XOM - Using Return On Capital Employed To Generate Alpha With Dividend Aristocrats

2023-06-22 11:28:35 ET

Summary

• Return on Capital Employed (ROCE) is a financial ratio that measures a company's profitability and efficiency in utilizing its capital to generate returns.
• Strategies that focus on investing in companies with high ROCE or significant improvements in ROCE have historically outperformed the overall market.
• ROCE should be incorporated into stock research as it is an important metric for evaluating the long-term performance of a business.

What is Return on Capital Employed?

The Return on Capital Employed ((ROCE)) is a financial ratio that can be used to measure the profitability of a company or how efficiently it utilizes its capital to generate returns. Companies that are able to generate high ROCEs are deemed as quality businesses and over long periods of time they tend to generate ample returns for patient investors. In 1994 Charlie Munger said the following.

"Over the long term, it's hard for a stock to earn a much better return that the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result."

What Mr. Munger is saying here is that if you hold a stock for a long period of time, the valuation at which you purchased shares has minimal impact on your total return, the more important factor is the rate of return the business is able to generate on its capital during the duration you own it.

So perhaps it's more important to pay attention to the ROCE of a business rather than its current valuation. I wanted to put this theory to the test and I decided that the Dividend Aristocrats would be a perfect universe of stocks to do so.

ROCE is a simple financial ratio that can be easily computed using the Income Statement and the Balance Sheet. The formula is as follows:

ROCE = EBIT / (Total Assets - Current Liabilities)

All of the Dividend Aristocrats span multiple market sectors and there are limitations to using the ROCE. Comparing ROCE across different sectors may not be an ideal application of this ratio. It also penalizes companies with large unused cash balances. For the sake of my test I applied the ROCE to all dividend aristocrats in the same fashion to see what type of results this financial ratio could generate. I tested 3 different theories using data from the last decade, they are all explained and summarized below.

Strategy 1: Highest ROCE

The first and simplest theory was to identify aristocrats with the highest ROCE in a given year and purchase them in the following year. I tested this theory starting in 2013 with the first purchases taking place in 2014, giving me a 9 year and 5 month test window through May 2023.

I also used the current list of dividend aristocrats (67) that have not all held this status since 2013.

The outcome was favorable for a handful of the highest rated aristocrats. The total return of investing equally in all 67 aristocrats was 167.89% or a CAGR of 11.03%. Investing in the top 5 aristocrats with the highest ROCE in the preceding year generated a total return of 196.68% or a CAGR of 12.24%. That's a 1.21% better CAGR or an almost 30% better long term total return. The top 10 aristocrats generated a total return of 191.84% or a CAGR of 12.05%. This was less favorable but still considerably better than investing in all of the aristocrats. Any further iteration of 5 more aristocrats did not generate a better total return compared to simply investing in all of the aristocrats.

The top 5 aristocrats with the highest ROCE outperformed all of the dividend aristocrats during 5 out of the 9 full calendar years and they are also winning in partial 2023.

Strategy 2: Biggest Improvement in ROCE

The second theory was to take the ROCE analysis a step further, instead of simply looking for the highest value I decided to look at the rate of improvement from year to year. In order to measure the first change in ROCE I needed to use both 2013 and 2014 values, therefore the return analysis had to be trimmed to the period January 2015 through May 2023 (8 years and 5 months). These results cannot be compared to the outcome from strategy number 1, instead they are measured against the returns generated by all of the dividend aristocrats during the same time period.

The total return of investing equally in all 67 aristocrats was 132.79% or a CAGR of 10.56%. Investing in the top 5 aristocrats with the biggest improvement in ROCE in the preceding year generated a total return of 242.03% or a CAGR of 15.73%. That's a 5%+ better CAGR or an almost 100% better long term total return. The top 10 aristocrats generated a total return of 164.39% or a CAGR of 12.25%. This was significantly less favorable but still better than investing in all of the aristocrats. The top 15 also produced a return superior to all of the aristocrats but with a very minimal margin. Any further iteration of 5 more aristocrats did not generate a better total return compared to simply investing in all of the aristocrats. Compared to strategy number 1, strategy number 2 proved to be substantially better.

The top 5 aristocrats with the biggest improvement in ROCE outperformed all of the dividend aristocrats during 6 out of the 8 full calendar years but they are underperforming in partial 2023.

Strategy 3: Biggest Improvement in ROCE and minimum ROCE threshold

The third and final theory I tested was a combination of the first two. Here I sought out to identify aristocrats that both improved their ROCE compared to the prior year and also met a minimum ROCE threshold. I tested all whole number percentage thresholds starting from 0% and going all the way to the highest ROCE found in the analysis. This test, similar to strategy number 2, spanned the time period between January 2015 and May 2023 (8 years and 5 months).

If you recall from the outcome stated for strategy number 2, all of the dividend aristocrats generated a total return of 132.79% or a CAGR of 10.56% during this test window. The best outcome for strategy number 3 was produced when applying an ROCE threshold of 11 or 15%. At the 11% ROCE cutoff the chosen aristocrats generated a total return of 263.72% or a 16.58% CAGR. The average count of aristocrats chosen per year was 25, with the fewest being 14 in 2021 and the highest being 37 in 2022.

The selected aristocrats outperformed all of the dividend aristocrats during 6 out of the 8 full calendar years and they are also winning in partial 2023.

At the 15% ROCE cutoff the chosen aristocrats generated a total return of 263.32% or a CAGR of 16.57%. The average count of aristocrats chosen per year was 20, with the fewest being 10 in 2018 and the highest being 32 in 2015.

The selected aristocrats outperformed all of the dividend aristocrats during 7 out of the 8 full calendar years and they are also winning in partial 2023.

Aristocrats With the Best ROCEs

Based on the latest trailing twelve month financial data the 5 aristocrats with the highest ROCE are:

Aristocrats With The Best Improvement in ROCE

Based on the latest trailing twelve month financial data the 5 aristocrats with the best improvement in ROCE are:

Number 3 is ADP, see output in section above.

For further details see: