ROIC vs Returns

My team is comparing ROICs of three different companies in the same industry over a multi-year period (8-10 years). We have found a weaker correlation between the stocks’ returns and the average ROIC over the same period, where the company with the highest ROIC has actually performed the worst in the market. Beyond incorrect calculation, what are some of the potential reasons for this?

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My thoughts:

  1. ROIC is only half the story with growth being the other driver. You know that a high ROIC business with low growth gets only marginal benefits from further increasing its ROIC & should be focusing on growth, and vice versa for a high-growth business with a low ROIC. So the best spot for value creation is a goldilocks zone of good ROIC & good growth rather than one extreme. So if we're talking 2 companies with very good (say 25%) ROICs & good growth and one company with a very very good (30-35%+) ROIC but low growth, it might make sense the former are creating more value. 
  2. If you're looking only at historical ROIC it may be that investors have expectations that ROIC is going to inflect up for the lower ROIC businesses, or don't believe that the high ROIC business can sustain its edge. (or equally you might realize the names are under/overvalued based on their track record & the market isn't facing up to reality). I'm not a semis guy but an example I can think of is TSMC, to my uninitiated brain at least it screens as offering a pretty nice ROIC/structural growth profile for what it's trading on vs competitors but you have the unique risk of a Chinese invasion hanging over your 5-10 year investment horizon
  3. If you're taking adjusted profit to calculate NOPAT you could very well mistaking the company with the lowest earnings quality (e.g. most juiced by adjustments) as having the highest ROIC. Also make sure you punish them for share based comp in the NOPAT. I take reported operating profit & only 'exceptionals' I'll usually allow them are some components of PPA I think would be double charging.
  4. On the topic of adjustments, even if you take reported profit you may be allowing lower quality businesses to get away with it on the invested capital side by aggressively amortizing acquired intangibles or writing down their goodwill (which flies under everyone's radar since this usually gets removed from adjusted metrics). 

If you give more color on the ROIC components for each company other things might come to mind. 

ROIC is the gold standard & what you should be mainly using, and it also has the huge advantage that it pairs directly with WACC to tell you if a company is meeting its cost of capital. ROCE is a close variant you'll often see management team's using to benchmark their own performance but as an investor I would stick with ROIC. 
ROE shouldn't be the main metric you rely on since it gets massively distorted by how much debt a company takes on (e.g. is this really a business that's creating more value than peers or just one that's levered itself up to its eyeballs?), but it doesn't hurt to use it alongside ROIC since a sensible amount of debt can indeed improve returns for the equity holders. 

The only thing ROA has going for it is that it's standardized & easier to calculate (since both net income and total assets are reported numbers vs 'theoretical' values like NOPAT and IC that you won't find anywhere in an annual report). Maybe other people have a different view on this though. 

ROIC just overrated and noisy IMHO. I know a lot of professors and value guys treat it as a more insightful metric but I just don’t see it.

There’s so many ways to imagine that kind of a ratio misleading you, but maybe the simplest way is to think of a high growth tech company.  It’s market cap today is a lot higher than it’s IC.  Now let’s say over the next year it generates a disappointing level of EBIT (20% below expectation) on poor growth.  It’s market cap tanks because all the future growth expectation is reduced as a result of the poor growth & low EBIT.  Failed growth story, bad stock.

But ROIC will still be high because that weak EBIT was a high fraction of IC. 

It’s just a screwy metric, I understand what it’s proponents are trying to get at but it’s really not too useful.  

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