Bullbear Buffett

Wednesday, 3 June 2009

The Right Rate of Return on Total Capital (ROTC)

Problem with ROE

The problem with looking at high rates of return on shareholders' equity is that some businesses have purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors. Thus, you will find companies in a price-competitive business, like General Motors, reporting high rates of return on shareholders' equity. To solve this problem, Warren Buffett looks at the return on total capital (ROTC) to help him screen out these types of companies.

ROTC

ROTC is defined as the net earnings of the business divided by the total capital in the business. (Total capital = Equity + Long-Term Debts + Short-Term Debts).

Warren Buffett is looking for a consistently high rate of ROTC, AND, a consistently high rate of ROE.

General Motors' return on equity for the 10-year period (1992 to 2001) was an average annual rate of 27.2%, which is very respectable but suspect because of the 0% return in 1992. Its total return on capital (ROTC) for the 10-year period shows a different story. Its 9.5% average is not enticing. Compare this to H&R Block, which logged in an average annual rate of ROE of 21.5% and an average annual total return on capital (ROTC) of 20.7%.

Take Home Message

Companies with a durable competitive advantage will consistently earn both a high rate of ROE and a high rate of return on toal capital (ROTC). Again, the key word is CONSISTENT.
Companies in a price-competitive business, will typically earn a low rate of ROTC.
Warren Buffett looks for a consistent ROTC of 12% or better.

Also Read:
Return on Total Capital (ROTC)
The Right Rate of Return on Total Capital (ROTC)
ROA of Banks, Investment Banks and Financial Companies
Using ROTC Where the Entire Net Worth of the Company has been taken out
ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

Summary

In essence, the passage warns against relying solely on Return on Equity (ROE), as it can be artificially inflated by share buybacks or dividends, making a company look more efficient than it is. The solution is to also analyze Return on Total Capital (ROTC), which measures profitability against all capital invested (equity + debt), providing a clearer picture of true operational efficiency.

Key Conclusions:

A high ROE can be deceptive. Always check if it's driven by a shrinking equity base rather than growing earnings.
ROTC is the reality check. A genuinely great business will show both a high ROE and a high ROTC.
Consistency is the hallmark of quality. Companies with a durable competitive advantage, like H&R Block in the example, will post consistently high numbers for both metrics.
Use them together. By demanding both a consistently high ROE and a consistently high ROTC (Buffett's benchmark is 12%+), an investor can screen out financially engineered mirages and identify truly exceptional, profit-generating machines.

Click here to read an expanded version:

https://myinvestingnotes.blogspot.com/2025/11/warren-buffetts-strategy-uses.html

Return on Total Capital (ROTC)

Return on Total Capital (ROTC)

Total Capital = Long-Term Debt + Short-Term Debt + Equity

Return on Total Capital = Net Earnings / Total Capital

The calculation of ROTC is illustrated here: http://files.shareholder.com/downloads/SYY/654431717x0x226567/EC4E58FF-E488-4CBB-A19B-570745E81387/Non-GAAP%20ROTC%20calculation.pdf

It is important to note the numerator and the denominator used in calculating ROTC by various other groups.

Value Line defines the return on total capital as "annual net profit plus 1/2 of annual long-term interest divided by the total of shareholders’s equity and long term debt." Shareholders’s equity is the net worth of the company.
Some defines total capital as equity plus long-term debt.

Also Read:
Return on Total Capital (ROTC)
The Right Rate of Return on Total Capital (ROTC)
ROA of Banks, Investment Banks and Financial Companies
Using ROTC Where the Entire Net Worth of the Company has been taken out
ROTC, ROA, ROE and Buffett's Durable Competitive Advantage

Return of capital

Return of capital

A distribution of cash resulting from depreciation tax savings, the sale of a capital asset or securities, or any other transaction unrelated to retained earnings.

Return on Total Assets

Return on Total Assets

Abbreviated as ROTA, refers to a measure of how effectively a firm uses its assets.

Calculated by (income before interest and tax) / (fixed assets + current assets).

Return on Assets

Return on Assets

Abbreviated as ROA, refers to a measure of a firm's profitability, equal to a fiscal year's earnings divided by its total assets, expressed as a percentage.

Return on Investment

Return on Investment

Abbreviated as ROI, refers to a measure of a corporation's profitability, equal to a fiscal year's income divided by common stock and preferred stock equity plus long-term debt.

ROI measures how effectively the firm uses its capital to generate profit; the higher the ROI, the better.

