Importance of Return on Capital Employed in Equity Investing Part 2

In the first part of the article, we discussed what Return on Capital Employed (ROCE) is and why it is important for stock selection. In the second and concluding part we will discuss the analytical framework of cost of equity and how the Capital Asset Pricing Model (CAPM) Model quantifies the expected returns from the stock. Please read on…

Let us now discuss the analytical framework of cost of equity. Capital Asset Pricing Model (CAPM), quantifies the expected returns from the stock. To understand CAPM, we have to understand another technical parameter known as Beta. Beta is a metric which helps us understand the risk taken by a stock or fund relative to the market. Beta of a fund is defined as the excess returns of the fund over the risk free rate relative to the excess returns of the benchmark index over the risk free rate. As per CAPM, the expected return from a stock is:-

We will not discuss beta and CAPM in detail in this post, but if you are interested in knowing more about these concepts, please read our blog, How to select the best mutual fund: The importance of Alpha. For the purpose of understanding the importance of return on capital employed (ROCE), all you need to know, is that expected return in CAPM is the Cost of Equity. As per an Ernst and Young study, done about 2 years back, the estimated Cost of Equity in India is a little over 15%.

We have discussed Cost of Debt and Cost of Equity. So what is the cost of capital for a company? It is weighted average cost, based on the debt equity ratio of the company. If a company has a debt equity ratio of 50:50, cost of capital will be, 50% X 13% + 50% X 15%, which is around 14%. For the entire range of debt equity ratios, the cost of capital is 13 – 15%.

If the ROCE of the company is higher than the cost of capital, If the return on capital employed by the company is greater than the cost of funds of that company, then the business is strong and self sustainable. The company can meet its obligation towards both its creditors and shareholders from its own business, without the need to raise capital. In fact, if the company’s ROCE is higher than its cost of capital by a substantial margin, it can fund growth investments on its own, growing earnings and thereby shareholder value. Companies like these are favoured by fund managers because they help the fund managers deliver alphas for mutual fund investors.

Stock selection is important in mutual funds

In Advisorkhoj, we get queries, whether bottom up or top down investment strategy is more effective. Irrespective of whether, the fund manager follows top down or bottom up strategy, stock selection is very important. Neelesh Surana, CIO-Equity of Mirae Asset India, told us that, “We would continue to focus on stock selection to generate alpha. We strongly believe that stock selection is equally important within as sector due to factors like different earnings growth expectations, valuation, management, etc” (Read the Full Interview) ROCE is in an important metric that good fund managers look at when selecting stocks. As discussed earlier, these stocks help the fund managers generate alphas for their schemes. If the fund manager of the mutual fund scheme that you have invested in focuses on ROCE, it should give you a degree of comfort that, your investment is in good hands.

Conclusion

About 2 years back, I was discussing ROCE in the context of Indian equities with a friend of mine, who is quite knowledgeable about equities. He told me that, most of the high ROCE companies in India, back then were FMCG companies, but what about growth and wealth creation, he asked. He was right that, good FMCG companies typically have high ROCEs, but the growth potential may not be as high as cyclical companies.

I would like share with our readers, two points that I discussed with my friend, in response to his comment. I asked him to track two stocks, one high ROCE (from FMCG space) and one low ROCE (from Real Estate). I will not mention the name of the two companies, but the real estate stock, quite a well known name, had an ROCE of about 2% in March 2014. In the last two years, the stock price of this real estate company fell by 85%. What about the FMCG stock? The FMCG stock had an ROCE of 48% in March 2014.

In the last 2 years, the stock price of this stock rose by 4%. The performance of this FMCG stock would not have met the expectation of most equity investors, but ask yourself, given a choice between just these two stocks, which one would you have preferred? This was the first point. The second point, I mentioned to my friend was that, ROCE is not the only metric that one should use for stock selection. Earnings growth potential, Price earnings ratio, etc are also important, but ROCE should be used to identify companies which are inherently strong.

The best companies to invest in from a wealth creation perspective are companies with ROCEs sufficiently higher than cost of capital, strong earnings growth potential, run by efficient management teams. You need not restrict yourself to a few industry sectors to find great companies with good ROCEs. If you look diligently, you will find companies like these in most industry sectors. Or you can simply let your fund manager do that job for you.

If you are interested in Equity investing topics, you may like to read –

Importance of equity in Asset Allocation

Bull and Bear Market Investing

Investing in Bull and Bear Markets