The Number One Key to Long-Term Investing

03/02/2010 9:32 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Let the profitability of a company's investment in itself guide your stock picking. For an example, look at how McDonald's matches up against its competitors.
How do you decide what to buy?

I get the question a lot, and I think it's a good one. The answer depends on things like how long I'm planning to hold a stock, whether I see it as a value or a growth play, and where the momentum is in the market.

If I'm looking for a long-term investment, I don't start with any of the usual measures, such as price-to-earnings ratios, P/E-to-growth ratios, earnings growth rates, or price-to-book or price-to-sales ratios.

I start with ROIC, short for return on invested capital. I don't think there's a single number that tells investors more about whether they want to buy and hold a stock. It's also a good basis for lots of other investment decisions, such as whether a company acquisition is a good deal for shareholders. (For more on that, see my February 25 column.)

Return on invested capital tells investors how good a job a company is doing at investing its money in profitable opportunities and how good the company is at finding those opportunities. Crucially for long-term investors, it also indicates how good a job the company is doing at compounding investors' money through the rate of return the company gets on reinvested profits. (ROIC isn't the most common of financial measures, but you can find an example of it here.)

One of the reasons stocks are such a great long-term investment—if you pick the right ones—is that companies generate cash from their operations that they then reinvest in those operations. Today's profits compound over time to produce even more profits in the future.

You should own shares of a company with a high ROIC for the same reason you should put your cash in a savings account that pays a high rate of compound interest.

Let me explain how this works and show you how powerful it is by looking at one of the best ROIC stories in Jubak's Picks, McDonald's (NYSE: MCD). (See my most recent update on the Golden Arches here.)

McDonald's is almost the perfect ROIC long-term holding:

  • The company throws off a ton of cash. For example, in 2008, cash flow from operations came to $5.9 billion. It was $4.9 billion in 2007 and $4.3 billion in both 2006 and 2005.

  • The company has found opportunities to invest a huge hunk of this cash flow. In 2008, the company recorded $2.1 billion in capital spending. In 2007, that figure was $1.9 billion; in 2006, it was $1.7 billion.


  • It gets a huge return on this invested capital. The company's most recent return on invested capital was 19.1%. That's just a little bit better than your bank gives you on your savings account, right?


  • The company looks to have lots of opportunities for investing its capital in the years ahead. Capital spending in 2010 is projected to increase to $2.4 billion from its $2.1 billion outlay in 2009. The company has ambitious programs to expand into China, refurbish existing restaurants, and add items to its menus.

OK, McDonald's isn't perfect for a long-term investor. From that point of view, it distributes too much cash to shareholders in the form of dividends. A 3.4% dividend is nice, but I sure can't find anyplace to invest it and get a 19.1% return. I can easily fix that problem by reinvesting my dividends, though.

A bigger issue is the huge amount of money that the company has spent on stock buybacks: $11.6 billion over the past five years, according to Morningstar. Add the dividends paid out during that period to the buybacks and it comes to about $20 billion. That's more than the company's cash flow from operations after capital spending (known as free cash flow). That means McDonald's has been borrowing during this period so it can pay out this cash and keep investing in its business.

That's not a huge problem when interest rates are so low and when the company's balance sheet is so strong, but some conservative bone in my body doesn't like the idea of borrowing money just to pay it out again.

You know the saying "The perfect is the enemy of the good?" Well, it applies in spades to stocks. Investors don't need to find the perfect stock, just the better stock.

So let's compare McDonald's with two of its restaurant peers:

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It beats Burger King (NYSE: BKC) hands down. Cash flow from operations for Burger King in 2009 was just $311 million, and capital spending was only $204 million. And the company earned an ROIC of 9% in 2009. Not bad, but not even half as good as McDonald's 19.1%.

I've been getting a lot of e-mail from investment newsletters pushing Yum! Brands (NYSE: YUM) as a great fast food play because of the huge presence the company's Kentucky Fried Chicken brand has in China. Looking at the numbers, I can understand that recommendation: The company's ROIC is 21.2%.

But I have to disagree. Yum Brands generates a tiny fraction of McDonald's operating cash flow—just $1.4 billion in 2009—and runs a capital budget less than half that of McDonald's, at $800 million.

If you do the math, you discover that the larger cash flow and bigger capital budget compound faster over time, even at the lower ROIC.

But the comparison with Yum Brands and Burger King serves as a good reminder to long-term investors that ROIC isn't a static number. And changes in that number can be a reason for long-term investors and investors with other strategies to buy (or avoid) a stock.

So, for example, you can see signs of a Burger King turnaround in the improvement of ROIC from an average of 5.6% over the past five years to the more recent 9%.

Microsoft's (Nasdaq: MSFT) ROIC shows an interesting trend. From a five-year average of 28.6%—itself nothing to sneer at—the company's most recent ROIC has climbed to 33.9%.

Of course, ROIC can also move in the opposite direction, indicating a company that's in trouble and that investors might want to steer away from. BP, for example, shows a decline in ROIC from 14%, on average, over the past five years to 10% in the most recent year.

Yet a falling ROIC can also signal opportunity if an investor believes a company is ready for a rebound to something like an average return on capital. I pay special attention to this when the company in question is an asset-heavy, big capital spender. For example, the one-year ROIC for Transocean (NYSE: RIG) has tumbled to 9.7% from a five-year average of 12.4%. Considering how capital-heavy this offshore and deep sea oil and gas drilling company is, a return to even an average ROIC would produce huge earnings leverage.
 
I began this journey into ROIC in my February 25 column by arguing that the measure could help investors tell good mergers—those that promise to create shareholder value—from bad—those that destroy shareholder value.

I think ROIC can be even more useful in this slow economy when companies are so strapped for growth that buying it through mergers seems like a good idea. A company with an ROIC that's historically high but currently depressed is often an attractive target for a larger competitor that has managed to keep its ROIC high even through the recession.

So, for example, I'd say that Rockwell Automation (NYSE: ROK), with its five-year average ROIC of 14.2% and its recent 5.4% ROIC, is an attractive acquisition candidate for a company such as ABB (NYSE: ABB), with a five-year average 15.8% ROIC and a more recent 15.7%. It's a good time to snap up a struggling competitor with a product line that makes a great fit.

A final caveat or two: Don't ever fall so in love with any fundamental measure that you forget about price. The goal is to buy a great ROIC at a good price. And never forget about momentum. Many a long-term investor has said, "Oh, price doesn't matter, and I don't care if a stock goes down for a while because I'm going to hold long enough for it to come back."

The truth is that few of us can hang on to even the best of long-term stocks through a depressing slump that lasts months or years. (See this February 19 post for one depressing possibility.)

There's no point in putting your pain sensitivity to the test if you don't have to. Which is why I'm going to add ABB and Rockwell Automation to Jim's Watch List with this column and not make them immediate buys.

At the time of publication, Jim Jubak owned or controlled shares of the following companies mentioned in this column: Microsoft and Transocean.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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