The speed and acceleration of growth
There is more than just one way to think about the growth of a business.
I sometimes like to use homespun analogies to explain how I think about businesses.
Imagine you’re at the race track, and your job is to asses the performance of cars based on their speed. Return on capital (ROIC) would be akin to measuring the car’s current speed, and the return on incremental capital (ROIIC) over a rolling five-year basis would be like assessing how the car’s speed has increased over the last five laps. Now, which of these do you think better predicts the car’s performance in the race?
ROIC is a snapshot. It measures how much profit a company is generating from its total invested capital at a specific point in time. It’s similar to the speedometer of our racing car showing its current speed.
On the other hand, ROIIC over a rolling five-year basis is more dynamic. It evaluates how effectively a company is using additional invested capital to generate additional profits over a five-year period. It’s like tracking the acceleration of the racing car over the last five laps.
Now, let’s picture two companies, Alpha and Beta.
Alpha has a high ROIC of 20% in the current year, but it has been stagnant over the past five years. This situation is akin to a car that is moving fast but hasn’t accelerated over the last five laps.
Beta, however, has a slightly lower ROIC of 18% in the current year. But, its ROIIC has grown from 10% to 18% over the last five years. This is like a car that might be moving a bit slower currently but has been accelerating steadily over the last five laps.
If you were betting on which car will win the race, you’d likely pick the one that’s shown steady acceleration, even if its current speed is slightly lower. Similarly, as an investor, you might lean toward Beta due to its improving efficiency in using incremental capital over time.
A company that exhibits a rising ROIIC over a rolling five-year basis demonstrates it’s not just making profitable investments but is also getting better at it over time. This trend can be a stronger indication of management’s effectiveness in allocating capital and the business’s potential for future earnings growth.
This helps to iron out short-term anomalies that might artificially inflate or depress a single year’s ROIC. Just like one lap with a sudden burst of speed doesn’t make a car a winner, one year of high ROIC doesn’t necessarily make a company a great investment.
This is essentially what Warren Buffett means when he asks whether an investment can not only utilise capital at high returns, but continue using incremental capital at those same high returns. He’s asking whether he can pour more money into the enterprise with the expectation that it’ll compound over time. Or, preferably, can it reinvest its earnings at a high clip without him having to provide further capital?
While a rising ROIIC is a positive sign, it’s equally essential to consider whether this trend is sustainable. For our racing car, an engine running too hot to achieve acceleration might cause a breakdown. A company pushing for higher ROIIC might have already reached its peak performance—not a terrible thing in itself, but something to consider.
While ROIC and ROIIC over a rolling five-year basis each offer valuable insights, the latter might be a more robust indicator of business quality. It captures the company’s capital allocation skills and its capability to improve them over time, providing a better predictor of its long-term performance. Just like in our car race, it’s not just about speed but consistent and sustainable acceleration.