‘Return on capital employed is the one KPI every board needs’

I want to focus on a metric that I have learned, sometimes to my cost, is of paramount importance in our industry – return on capital employed or ROCE, including derivatives such as cash return on investment or return on invested capital.

Despite its relevance and importance, almost nobody talks about ROCE. Practically no one reports it, analyses it and most interestingly uses it as the key driver of whether to buy a share of a company.

As the ex-head of JP Morgan’s retail franchise, I am astounded how few analysts focus on it given the accounting shenanigans and spurious ‘adjustments’ that now plague reporting of corporations’ financial performance.

The reason ROCE is so important is it shows that the management team are building a better business for its owners not just a bigger one. As a consequence, our preference is that management teams are not just owners in the business but that remuneration schemes driving further ownership are clearly linked to ROCE performance.

It is that metric and one other, free cash flow yield pre and post management’s strategic capital allocation, that drives company and therefore stock price performance in the long term in our view and it is these metrics we refer to vigorously in our True Public equities portfolio. It also tells you a lot about the skillset of your management team in terms of capital allocation and stewardship.

The reason ROCE is so important is it shows that the management team are building a better business for its owners not just a bigger one

Consider Moonpig for example. Moonpig is a clear online market leader, it has strong gross margins (above 60%) and EBIT margins (approximately 20%), it is growing at an attractive rate and delivers more than 30% post-tax return on capital employed.

Moonpig also offers investors an entry point where its free cash flow yield is more than 8% whilst delivering double-digit EBITDA growth. It has recently introduced a dividend that we would expect to progress in the years to come and initiated a share buyback programme as a mechanism for returning further cash.

One specific nuance to Moonpig is it has consistently generated above 120% of its profit after tax in cash flow as a result of strong working capital dynamics. This compares to 94% for the FTSE 250 index. Therefore, any lazy P&L valuation comparison to the ‘index’ is immediately wrong given the Moonpig owners receive much more cash than the market provides (35% to be exact).

The key point here is that this is a high-quality dominant franchise and every three to four years its management team would have built its owners a whole new Moonpig. All things being equal, the share price should deliver a similar return to its ROCE over the medium to long term.

Dunelm is another example of a well managed retailer that has consistently achieved a very attractive return on capital (averaging over 30% on a post-tax basis over the last six years). Crucially, management has also exercised good judgement with regards to the cash it has generated over the years, eschewing distracting or destructive M&A and returning excess capital to shareholders via regular special dividends. Investors have been duly rewarded with total returns compounding at a rate of 16% per annum from 2007 to 2024.

Market leaders have become global failures as such pursuits drag ROCE down to a level where it becomes value destructive rather than enhancing

Flipping the coin, consider a business that is achieving a post-tax ROCE of 5% versus its cost of capital of 8.5%. What this means in simple terms, every £1 the owners provided to its management team to invest, the management handed back just 5p versus 8.5p of cost.

This capital destruction adds up over time but sometimes it takes markets time to figure out the lower returns on incremental capital. This often happens as expansion and market share gains become more marginal in its core market or the business pivots into a market it knows little about and management, keen to keep the ‘growth’ music playing, pursues expansion with vigour.

Retail is littered with such tales given its inherently cyclical nature and the risk to management is exaggerated further if a careful eye is not kept on ROCE and incremental spend.

Market leaders have become global failures as such pursuits drag ROCE down to a level where it becomes value destructive rather than enhancing. The stock market, simplistically, places too great an emphasis on earnings per share growth or accretion (rather than return on capital and cash generation) and this frequently results in poor capital allocation decisions. Growth and value destruction are not mutually exclusive.

As Warren Buffett has observed: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed…and not the achievement of consistent gains in earnings per share.”

The truth is, if I had applied this wisdom in my twenties, I would have made significantly fewer mistakes. All management teams would do well to have this at the top of every board pack.