kcchongnz blog

Earnings Growth or High ROIC? They are both equally important kcchongnz

Publish date: Sun, 08 Dec 2019, 06:17 PM
This a kcchongnz blog

Recently, I read about comments by a forumer in i3investor in a thread in Thong Guan, sharing his view on the emphasis of the importance of return on capital in investing. I thought he provided many good comments and people should have appreciated his sharing of knowledge. Instead, he was ridiculed by several people, and none seems to agree with him, to my amusement. Let us just go straight to the subject matter as shown in a critical but a more civilized comment below,

[Posted by Blanked > Dec 6, 2019 2:55 PM | Report Abuse

out of 100 investors, only one appreciates roic, the rest dont. if they dont value, they wont buy, then share price how to go up?
u must know what it takes for the share price to go up. it is earning growth.]

ROIC mentioned in the comment is Return on Invested Capital; the percentage of return from the capital a company invests in its business. This is similar to the return on the amount of money one puts in (equity) in a business, ROE, or the return from a combination of equity and money borrowed from the bank, ROIC.

When I invest a stock, I normally treat it as investing in part of a business, and I won’t expect to make huge profit such as 100% within a day, a week, a month or even a year, just like investing in a business. I would expect reasonable return over a few years. Of course, if the good return happens in a year, that would be good, great if within a few weeks. In general, if you are right in investing in a good company, when nobody is interested in it initially, because only “one out of 100 appreciates it”, and hence a good bargain, the share price will go up. So, no worry about it.

Regarding the second statement that “u must know what it takes for the share price to go up. it is earning growth”, I kind of agree to it, with several caveats.

  1. Your earnings growth projection, which is in the future, must be correct.
  2. You must be better in projection of the future earnings growth than most people, including the professional analysts, because they are at the other side of your trade.
  3. The earnings growth must be accompanied by revenue growth, otherwise it is not sustainable.
  4. The growth must be quality growth
  5. No. 4 above means the return on capital must be higher than its costs, and best comes with good cash flows.
  6. You must not overpay for it.

All the above are not theories, although I can use theories to prove them. But they are also pure and simple logic. No difficult theory or complicated maths is required.


Earnings projections

Investors often turn to professional analysts and investment bankers for guidance regarding corporate earnings growth. Unfortunately, they are not very accurate when it comes to forecasting earnings. In fact, their forecasts were often way off, and often going the opposite direction as shown in a research in Figure 1 below.

How good is your own forecast earnings projection? Better than the professionals? I don’t deny that there are some among those in i3investors, but they are the rare species. And don’t discount luck too, which is a big factor on outcome in investing.

If you are long enough in i3investor, you would probably know how some people lost their pants using their just “profit growth” investing strategy.

Figure 1: EPS forecast versus actual outcome

Why Return on Equity Is Important?

A business that has a high return on capital is more likely to be one that can generate cash internally and has a competitive advantage. For the most part, the higher a company's return on capital compared to its industry, the better. This should be obvious to even the less-than-astute investor. Consider this, you have $1m to invest in a company earning $150k a year, or a ROC of 15% versus another earning 3% a year, and you reinvest the profit every year back to the business, returning the same ROC.  What will be the difference in the total money you would have after 10 years?

Table 1 below shows that after 10 years, the investment with ROC of 15% (Case B) becomes RM4.046m, three times more than the Case A, with the ROC of 3%. This is just simple maths, nothing complicated. No big theory too.

Table 1: Return on $1m after 10 years with ROC of 3% and 15%

In fact, a company can easily “manufacture” growth. Take for example, company A above borrows another RM1 from bank at 5% and just put the money in another bank earning 3% a year. Without doing anything else, the company will have profit growth every year. But is that a shareholder value enhancing act?

This is what Warren Buffet said in one of the AGM of Berkshire Hathaway,

Each year, a successful company generates profits. If management did nothing more than retain those earnings and stick them a simple passbook savings account yielding 4% annually, they would be able to report "record earnings" because of the interest they earned. Were the shareholders better off? Not at all; they would have enjoyed heftier returns had the earnings been paid out as cash dividends. This makes obvious that investors cannot look at rising per-share earnings each year as a sign of success. The return on equity figure takes into account the retained earnings from previous years and tells investors how effectively their capital is being reinvested. Thus, it serves as a far better gauge of management's fiscal adeptness than the annual earnings per share.”

