“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.”
–Warren Buffett, 2007 Shareholder Letter
Return on invested capital is one of the best ways to calculate whether or not a company has a moat. Finding a company with a moat that gets a great return on its invested capital makes investing easy, not that this is an easy thing to find. The reason this makes it easy is the company can grow their value over the years and you can compound along with it. Helping grow your wealth as they continue to add assets and grow their business.
The trick to finding a company that is a great allocator of capital is finding a company that has had success in the past getting a great return on invested capital. The higher the percentage the better allocators they are.
Today we are going to look further into return on invested capital. We will take a look at what it means and how to calculate it, along with examples for you to follow along.
Let’s dive in.
Definition of Return on Invested Capital
What is a return on invested capital?
“Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e. bondholders and stockholders. ROIC tells us how good a company is at turning capital into profits.”
“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”
-Charlie Munger, 2008 Berkshire Hathaway Annual Meeting
Another great thought from Charlie. I love this explanation and this is a great idea to strive for, finding a business that is conservatively financed that can write us a check every year. Better yet, would be a company that in addition to giving us a dividend would be fantastic compounders.
Continue reading “Return on Invested Capital in Two Easy Steps”
Finding a company with a strong competitive advantage like an Apple (AAPL) is what every investor is looking for. It is not easy and there are not a lot of formulas that you can use to find them. We are all on the lookout for companies with wide investment moats. Especially value investors. We love these types of companies. Companies with wide investment moats are likely to be around for a long time, not that they are invincible. But they are great companies for growing wealth over time.
“But all the time, if you’ve got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it.”
Warren Buffett from a talk he gave to MBA students at the University of Florida
What is the definition of an investment moat?
Charlie Munger and Warren Buffett are generally accepted as the originators of the term “moat”.
A moat refers to “business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”
Competitive advantage is going to be any factor that allows a company to provide a good or service that is essentially the same as it’s competitors. But allowing them to beat their competitors in profits.
An example of this would be if you shop online for a product. Chances are you will see many different companies offering the same product but one stands out because they offer a lower price or perhaps free shipping.
This gives that company a competitive advantage over their competitors because of the free shipping, that the others may not be able or willing to offer.
Continue reading “How to Find Wide Investment Moats the Easy Way”
How do we become better investors? Better decision makers? Having a latticework of mental models to hang our thoughts and choices on is a great start. Creating these models is how we learn to become better decision makers. Before creating our latticework of mental models we need to create the mental models that we will use. We must explore the big ideas from the major disciplines.
Physics, biology, psychology, philosophy, literature, history, sociology, and others.
These are the big disciplines that we call the models.
Our goal is not to remember facts and be able to repeat them, like on a test in college. The goal is to hang these models on a latticework of mental models with concrete examples in our head to help us remember them. And apply them in our life.
The latticework of mental models puts them in a form that we can use analyze a wide variety of situations. This enables us to make better decisions. When these big ideas from multiple disciplines all point toward the same conclusion. Then we can begin to make the conclusion that we have come across an important truth.
Charlie Munger and the latticework of mental models
This idea of a latticework comes Charlie Munger, co-chairman of Berkshire Hathaway. Munger is one of the greatest cross-disciplinary thinkers in the world.
I could try to explain his thoughts on worldly wisdom, but I would fail miserably. So instead we will use his words.
Well, the first rule is that you can’t really know anything if you just remember isolated facts and try and bang ’em back. If the facts don’t hang together on a latticework of theory, you don’t have them in a usable form. Continue reading “Latticework of Mental Models: Better Decisions, Better Investors”