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  1. Home
  2. / Investing

Using Return on Capital to Find Bargains

Look for stocks that are lagging their 10-year average ROC.
By TIM MELVIN Jul 22, 2014 | 04:00 PM EDT
Stocks quotes in this article: RDC, AAWW, TWMC

While I was down at the beach this past weekend, I got a chance to read a new book on value investing that was highly recommended by a couple of friends: Excess Returns: A comparative study of the world's greatest investors, by Frederik Vanhaverbeke does not really break any new ground, but it is an excellent, very in-depth review of the value-investing thought process and practices. One section dealt extensively with return on capital, a metric much favored by other successful investors like Joel Greenblatt and Mark Spitznagel among others. In fact, it is one of the linchpins of Greenblatt's magic formula for stocks that is widely used by many individual investors.

There are a couple o definitions of return on capital out there, but I will simply use the one that Greenblatt favors. It seems to have worked pretty well for him, and he is much smarter than I am, so we will stick with his methodology. He defines return on invested capital as earnings before interest and taxes divided by net fixed assets plus working capital. Using enterprise value rather than just the market capitalization retakes into account the entire capital structure including debt, so it is a more accurate picture of actual returns on all the cash invested in the business.

In his magic formula Joel Greenblatt uses earnings yield to find bargains. As an asset-based guy, I decided to take a look and see what non-financial stocks traded at a discount to asset value and were earning a decent return on capital. Consistent with all value-oriented screens we have run in the past year, there are not a lot of names on the list, but there are a few interesting ones worth investigation and consideration right now.

I focused my attention on those that have a positive return on capital right now but are lagging their 10-year average ROC. This suggests to me that there is room for improvement going forward, as conditions in the sector or broader economy improve. The largest company on the list is Rowan Companies (RDC). The offshore drilling sector is almost universally disliked on Wall Street; it has been a tough year so far for Rowan. The company is earning a return on capital of just 5.1%, which is well below the 10-year average of about 8%. The shares trade at 80% of book value right now, so they are definitely a bargain. Global demand for oil and gas will increase steadily for several decades to come and offshore oil fields will very much be a part of the supply equation. Rowan should therefore prosper in time and see return climb back toward historical levels.

Atlas Air Worldwide (AAWW) has also seen returns on capital slip from historical levels. A generally slow economy and the loss of military business have hurt the aviation services company. The current return on capital is just 6.6%, which is well below the 10-year average of 10%. Management has been working hard to transform and diversify the business model; it seemed to be working, as earnings improved sharply in the first quarter. CEO Bill Flynn was very upbeat in the first quarter earnings call, telling investors: "we remain confident in the resilience of our business model and our ability to leverage the scale and efficiencies in our operations. The business initiatives we've undertaken and the investments we have made have transformed the company, to deliver meaningful earnings in any environment. Should 2014 be the inflection point, when growth returns to commercial air freight and yields improve, Atlas is well positioned to be one of the prime beneficiaries." The stock is very cheap at 70% of book value, so if returns on capital do go back to historical levels, the upside in this stock is tremendous.

One of the better returns on capital is a stock we have mentioned on a regular basis lately. Trans World Entertainment (TWMC) trades at about 70% of net current asset value but surprisingly has a strong 13% return on capital. Trans World needs a stronger economy and a successful penetration into online sales to really thrive, but the company is cheap and profitable and should provide solid returns from current super-bargain levels.

Cheap stocks with positive returns on capital could easily become growth stock leaders when the economy recovers in the future. Those whose returns are below historical averages would seem to have the most upside form current prices.

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At the time of publication, Tim Melvin was long RDC and TWMC. 

TAGS: Investing | U.S. Equity | Stocks

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