The 52-Week Low Formula: A Contrarian Strategy that Lowers Risk, Beats the Market, and Overcomes Human Emotion

Chapter 7Filter 3: Return on Invested Capital

Jacobian Inverse: I want to seek out and invest in industries and companies that have a knack for generating returns on capital less than their cost of capital. This will increase my chances of losing my total investment over time due to the erosion of shareholder value.

This leads to the correct way of thinking. If I want to increase the probability of compounding my investment, I will look at industries and companies that not only generate returns on capital over their cost of capital currently but have a knack for generating returns on capital in excess of their cost of capital over 10 years.

For a business to pass this filter it must achieve a minimum return on invested capital (ROIC) to ensure that the company is earning more than its cost of capital (COC). I am interested in identifying businesses that generate ROIC greater than their current COC. I also then study their long-term ROIC results to ensure that the company in question has a knack for achieving ROIC greater than its COC over a 10-year cycle.

The concept of ROIC is quite intuitive, as it is the percentage return an investor earns on his invested capital in the company. However, ROIC does not mean much unless you compare it to a company’s COC. If a company is earning 12 percent ROIC and its COC is 10 percent, it is said to be adding economic value. If a company’s COC is 9 percent and its ROIC is 7 percent, it is said to be destroying economic value because every ...