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Legg Mason
Legg Mason

ROIC Patterns and Shareholder Returns

January 22, 2008

Legg Mason study on Sorting Fundamentals and Expectations: Our recent piece, “Death, Taxes, and Reversion to the Mean” , aimed to provide context for analysts building financial models by documenting return on invested capital (ROIC) patterns for a large sample of companies. But the report was silent on the question most relevant for investors: Does an understanding of ROIC patterns help with stock picking? This piece addresses that question.

Three main points emerged from the analysis of ROIC patterns. First, analysts need to consider the lessons of history when modeling rather than approaching each model as unique. Analysts should view the experience of a large sample of companies as a rich reference class. Second, the empirical evidence shows ROICs tend to revert to the mean, a level similar to the cost of capital. Randomness plays an important role in the mean-reversion process. Finally, some companies do deliver persistently high or low results beyond what chance would dictate. Unfortunately, pinpointing the causes of persistence is a challenge.

In an efficient market, stock prices are an unbiased estimate of value. Market efficiency does not say that stock prices are always right; it only asserts that prices are not wrong in a systematic way. For this analysis, we combined our data on ROIC patterns with total shareholder returns to see whether there is a consistent way to generate excess returns.

Buy the Best, Sell the Rest

Investment pros often recommend buying good businesses. So we started our total shareholder return investigation by analyzing the returns from equal-weighted portfolios based on 1997 ROIC quintiles (our data are from 1997 through 2006). The first quintile represents the 20 percent of the companies with the highest ROICs, while the fifth quintile comprises the worst-ROIC companies. Exhibit 1 shows the annual total shareholder returns (TSR) and the combination of returns and standard deviations for each portfolio from 1997 through 2006. Appendix A provides the full distributions. To provide some context, the 1,000-plus companies in this sample came from the Russell 3000, which provided an 8.6 percent return during this period. Appendix B reconciles the index’s returns with those from our sample

Read the complete study

About the author:

Legg Mason
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 3.8/5 (5 votes)


Dr. Paul Price
Dr. Paul Price - 9 years ago    Report SPAM
Interesting to reaq but unusable for investment purposes.
Kbodawala - 9 years ago    Report SPAM
The belief that ROIC will always revert to the mean is naive. History should not be your guide. The current competitive landscape of the industry should be considered. Remember always that ROIC is a measure of profitablity as it relates to invested capital. So therefore companies that have barriers to entry or some competitive advantage will prevent competitors from displacing them. Without such "moats" a companies once high ROIC will fall as competitors will enter the areana and price wars will develop leading neither competitor to post high ROIC. The formula for ROIC is net operating profits in the numerator and invested capital in the denominator. The numerator is made up of profit margin times growth. Therefore if competition increases growth will slow and profit margins fall. So a once mighty ROIC will fall to the cost of capital in which case the company is no longer generating economic profits. When this happens it should leave the industry. So that is why Buffet and other investors emphasize investing in companies with developed and defendable moats. The depth and lenght of this hypothical moat will tell you how long a company can keep competitors at bay. So to summarize look at the competitive position of the company this will tell you if its high ROIC is sustainable.

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