Joel Greenblatt, a University professor, an academician and a well-known extremely successful fund manager has made billion for himself and his investors using ROIC as one of the two metrics in his Magic Formula in quantitative investing. You can goggle and you will surely find many real super investors in the world have successfully done that.


Overpaying for growth

Is it always profitable investing in high growth stocks? It depends on whether the growth is a quality growth which produces a high return on incremental capitals as shown above, and most of all, the premium one pays for the growth expectation.

Microsoft, a high growth stock

Let us look at a great company in the United States, Microsoft Corporation. In December 2000, Microsoft was trading at around RM59.00, at a PE ratio of 84, with earnings per share (EPS) of 70 sen then. In the seven years leading to 1999, Microsoft’s EPS has grown by 775%, or a compounded annual growth rate (CAGR) of 34%. That high PE ratio for such a high growth company was logical, wasn’t it? Microsoft was such a high growth company, and it was also at the peak of euphoria of internet stocks. Microsoft’s EPS was $2.63 for the last twelve months ending 30th September 2014, or an increase of 276% since 14 years ago. It was still a fantastic CAGR of 10% for such a long period. Microsoft is trading at $48.79 end of 2014. Its share price was still 17% below what it was 14 years ago, despite that its share price has risen by about 200% since the US subprime housing crisis 5 years ago.

Coca Cola, another high growth company

Warren Buffet through Berkshire Hathaway invested in Coca Cola from year 1987. He invested in it because in his analysis, Coca Cola was an excellent quality company, and it still is. On 1st July 1990, share price of Coke was $5.69. At earnings of 30 cents per share, PE was only 19, a fair price to pay for a company which grew its earnings at a CAGR of 13.4% over the next 8 years to 82 cents a share in 1998. The share price grew at a much faster rate at a CAGR of 29% over the next 8 years to an adjusted price of $42.59, six and a half baggers. PE ratio of Coca Cola in 1998 expanded to 52.That price suggested that every man, woman and child on earth had just pledged to drink a bathtub full of soda a week for life.

Over the next 21 years from July 1998 to July 30th, 2019, EPS of Coca Cola still grew by 83%, but just at CAGR of 2.9%. Its share price barely grew by 22.6% to $52.2 per share, or a CAGR of just 1%, while the Dow Industrial Index has doubled during the same period. The PE ratio of Coke has contracted to about 35. Those investors who bought Coke, a great company, at its peak price 21 years ago way under-performed the broad market during the same period.


The August 2000 issue of Fortune Magazine included an article titled “10 Stocks to Last the Decade.” Those recommended growth stocks (which were described as “Here’s a buy-and-forget portfolio” that would let you “Retire when ready”) suffered an average loss of 80% at the end of 2002. Some have gone into oblivion like Enron, Nokia, and none of them have recovered to their previous prices as at end of year 2014. Sure, investors can retire when they are 80 years old, and by eating instant noddle every day.

The pertinent question here is “Would you buy a stock if you knew that the company would have to grow at a ridiculous rate of 30% every year for the next 20 years merely to justify its current stock price?”. Yes, they are exception; Goggle, Amazon, Facebook, etc. at their initial stages, but they were way far and between. But more importantly, few spotted them before the fact.


High growth stocks in Bursa

Let us look at our own backyard and some of the high growth stocks in the past as mentioned in my favourite article here again:


There were nine stocks mentioned in the above article, and I can see at least 6 of them can be considered to have very high expected growth. However, time has shown that most of them ended up losing huge amount of money from their growth. I was wrong only for one of them eventually as its share price has gone up a lot from when I wrote about them. Let’s discuss on two of them here.


KNM’s growth for the ten years from 2003 to 2013 outpaced Microsoft. Its revenue grew by 30 folds from less than RM65m in 2003 to a RM2 billion revenue company. The CAGR is a whopping 41%. I bet you can’t find another one in Bursa that grew at this rate for a period of 10 years. it has never lost any money in any year since its listing until year 2016. At that time, many institutional investors, local and abroad, were shareholders of the company.


