In response to a post discussing the importance of return on invested capital (ROIC), a reader asked an interesting question which raises a number of points which are relevant to the value investor. The comment was as follows:
Lets say I would have to choose between two investments ..True Religion Apparel (TRLG) with a ROIC(TTM) of 50% and Joes Jeans (JOEZ) with a ROIC of 10% (TTM), you would favor TRLG even though JOEZ might be a young company with a "growth" story?
The question is seemingly simple, but the process to answer it is anything but! There are a number of items that must be considered, each of which has the potential to add substantial complexity (i.e. in a very non-linear manner, as discussed here).
First of all, while it is true that in general a higher ROIC is better than a lower ROIC, the time frame over which the ROIC is measured must be considered. Here, with the "TTM" notation, the commenter is stating that these ROIC numbers are based on the last twelve months ("Trailing Twelve Months"). But a lot can happen in twelve months, including asset sales (for both gains or losses), one-time drops/increases in demand, and other items that can affect whether the last year is truly representative of a company's earnings power. For this reason, value investors prefer to look at returns over longer time periods to assess a company's earnings power.
One's circle of competence must also be considered. For example, personally I know nothing of this industry nor of these companies. As such, I don't have the ability to attest as to whether one or both of the ROIC's of these companies is sustainable. This is very important because a high ROIC invites competition, which in turn brings down returns unless the company has a competitive advantage that keeps its competitors at bay. Past returns may be terrific, but here the investor must determine whether future returns are likely to be kind as well.
Relatedly, the fact that one company is labelled a "growth story" (as is done in the comment) is also worth noting. Value investors don't usually like "stories" unless they are backed up by ROIC numbers over the course of a number of years. In this case, it is the low ROIC company that is purported to be the growth story. But while earnings momentum looks great and the market tends to extrapolate growth rates going forward, value investors aren't willing to pay for expectations of future growth. The growth has to be borne out first, as value investors don't like to play the role of the venture capitalist.
Finally, this would not be a post on the subject of value investing if the question of price was not considered. One could have the best return on capital in the world, but if high expectations are baked into the price, the investment has little appeal to the value investor. To that end, the companies' respective debt/cash levels should also be considered to help determine the risk inherent in each investment.