Diploma Plc, a supplier of specialist technical products, issued its preliminary results for the year to the end of September today (20/11/2017). This company may not be a household name and hence can fall under the radar of investors. But it has demonstrated a consistent track record in recent years. Today was no exception. Adjusted earning per share were up 19%, and revenue was up 18%, although a significant proportion of the improvement was down to currency movements (they are a very international business and the falling pound has no doubt helped). The share price has risen 10% on the day at the time of writing.
But why do I like this company? Apart from the track record, the directors have a strong focus on obtaining a good return on capital both from their on-going businesses and from acquisitions. But which measure do they use (Return on Equity – ROE, Return on Assets – ROA, or Return on Capital Employed – ROCE. These are all useful measures, and you can no doubt look up their definitions on the internet. But they use none of the above. They actually report “Return on Adjusted Trading Capital” – ROATCE. This they report as improved to 24% (their target is to exceed 20% which they have beaten in the last five years – that’s certainly the kind of figure I like to see).
How do they calculate this figure? I quote from the announcement: “A key metric that the Group uses to measure the overall profitability of the Group and its success in creating value for shareholders is the return on adjusted trading capital employed (“ROATCE”). At a Group level, this is a pre-tax measure which is applied against the fixed and working capital of the Group, together with all gross intangible assets and goodwill, including goodwill previously written off against retained earnings.”
Personally, I don’t think one measure of return on capital is particularly better than another. Return on Assets is good enough for me although it certainly helps that the company has added back write-offs of goodwill from past acquisitions to save one working it out for oneself. For a company that does repeated acquisitions, these “disappearing” assets are worth bearing in mind. Return on Equity might be considered by some as the most important for equity investors, but using that as a target by management can result in risky behaviour such as gearing up with debt. Bank directors were often keen to talk about that number before the 2008 crash.
Why is return on capital so important? Because when one invests in a company, you are investing in the expectation of a future return. How much they can generate in returns from the assets under their management is a key measure (that’s ignoring the profits from investment from getting a greater fool to buy your shares in a game of “pass the parcel”). I learned this was the best measure of the quality and performance of a company when I went to business school, and I never forgot it when I ran a business. In the modern world, it can be easy to borrow capital and blow it on expansive plans. This can help the management increase their salaries. But for equity investors, it dilutes your returns and you lose the benefit of compounding the retained profits.
The best, and shortest book, that explains this in layman’s terms is Joel Greenblatt’s “The Little Book That Beats The Market”. He uses return on capital (as he defines it) in a calculation of a “Magic Formula” for success. But of course using a simplistic formula has its dangers. If everyone followed it, prices might be driven up to unreasonable levels on the stocks chosen by such a formula. In addition I just looked at the stock list that Stockopedia suggests would be “buys” using the Magic Formula. It results in a mixed bag of shares. For example, it includes Safestyle which I also own when that company’s share price has been falling of late due to concerns about the retail market for large general merchandise items (they sell replacement windows). It might be a “BUY” now but it could also be a share where you could wait a long time for it to return to favour. So the moral is, use return on capital as one measure of the merit of a company, but look at other factors also. In addition, bear in mind that sometimes the market can favour other companies, such as those with little profits in a go-go bull market, or those with massive, if underutilised, assets in a gloomy bear market. So the Magic Formula is best applied to a basket of shares and you might need patience over some years to see the benefits realised.
Lastly, financial numbers do not tell you everything about a company. The historic numbers can be inflated by clever, or false accounting. And they can ignore major strategic or regulatory challenges that a company faces that might not be reflected in historic numbers.
But a company whose return on capital is low is certainly one I like to avoid. It is also helpful when the management talk about return on capital as having importance in their business strategy, and Diploma certainly do that. I consider that a positive sign because if they stick to it, then it should ensure the overall financial profile of the company remains positive and that profits will grow.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )