Return on Capital Employed

Today's Financial Times carries a letter from me about the subject of how to measure managerial performance.

This is a matter which has attracted a lot of attention as a result of the debate about executive pay. Having a yardstick of company performance which aligns the rewards for managers with the interest of investors is vital to this debate.

I have been amazed by the poor quality of the debate and the work on managerial incentives. Probably the most commonly used measure of fundamental performance is growth in Earnings Per Share or EPS. This is garbage: it takes no account of the amount of shareholders' capital employed to achieve that growth. This is a mistake that a novice investor choosing a bank savings account would avoid.

I was therefore pleased but slightly irritated to read that the Association of British Insurers, one of the trade associations which seeks to represent the interests of insurance investors, and which has expressed many views on executive pay, has said that growth in EPS may not be a suitable measure for this purpose. Neither is Total Shareholder Return, another commonly used measure, or even Return on Equity or ROE as it can be distorted by leverage or debt gearing. They are beginning to recommend Return on Capital Employed or ROCE. So are some institutional investors.

What is galling about this is that not only have I been saying that for about 20 years, but Warren Buffett said it in his 1979 Chairman's letter for Berkshire Hathaway. It has taken these self-appointed guardians of investors' interests a mere 33 years to catch up.

The next concept they may need to study is asset life or the duration of those returns. At their present rate of progress we can expect a result is 2045.

Buffoonery.

Comments

[MickC]

But they are not guardians of investors interests are they? They are guardians of their own personal interests.
This is precisely why the British prefer to "invest" in property, mostly residential. They view much of the "City" as spivs and conmen who are not professional advisers, but mere salesmen seeking to get the most commission, no matter what the quality of the "product". Recent history has again proved this to be the case.
It would be enlightening, and no doubt entertaining, to carry out a cost/benefit analysis on the City with regard to its utility for the UK over the long term. My money would NOT be on the City being an overall benefit to the UK-other countries seem to have prospered without such a casino.

[dezzie]

Buffoonery? I think not!

A conspiracy of self interests more like.

Well said MickC

[team dave]

@mickc - Brilliant summary.

[Glider66]

micki. Name the other countries that have prosperd without a city.I cannot think of one.

[MickC]

Glider66

Germany

[Apollo Fire]

Well put views, with a rounded and balanced aspect. I'll be looking out for more from you.

[Peter Jones]

This blog makes sense in line with other aspects of Terry. However, I question how such a fit & intelligent person justfies investment in tobacco companies which are foreshortening the lives of millions of people.

[Terry Smith]

Peter,

Thank you for your comment.

I operate on the premise that if an activity is legal, it is investable. If I chose to exclude a sector from our investable universe on what for want of a better term I will call ethical grounds (although I suspect that this commonly used term is inaccurate as ethics have little to do with attitudes in this respect) whose ethics should I apply? Mine? Yours? Some other individuals? This is relevant as some investors have legitimate concerns about sectors other than tobacco. For example, I have Muslim investors in the Fund who are more concerned about alcoholic drinks. Apart from obvious religious grounds for this view, they can point to the fact that alcohol abuse is definitely the cause of significant health and social problems. And if we are focusing on health problems, I would suggest that manufacturers of processed foods with high fat content, sugar and other sweeteners and fast food vendors could be and often are criticised for their contribution to the growth of type B diabetes. This is almost certainly the most rapidly growing disease worldwide and has serious consequences in terms of heart disease, stroke, kidney disease, blindness and dementia and a consequent significant reduction in life expectancy.

So my suggestion is if you object to tobacco consumption is that you campaign to have it declared illegal, but until you do I continue to regard it as investable.