"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite. That is, consistently employ ever-greater amounts of capital at very low rates of return."
Consistently superior return on capital is a strong indicator of a durable competitive advantage and sustainable value creation. Nonetheless, an attractive return itself would not make the business great without the ability to reinvest at least a portion of its earnings at a similarly attractive rate of return. In our opinion, such so-called compounding machines are a great source of long-term alpha, even if purchased at a bit of a premium.
Assuming that the business has a wide moat and predictable cash streams, investors may want to look into the industry prospects, the possible sources of secular growth and the management’s growth strategy for such companies. In the meantime, they should also be interested in gauging the recent rate of compounding returns.
At Urbem, we employ a couple of different approaches to give us a sense of what this number would be, but the most straightforward indicator we have found is the “incremental return on equity,” which is the increase in annual earnings over the increase in book value over a certain period.
To illustrate, let’s take a look at two market-leading businesses in their respective arenas, Rollins (ROL, Financial) (a premier provider of pest and termite control services) and Monster Beverage (MNST, Financial) (a developer of energy drinks).
Rollins leverages its reputation for quality and safety to ensure its top market position in a relatively price-inelastic industry. It primarily adopts an acquisition-driven strategy to reinvest in the consolidation of the fragmented market, both domestically and internationally.
Monster Beverage mainly takes advantage of consumers’ mind share of its flagship brand to fend off competition and gain market share against peers like Red Bull and Rockstar. Its business model is built upon outsourced manufacturing and distribution, which enables the company to expand geographically in an asset-light way. The business also emphasizes investing in innovation pipelines to extend its product lines and fuel long-term growth.
Both Rollins and Monster Beverage earned super-normal returns on equity capital consistently over the past decade, as displayed below. For the last three years, in particular, Rollins generated an average 30% return on equity, slightly outperforming Monster Beverage's 26%.
Nevertheless, when it comes to the recent three-year incremental return on equity, Monster Beverage’s 68% rate of return is far more attractive than Rollins’ 16%, which is even below its return on equity for any single year over the last decade. This may hint that there can be better projects at Monster Beverage to put new equity capital into use and send a warning signal with regards to the room for further quality growth at Rollins. It is worth noting that Rollins pays out nearly two-thirds of its profit as the dividend, while Monster Beverage retains all its earnings to reinvest. Both companies repurchase shares opportunistically from time to time.
Based on the difference in incremental return on equity, investors should be able to gain some visibility into how well the company has been compounding its shareholder value and how well the management has been allocating capital.
Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We own shares of Rollins and Monster Beverage.
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