Return on Equity

Return on Equity

Abbreviated as ROE, refers to a measure of how well a firm used reinvested earnings to generate additional earnings, equal to a fiscal year's after-tax income (after preferred stock dividends but before common stock dividends) divided by book value, expressed as a percentage.

It is used as a general indication of the firm's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. investors generally look for firms with returns on equity that are high and growing.

Return on Invested Capital

Return on Invested Capital

ROIC is a calculation used to assess the profitability of a firm by determining how well capital is being allocated into its operations.

By comparing a firm's Return on Investment Capital with its Cost on Capital (WACC), it can be deduced whether or not capital is being used effectively.

The calculation for ROIC is as follows:
Return On Investment Capital - ROIC = (Net Income - Dividends) /(Total Invested Capital)
(typically expressed as a percentage)

A downside of the ROIC calculation is that it does not explain where returns from capital are generated from (i.e. whether they came from one source or from continuing operations). This can lead to misguiding figures that do not accurately explain the overall profitability of a firm.

Return on Capital Employed

Return on Capital Employed

Abbreviated as ROCE. A measure of the returns that a firm is realizing from its capital.

Calculated as profit before interest and tax divided by the difference between total assets and current liabilities.

The resulting ratio represents the efficiency with which capital is being utilized to generate revenue.

Return on Capital

Return on Capital

Abbreviated as ROC, refers to a measure of how effectively a firm uses the money (borrowed or owned) invested in its operations.

Return on Invested Capital is equal to the following:
= net operating income after taxes / [total assets minus cash and investments (except in strategic alliances) minus non-interest-bearing liabilities].

If the Return on Invested Capital of a firm exceeds its WACC, then the firm created value.
If the Return on Invested Capital is less than the WACC, then the firm destroyed value.

Where Warren Buffett Discovers Companies with Hidden Wealth

Warren Buffett has discovered 4 basic types of businesses with durable competitive advantages:

1. Businesses that fulfill a repetitive consumer need with products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business. This is a huge world that includes every thing from cookies to panty hose.

2. Advertising businesses, which provide a service that manufacturers must continuously use to persuade the public to buy their products. This is a necessary and profitable segment of the business world. Whether you are selling brand-name products or basic services, you need to advertise. It's a fact of life.

3. Businesses that provide repetitive consumer services that people and businesses are consistently in need of. this is the world of tax preparers, cleaning services, security services, and pest control.

4. Low-cost producers and sellers of common products that most people have to buy at some time in their life. This encompasses many different kinds of businesses from jewelry to furniture to carpets to insurance.

PETRONAS Dagangan Berhad

Business Summary

PETRONAS Dagangan Berhad engages in the marketing of petroleum products and operation of service stations. The company markets a range of petroleum products, including motor gasoline, aviation fuel, kerosene, diesel, fuel oil, bunker fuel, lubricants, liquefied petroleum gas (LPG), and asphalt to motorists, households, airlines, shipping lines, transporters, plantations, processing and manufacturing plants, power stations, and commercial enterprises in Malaysia. It markets its products directly to customers, as well as through its network of service stations, LPG dealers, and industrial dealers. The company was incorporated in 1982 and is based in Kuala Lumpur, Malaysia. PETRONAS Dagangan Berhad is a subsidiary of Petroliam Nasional Berhad.

Exchange
Bursa Malaysia
Company Name
Petronas Dagangan
Stock Code
5681
Sectors
Paid Up Capital *
MYR 993.45
Par Value
- (as at 2008-03-31)
Market Cap *
MYR 7,848.29 (based on value of 7.9000 per share)

Performance (as at 2008-03-31) *
Total Assets:
MYR 8,609.61
Intangible Assets:
MYR 23.40
Revenue:
MYR 22,301.58
Earnings Before Interest and Taxes:
MYR 908.16
EPS (Basic) Inc. Extraordinary Items:
MYR 0.67
PE Inc. Extraordinary Items:
11.86
EPS (Basic) Exc. Extraordinary Items:
MYR 0.67
PE Exc. Extraordinary Items:
11.86
Net Income:
MYR 661.67
Dividends - Common/Ordinary:
MYR 332.91
Dividends - Total:
MYR 332.91
Goodwill:
MYR 23.40
Minority Interest:
MYR 46.73
Reserves:
-
Return On Assets:
7.69%
Return On Equity:
16.89%
Shareholder's Equity:
MYR 3,917.42

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Historical 5 Yr PE 11.3 to 15.8

Historical 10 Yr PE 9.8 to 14.0

Present PE based on 7.90 = 11.9

Earnings Yield = 8.4%

DY = 4.24% (MYR 332.91/MYR 7,848.29 )

