Profitability measures such as return on capital employed (ROCE) are a useful way to gauge the “quality” of a company. If a company can generate consistent returns on capital far above the cost of capital, that alone suggests some kind of durable competitive advantage or economic moat.
If the company didn’t have a competitive advantage then other companies would copy what it was doing in order to earn those same high rates of return. That in turn would increase competition and decrease profit margins and profitability.
As a defensive value investor, I’m interested in combining the defensive investor’s love of relatively defensive, high-quality companies, with the value investors’ preference for low prices.
One way to find such companies is to look at very high-quality companies, using measures such as profitability or return on capital employed, and then weed out the ones that appear to be too expensive.
In an effort to do that, here are the current top 10 companies from my stock screen as measured by ROCE:
ROCE in this context is in fact the 10-year median net ROCE, where net ROCE is ROCE calculated using post-tax profits rather than operating profits. Doing it that way means that interest payments are factored into the result, so companies with large debt and interest obligations typically have lower net ROCE scores.
Every one of those 10 companies has a 10-year unbroken record of dividend payments and has produced a 10-year net profit as well (i.e. total profits were more than total losses). But it is possible to be far more selective.
Excluding expensive shares
Generally, I don’t like to invest in anything where PE10 (share price to 10-year average earnings ratio) is greater than 30. In the table, you can see the stocks that fall above that level as their PE10 value is highlighted in bright red.
So using that criterion Micro Focus International, Next, Telecom Plus, Domino’s Pizza UK & IRL and Rotork would be considered too expensive, regardless of how quickly they were growing (the Growth column) or how high the consistency or quality of their growth was (the Quality column).
Where PE10 is coloured light red (or pink) its value is less than 30 but higher than the market average, i.e. the FTSE 100, which currently has a PE10 ratio of 15.
So most of these stocks are more “expensive” than the market, but that’s reasonable and to be expected because, quantitatively at least, they are all “better” than average companies. In other words, they have all grown faster and more consistently than the market as a whole (any value in the stock screen table which is better than the FTSE 100 equivalent is coloured green).
Focusing on the cheapest, most profitable dividend-paying shares
From this group of highly profitable dividend-paying shares, Admiral stands out.
It has a dividend yield of 6.5%, including the “special” dividend which the company has paid out every year since it joined the London Stock Exchange. It has grown at almost 13% a year, with 87.5% consistency and has no borrowings.
It also has a ROCE figure of 53.73% in the table, although as it’s an insurance company that figure is actually for return on equity (ROE) because ROE makes more sense than ROCE due to the structure of insurance company balance sheets.
Admiral does “cheat” slightly in that its amazing profitability is driven to a large extent by a heavy reliance on reinsurance (taking out insurance on a proportion of the risks the company has insured) and coinsurance (sharing risks with other insurers). However, as far as I can see it still appears to be a well-run business.
In De La Rue’s case, the dividend has recently been almost halved, while PayPoint may have to pay an additional £1m to £2m in VAT, which will negatively impact its current adjusted post-tax profits, which are about £35 million.
While I cannot say which of these stocks will do well in the future, I can say that each of these businesses has produced exceptionally high returns on the capital employed within their businesses.
In many cases, it’s likely that those outstanding results were driven by some sort of sustainable competitive advantage, which is exactly the sort of thing sensible investors should look for.