As a value investor, we are sure you also believe that buying bad companies at very low prices is a perfectly viable strategy, provided the companies don’t go bankrupt. But what about buying good companies that generate a high return on invested capital without seeing if the companies are over- or undervalued? A lot of investors believe that this is a way to identify market-beating investments as it measures how effectively a company invests shareholder's money.
Previous research shows this is not the case. In his book, ‘What works on Wall Street’, in chapter 14, James O'Shaughnessy tested return on equity using a decile analysis. He found that stocks in the top decile (highest return on equity) were, on average, only mediocre investments underperforming the market. Surprisingly, deciles two and three did considerably better than their market.
We defined ROIC as the past 12-month operating income divided by the sum of net working capital (current assets minus excess cash minus current liabilities) and net fixed assets (total assets minus current assets minus intangible assets). We tested ROIC over one year, as well as the 5-year average, and this is what we found.
12 Month ROIC
5 Year Average ROIC
Similar to the above-mentioned study, we also found ROIC to have a mixed influence on the returns during the test period. Companies with the highest ROIC (Q1) did not always perform the best, and there was no linearity in returns from Q1 to Q5. Thus you can safely say that a great company does not automatically make for a great investment.