ROTC = 16.89%

Between the end of 1998 and the end of 2007:

total earnings were $3.129 a share,
total dividends were $1.09 a share and
retained earnings were $2.039 per share ($3.129 - $1.09 = $2.039) to add to its equity base.
the company's per share earnings increased from $0.216 a share to $0.645, the difference was $0.426 a share.
return on retained capital/earnings RORC was 0.426/203.9 = 21%

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I like this company. It is a company that I can relate to. Petronas service stations are sprouting all over the place. It has a virtual monopoly supplying energy to certain niche sectors. Its revenue has been good and profitable. It generates a lot of free cash flow. It has been reinvesting into its business regularly, and the return on the equity is a 16.89% which is one of the my investing criteria. Its ROTC is 16.89%, as this company has no borrowings. Its earnings yield is at least 2x that of the risk free FD interest rate. Its dividend has been increasing over the years and I do not anticipate any decrease in future dividend despite the poor economic environment. In fact, it is predicted that the future earnings should continue to show an uptrend, and growth is encouraging with new Petronas stations opening up in new locations funded by self generated profit. The company is debt free.

At 7.90, its PE of 11.86 is at the lower end of its historical 5 year and 10 year PEs. There is safety of capital with a reasonable potential for moderate return (low risk with moderate return) for those with a longer term investing horizon. Just loudly sharing my view, you will need to make your own investing decision based on your personal assessment.

Opportunities in Calamities

Bad-news situations come in 5 basic flavors:

Stock market correction or panic
Industry recession
Individual business calamity
Structural changes
War

The perfect buying situations is created when a stock market correction or panic is coupled with an industry recession or an individual business calamity or structural changes or a war.

Company Recovery after a correction, panic or bubble-bursting situation.

1. Companies with durable competitive advantage

a) Correction or panic during a bull market: Any company with a durable competitive advantage will eventually recover after a market correction or panic during a bull market.

b) Bubble-bursting situation: But beware: In a bubble-bursting situation,during which stock prices trade in excess of 40 times earnings and then fall to single-digit PEs, it may take years for them to fully recover. After the crash of 1973-74, it took Capital Cities and Philip Morris until 1977 to match their 1972 bull market highs. It took Coca-Cola until 1985 to match its 1972 bull market high of $25 a share. On the other hand, if you bought during the crash, as Warren Buffett did, it didn't take you long to make a fortune.

2. Companies of the price-competitive type

Be warned: Companies of the price-competitive type may never again see their bull market highs, which means that investors can suffer real and permanent losses of capital if they buy them during a bubble.

Take Home Lessons

The bull/bear market cycle offers many buying opportunities for the selective contrarian investor.

The most important aspect of these buying opportunities is that they offer the investor the chance to buy into durable-competitive-advantage companies that have nothing wrong with them other than sinking stock prices.

The herd mentality of the shortsighted stock market creates buying opportunities for both you and Warren.

After the bubble bursts

After the bubble bursts, a couple of things can happen.

The first is that the country will slip into a recession. You will see reports of layoffs and falling corporate profits. The Fed will actively drop interest rates, which will, in a year or so, respark the economy. The immediate impact of lower interest rates will be an increase in car and house sales. Seeing this, investors will anticipate the revival of the economy and jump back into the market. This time, though, they will be investing in the big names -like GE and Hewlett-Packard - that have earnings. They won't chase after the once-hot bubble stocks. Those stocks are dead until they begin earning money.

If the Fed's dropping of interest rates doesn't revive the economy, the country will slip into a depression and stock prices will really go to hell. It happened in the early 1920s, and the ensuing crash made 1929 pale in comparison. If that happens, you are in a major recession/depression and the stock market will be giving companies away. Value investors, including Warren, dream of such an opportunity, while the rest of the world dreads it. That's because Warren is a selective contrarian investor with a ton of cash and a long-term perspective.

However, Warren Buffett does not buy or sell baseed on what he thinks the market will do. He is price-motivated. This means that he will only invest when the price of the company makes business sense.

