Very few business leaders and companies are good at allocating capital consistently over time. While past performance is no guarantee of future performance, investing alongside the better users of capital is a strategy that consistently delivers superior investment performance.

Whether explicitly or implicitly, most investors use some form of quality filter when assessing investment opportunities.

Professional investors will drill down into many quality metrics – including strength of balance sheet, interest coverage, cash flows versus accruals, earnings stability and revenue growth.

However, two of the most consistently watched indicators are return on equity (ROE) and return on invested capital (ROIC).

ROE measures the amount of profit generated by a company relating to its shareholders’ equity, while ROIC is a broader metric and measures the amount of profit generated relating to all invested capital, including equity and debt financing.

While a focus on ROE may have been sufficient in a world of low interest rates and quantitative easing where the supply of debt was abundant and the cost almost free (some companies were able to lock in term funding at negative rates), blindly following ROE can mask the risk that sits on the balance sheet.

A company with high debt levels may have a higher ROE when times are good but be more vulnerable when financial conditions tighten, and the supply of debt capital is rationed.

ROIC is way more important to focus on now that we have entered a higher inflation and interest rate environment. ROIC helps investors get a better understanding of a company’s ability to efficiently generate returns on all invested capital, so the company can service its debt obligations and consistently deliver profits to equity holders that can be delivered in the form of dividends or stock buybacks.

Optimal allocation

A little like the adage about common sense not being that common, capital discipline is rarer than you would intuitively think in the corporate world. Many companies destroy value through acquisitions and expansions, unable to extract the benefits through a failure to execute on a well-considered plan.

Most companies follow some form of capital allocation framework to determine how to invest their financial resources in different areas of the business. This model considers various factors – such as risk, return on investment and financial goals – to determine the optimal allocation of capital across various projects, business units or investment opportunities.

The process typically involves a thorough analysis of the potential risks and rewards associated with each investment option, and an assessment of how each investment aligns with the company’s strategic goals. By using a capital allocation model, companies can make informed decisions about where to allocate their resources in a way that maximises long-term value for shareholders and ensures the financial health of the business.

The big global technology firms have demonstrated they have an ability to consistently deliver a high ROIC – with Apple and Microsoft earning an incredibly strong 39 per cent and 25 per cent a year respectively over the past five years. These companies have been able to maintain this high ROIC through a combination of strong product development, proprietary technology, a dominant market position, effective capital management and a superior brand position.

In Australia, banks and miners have had a chequered history adding value through acquisitions. Miners lacked capital discipline in the last commodity boom but have shown more restraint in the most recent period – spinning out non-core assets, resetting their operating costs to a relatively low commodity price level and returning excess profits to shareholders.

Companies and management teams can build up a reputation as great users of capital and granted the licence to expand. Amcor, Wesfarmers and CSL have all had periods where their ability to execute has been backed by the market. A particular favourite of investors is Macquarie, which through successive management changes remains the poster child for the relentless focus on capital allocation discipline.

While it may sound blindingly obvious, your portfolio should focus on backing people and companies that treat your capital with care and have a track record of delivering returns on invested capital. It pays to do your homework. A change of CEO or board composition can quickly change the culture of an organisation and its ability to execute on invested capital.

Companies that can demonstrate a high ROIC on a consistent basis through their strong business discipline and practices are far more likely to survive well during the tougher times – something to bear in mind as the expected economic slowdown in 2023 unfolds.