What happen to its share price? It has dropped from an adjusted price of close to RM10 in 2007 to less than 10 sen at one time and closed at 36 sen on 6th December 2019. What happened to this extremely high growth company?


Alas, its high growth was a shareholder value destroying endeavour by the management acquiring jobs all over the world with low margins which dissipated quickly due to poor management. Its return on capitals can’t even match half of their costs of capitals, exaggerated by poor cash flows.


London Biscuits Berhad

LonBis’s growth is also very high. Its revenue grew by 3.4 times since 9 years ago from RM82m to RM360m as at 30th June 2014. It’s earnings, as that of KNM, has not been very exciting, but it also has never lost any money since listing. It is another wonderful growth company, isn’t it?


What happened to its share price? It has dropped from a peak of RM2.50 since then to 9 sen last Friday on 6th December 2019, after defaulting on a mere RM9m bank loan. It is another high growth company buying tens of millions of plant and equipment (PPE) every year with the aim of growing its business at a high rate. Alas, the PPE were way under-utilized, resulting in massive shareholder value destroying with return of capitals way below its costs, and negative free cash flows almost every year.


Earnings growth is an important criterion for investment for long -term, and savvy investors normally look for company with high growth potential to invest in for extra-ordinary return. However, unless the growth is shareholder value enhancing with return on capitals higher the cost, and make sure you don’t overpay for growth, investing in high growth companies doesn’t always end up well. The examples on KNM and London Biscuits above, and many others have shown the perils of chasing growth blindly. More importantly, one should not pay too high a price for growth expectation.


Do the above discussion so theoretical and complicated? Do they involve high level theories and complicated maths, or just simple logic and addition and subtraction, multiplication and division?

Do I have the personal experience of using ROIC, instead of the “theory”? This you will surely demand as from the others who shared their knowledge and experience. What I can say is a resounding “Yes”, but that is beyond the scope of this discussion. You may goggle it if you are interested. But please don’t be biased, and just choose the few which failed and ignore the big majority of them which were successful.

"Everything should be made as simple as possible, but not simpler" Albert Einstein

There are resources in the internet including many good books on learning about the fundamentals of investing. Here is one,

This book is on sale in the major bookshops such as MPH and Popular. You may also contact me to purchase a copy if you wish at the following email address.


This may end up as your best investment.


4 people like this. Showing 6 of 6 comments


Dear KCChong,
May the Year of the Metal Rat bring you Good Luck, Good Health, Good Fortune, Plentiful of Laughter, Happiness, Success and at Peace with Oneself and Others. Happy Chinese New Year 2020

Thank you
P/S: https://klse.i3investor.com/blogs/Sslee_blog/2020-01-22-story-h1482896...

2020-01-22 21:01


Dear Sslee,

Happy Chinese New Year to you too.

Happy Chinese New Year to everyone in i3investor.

2020-01-23 09:51


Dear kcchong,
I am a strong believer of value investing and wanting to put some saving into Berkshire Hathaway. However the price is sky high at the moment. I am wondering what would be the fair price in your mind for it ?

2020-01-27 11:54


Posted by malaysianboleh > Jan 27, 2020 11:54 AM | Report Abuse
Dear kcchong,
I am a strong believer of value investing and wanting to put some saving into Berkshire Hathaway. However the price is sky high at the moment. I am wondering what would be the fair price in your mind for it ?

One way to evaluate BH is look at the price to book value and decide on how much premium you are willing to pay for the service of the Oracle of Omaha; 1.1, 1.2, 1.5, or 2.0?

I don't buy BH as I am an active investor myself, and often dwell in the mid to small cap space to find better value. BH may suit many but doesn't suit my risk appetite.

Everyone is different.

2020-01-28 17:07


Thanks kcchong. The current price to book value is about 1.6! It was 1.02 in Feb 2009.
I am a health care professional and won't have much time for research to be an active investor. I guess I just need to be patient and wait for the right time to strike!

2020-02-02 11:24


Post removed.Why?

2020-02-28 23:02

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