June 2013
Vol. 6 No. 6  
in this issue
It's a Bird, It's a Plane,
It's... ROIC-Man!


Where's the ROIC?






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Daruma Capital Management LLC
80 West 40th Street, 9th Floor
New York, NY 10018
www.darumanyc.com   
 










 
 
About Us

Founded in 1995, Daruma Capital Management invests in high-conviction portfolios of no more than 35 stocks.

Daruma manages $2.1 billion for public and corporate pension plans, endowments, foundations and individuals. Our annualized Small-Cap return net of fees since inception is 12.7% vs. 8.2% for the Russell 2000 (7/28/95 to 3/31/13). Our annualized SMid-Cap performance net of fees since inception is 8.4% vs. 13.2% for the Russell 2500 (4/30/10 to 3/31/13).

 

Notes to Performance

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Hello!
 
Return on Invested Capital (ROIC) is an important measurement tool. Like any metric, however, it doesn't paint a complete picture of a given business.
 
Read on below for a story of how one man's hyper-focus on ROIC during a dinner party gave me mental indigestion.
 
(To listen to this month's newsletter, click here.)

All the best,
signature - Mariko 
Mariko O. Gordon, CFA
Founder, CEO and CIO
Daruma Capital Management LLC 
 
articleOne It's a Bird, It's a Plane, It's... ROIC-Man!

Normally, I wouldn't have accepted an invitation to dinner with the management of Company X, a global distributor of massive size and scope. If this stock (as opposed to the business or management itself) were a dinner party, the meal would be cheap and unimaginative, and the company excruciatingly boring.

However, having recently read an interview in which a money manager stated the investment case for the stock, I actually wanted to go. Not only was there change afoot (a new CEO and an intriguing acquisition), the business printed cash. As an added bonus, they had just whiffed the quarter, which meant the stock was also on its ass.

I love the possibility of ditching preconceived notions, especially if it might mean our clients make money. (Better than unicorns and rainbows, any day.) So I got up to speed on the company and, full of hope and barely suppressed excitement, I strutted into the dining room.

Little did I know the dinner would be ruined by "Return on Invested Capital Man."

ROIC-Man was the dinner party equivalent of the guest who won't stop talking about his gallstones. Or his politics. Or his prowess at [insert boring sport here]. Whatever - pick the thing you least want to discuss at dinner, take it to the 10th power, and you'll begin to experience the full horror. An ice pick to the left temple might have been preferable.

More on ROIC-Man in a moment; first a bit of background...

Company X is slow growth and way overcapitalized (for you non-finance types, that means it's sitting on a pile of cash). Because it is also very cheap by any absolute measure, most people at the table were focused on how to "unlock value" (more finance code, this time meaning "do something, anything, that will make the stock go up right NOW").

When a company has too much capital and has missed the quarter, management is going to be asked 500 different ways why it's not returning capital to shareholders (e.g., buyback, dividend, special dividend) and how it can goose returns. That's normal; we investors like to get our pound of flesh after a quarter's been whiffed.

That said, the dinner conversation proved to be extreme. Every other question was asked by ROIC-Man and, as his name suggests, every one of his questions included his beloved acronym. Apparently, in his eyes, NOTHING ELSE ABOUT A BUSINESS MATTERS.

In practice, however, things are never quite so simple.

For example, the ecosystem in which Company X operates is undergoing tremendous change - if the new CEO doesn't make the right moves, this cash cow could find herself with four hooves up in the air. Perhaps the excess capital that is so depressing the holy ROIC ratio today might be needed to provide some flexibility in the transition, in order to ensure survival, or even (gasp) an acceleration in growth tomorrow if they play things right.

My favorite dinner companion wasn't having any of that. He played his final question card by asking whether Company X couldn't boost its ROIC by financing receivables, thus freeing up the cash tied up in working capital.

The CFO calmly explained that while that might indeed boost returns a bit, it could also put the entire business at risk should there be some sort of dislocation that vaporizes the financing. (I dunno, maybe something along the lines of a 2008 global crisis?)

In the case of such an event, a mismatch between the duration and availability of the financing and the cash conversion cycle could mean adios, Company X. "Is the ability to make a little more ROIC truly worth the risk of crippling the business?" asked the CFO. That shut ROIC-Man up for the night.

What we all need to remember is that ROIC, like many metrics, is only that. It's a way to keep score on what is a very important facet of a business. But it's not everything.

We could have spent the evening discussing all the changes going on in the food chain in which the company participates. We could have argued about shifts in competitive landscapes. We might have debated the proper price to pay for acquisitions, whether or not their end markets were in secular decline, what would cause a competitor with a death wish to stop nuking prices, or a million other things that might have allowed us to figure out if there was a brighter future and faster growth ahead.

ROIC, for all its merits, is not the Ark of the Covenant, the Holy Grail, or the key to eternal life. Indeed, if all business decisions are made solely to increase it, and at the expense of taking into account everything else that goes into the complex system that is a business, that business will likely die a grotesque and contorted death.

Of course, as investors, we want wise allocation of capital. And of course, we want the return on that capital to exceed its cost, so much so that we are rightfully tickled pink when it happens. But, as in life, there are always tradeoffs in both business and investing.

In the end, I didn't get the answers I was looking for that night and had to schedule a follow up call. But I did learn one thing: not every superhero is welcome at the dinner table.



articleTwo Where's the ROIC?

Just for giggles (and for future newsletter material), I read through the "letter to shareholders" from our top ten small and smid-cap companies.

There was plenty of jargon as well as thoughtful "state of the nation" commentary - but not one single mention of ROIC (one company did mention free cash flow five times).

Given that there are some world class capital allocators on that list, it goes to show that managements agree that there is life beyond ROIC!


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