony, as Smith points out, is that managers know their own company better than any acquisition target. “Surely the company you know best is not the company you’re acquiring; it’s the one you’ve already got. And you’re telling me you think it’s undervalued. By the way, I’ve checked, I think you’re right. Why don’t you buy those?”
For investors, the lesson is clear. Great financials, solid business fundamentals, and honest, intelligent management are the cornerstones of long-term success. As Smith succinctly puts it: “That’s it.”
You can watch the entire interview here:
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