If you missed Part 1, you can read it here.‍

Return on Invested Capital (ROIC) has become a popular metric among investors to assess the quality of a business and its ability to create shareholder value over time. While we believe it is a necessary condition, a higher ROIC can be misleading and can often be taken as a shortcut to indicate a “better business.”

At Langdon, we look for businesses that not only have a high ROIC but are also able to continue to reinvest a significant proportion of the cash they generate at that attractive ROIC.

To illustrate how a higher ROIC does not necessarily translate into more effective value creation, take the example of Company A and Company B as seen below.  

After hundreds of company meetings, you stumble upon Company A - a very special business capable of earning 40% on the capital it invests - and Company B - another excellent firm with a ROIC of 20%.

Company A’s management struggles to find reinvestment opportunities and can only redeploy ¼ of their cash flow into growing the business. On the other hand, Company B’s market and team are structured in ways they are able to reinvest the entirety of their annually generated cash.

Over the next 10 years, it turns out that Company A, despite having a 2x higher ROIC, is far outpaced by the cashflows of Company B, which grew at 2x the rate (CAGR). Additionally, Company A’s owners started with €400 to reinvest, which is 2x the amount that Company B’s shareholders were entitled to. However, the situation is different 10 years later due to Company B’s ability to redeploy a higher proportion of their cash while sustaining an attractive return. After a decade, Company A’s shareholders have seen their original investment increase 2.6x; whereas Company B’s owners have grown their initial investment by 6x over the same period.

To reinvest or not to reinvest?

There are many avenues from which a company can choose to reinvest its cash flows: purchasing inventory, increasing production capacity, hiring talent, opening an office in a new country, or funding an internal start-up, to name a few. These are all examples of internal reinvestments. External growth, in the form of acquisitions, can also serve as a powerful tool for deploying excess cash and earning attractive rates of return. Importantly, businesses with higher ROIC tend to attract competition, and a high reinvestment rate can help elevate barriers to disruption, there by prolonging the durability of superior compounding. Other uses of cash include paying down debt, which results in savings on interest expenses, or returning it to shareholders in the form of share repurchases or dividends.

A question we love asking management teams of high-quality businesses with a low reinvestment rate is, “Why do you pay such a high dividend?” Some of them want to be recognized as ‘dividend aristocrats’, some may have anchor shareholders relying on that income stream, and others simply do not see opportunities to invest excess cash flow. Selling your winners early is not the only way in which compounding gets interrupted. If a company’s reinvestment activities are disrupted, it limits the ability to grow cash flow per share, and ultimately, intrinsic value.

Keep the change, please!

In addition to growing intrinsic value at a higher rate, all else being equal, companies with a high reinvestment rate and ROIC solve several problems. Notably, they address the challenge of finding investment alternatives that meet our hurdles and experience a lesser interruption from taxes on distributions.

Let’s assume the owners of Company A receive dividends each year amounting to 75% of the annual cash flow, which is the amount they are unable to reinvest. Shareholders now have to find an alternative use for those funds. Reinvesting at the long-term stock market performance of 8-10% will result in lower incremental returns. The more cash flow a company can keep and grow for us, the better our return on time as well as our return on investment.  

When a company decides to return money to shareholders in the form of dividends, there is an additional leakage that hinders compounding: taxes. Dividends are distributed after the government’s claim on a corporation’s earnings has been paid. In turn, owners can be taxed on the distributions they receive from their business. What that means is that, in order to compensate for the taxes paid, one must earn an even higher nominal return.

Cash flow is our North Star

Our goal at Langdon is to deliver exceptional long-term returns for our clients. We own a high-conviction portfolio of companies that we continuously evaluate with thorough research. A crucial part of our process is taking time to build relationships with the people behind our businesses and assessing the leadership’s ability to allocate capital. We are thrilled when a company we already own can retain its capital and make high-quality decisions. Allowing great businesses to compound capital without interruption has created tremendous wealth for shareholders over time, provided they didn’t overpay. These interruptions can typically come from failing to appreciate the long-term prospects of a company but can also be due to cashflow being distributed by those businesses and reinvested at lower returns than internally generated ROIC. We tend to avoid high return but low reinvestment rate companies, which differs from conventional investing wisdom.

It is important to us that the stewards of our capital can articulate their reinvestment philosophy and that it translates into higher cash flow per share over time. After all, cashflow is our North Star.  

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