My 18 points guide to Successfully compounding your money in Stocks

Be a good stock picker.
Think as a business owner.
Always look at value rather than the price. Do the homework.
Buy and hold is alright for selected stocks.
Compounding is your friend, get this to work its magic.
Mr. Market is there to be taken advantage of. Do not be the sucker instead. BFS;STS.
Always buy a lot when the price is low.
Never buy when the stock is overpriced.
It is alright to buy when the selected stock is at a fair price.
Phasing in or dollar cost averaging is safe for such stocks during a downtrend, unless the price is still obviously too high.
Do not time the market for such or any stocks.
By keeping to the above strategy, the returns will be delivered through the growth of the company's business.
So, when do you sell the stock? Almost never, as long as the fundamentals remain sound and the future prospects intact.
The downside risk is protected through only buying when the price is low or fairly priced.
Tactical dynamic asset allocation or rebalancing based on valuation can be employed but this sounds easier than is practical, except in extreme market situations.
Sell urgently when the company business fundamental has deteriorated irreversibly.
You may also wish to sell should the growth of the company has obviously slowed and you can reinvest into another company with greater growth potential of similar quality. However, unlike point 16, you can do so leisurely.
In conclusion, a critical key to successful investing is in your stock picking ability.

http://myinvestingnotes.blogspot.com/2012/07/my-18-points-guide-to-successfully.html

11 Lessons From Peter Lynch

Peter Lynch taught me:

1. Behind every stock is a company. Find out what it’s doing.
2. Never invest in any idea you can’t illustrate with a crayon.
3. Over the short term, there may be no correlation between the success of a company’s operations and the success of its stock. Over the long term, there’s a 100% correlation.
4. Buying stocks without studying the companies is the same as playing poker – and never looking at your cards.
5. Time is on your side when you own shares of superior companies.
6. Owning stock is like having children. Don’t get involved with more than you can handle.
7. When the insiders are buying, it’s a good sign.
8. Unless you’re a short seller, it never pays to be pessimistic.
9. A stock market decline is as predictable as a January blizzard in Colorado. If you’re prepared, it can’t hurt you.
10. Everyone has the brainpower to make money in stocks. Not everyone has the stomach.
11. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.

Lynch’s advice had a profound effect on my stock market approach. He taught me that investment success isn’t the result of developing the right macro-economic view or deciding when to jump in or out of the market. Success is about researching companies to identify those that are likely to report positive surprises.

Capital Expenditure

A great company with a Durable Competitive Advantage will have a ratio of Capital Expenditures to Net Income of less than 25%. Less is better.

Capital Expenditures are expenses on:
- fixed assets such as equipment, property, or industrial buildings
- fixing problems with an asset
- preparing an asset to be used in business
- restoring property
- starting new businesses

A good company will have a ratio of Capital Expenditures to Net Income of less than 50%.

A great company with a Durable Competitive Advantage will have a ratio of less than 25%.

Less is better.

Benjamin Graham's 113 Wise Words

The true investor scarcely ever is forced to sell his shares, and at all times he is free to disregard the current price quotation. He need pay attention to it and act upon it only to the extent that it suits his book, and no more. Thus the investor who permits himself to be stampeded or unduly worried by unjustified market declines in his holdings is perversely transforming his basic advantage into a basic disadvantage. That man would be better off if his stocks had no market quotation at all, for he would then be spared the mental anguish caused him by other persons' mistakes of judgement."

Philip Fisher's Wise Words

"The refusal to sell at a loss, while completely natural and normal, is probably one of the most dangerous in which we can indulge ourselves in the entire investment process.

More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason. If to these actual losses are added the profits that might have been made through the proper reinvestment of these funds if such reinvestment had been made when the mistake was first realized, the cost of self-indulgence becomes truly tremendous."

(Common Stocks and Uncommon Profits)

The Ultimate Hold-versus-Sell Test

Here is the overriding primary test, followed by observations on why it is so critically important:

Knowing all that you now know and expect about the company and its stock (not what you originally believed or hoped at time of purchase), and assuming that you had available capital, and assuming that it would not cause a portfolio imbalance to do so, would you buy this stock today, at today's price?

No equivocation. Yes or no?

Answers such as maybe or probably are not acceptable since they are ways of dodging the issue. No investor probably buys a stock; they either place an order or do not.

Here is the implication of your answer to that critical test: if you did not answer with a clear affirmative, you should sell; only if you said a strong yes, are you justified to hold.

Some thoughts on Analysing Stocks (KISS)

Ideally a stock you plan to purchase should have all of the following charateristics:

• A rising trend of earnings dividends and book value per share.
• A balance sheet with less debt than other companies in its particular industry.
• A P/E ratio no higher than average.
• A dividend yield that suits your particular needs.
• A below-average dividend pay-out ratio.
• A history of earnings and dividends not pockmarked by erratic ups and downs.
• Companies whose ROE is 15 or better.
• A ratio of price to cash flow (P/CF) that is not too high when compared to other stocks in the same industry.

Margin of Safety Concept: Stocks should be bought like groceries, not like perfume

The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.

Chapter 20 - “Margin of Safety” as the Central Concept of Investment

A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?