Return on Invested Capital - A Multi-Silo Approach

I paraphrase Sanjay Bakshi when he says, being a great operator or a great capital allocator are rare skills; being both is almost unheard of. Return on Invested Capital is the most basic value of a business' success - how much money have you made as a percentage of how much money you invested. ROIC (and it's cousin ROE) is typically used to value public companies because it is easily calculable. With a base level of capital (or equity) what are the company's earnings? The use of debt can help leverage the ROIC by using someone else's money to increase your business assuming it is cash-flow positive.

The problem with the common understanding of ROIC is it's limitation to being used to evaluate within silos, not across them. Sadly, this is a tenant of most video games (and game theory) that is often not correctly applied to real life. Save up coins or dollars or credits and the more you have, the more you can trade in for a benefit producing advantage.

For years, I have listened to Buffett speak along the lines of, "if I had a million dollar portfolio, I could easily return 50% a year". The misinterpretation of this statement is that he is implying the necessitation of stock picking. The most recent Shareholder's Letter has been widely quoted due to Buffett's lesson on his commercial real estate in New York and his farm in Nebraska. An individual with a million dollar portfolio has an advantage because of the greater market mispricings in illiquid and/or psychologically misjudged investments on a localized level. That individual does still have greater opportunities than the billionaire investor in financial markets due to size but why even bother? If one found a gas station for sale that had a ten-year track record of 50% ROIC, there is no point to even do security analysis. You can't beat that.

So where does your gas station investment leave you? After your first year, you have a 50% return (since you are such a good operator) that you must now allocate in order to obtain maximum IRR. For generalization sake, you have three options at this point:

1. Invest in something with a higher ROIC
2. Invest in something with equal ROIC
3. Invest in something with lower ROIC

While this may seem like a mundane answer to the question, the application in real life is very important to consider. Consider the scenario:

1. Invest in a better opportunity with a higher ROIC. On paper this sounds like a no-brainer but in actuality, you may find this hard to accomplish. The 50% I chose as base case was from an actual listing I was reviewing. Anything above 1 would certainly be a no-brainer (and possible when there is blood in the streets). 
2. Invest in an opportunity with the same ROIC. Naturally, your thought process would lead to more gas stations, which could increase your ROIC if efficiencies are obtained. Or invest in similar mispricing scenarios available to the smaller investor. 
3. Invest in opportunities with lower ROIC. Unfortunately, this is what the vast majority of people do. After experiencing high levels of ROIC, they protect their earnings by placing them in "safer" scenarios, which are often deemed safer by access to liquidity. This is mind numbing. You have an initial investment that with some degree of certainty, you can predict will return another 50% ROIC next year yet you decrease your IRR by investing in "safer" alternatives rather than trying to match or increase ROIC. 

Clearly, the elephant in the room is absolute return compared to ROIC. If you can get more money to your bottom line, than you should. Or should you? Should you ignore absolute return (possibly decreasing IRR for the short term), to maintain a high level of ROIC in the long run. By any reasonable argument, you should do the latter. This is the problem with size. As you get bigger, investments that maintain a high ROIC become more difficult. But there is a major difference between size of a Fortune 100 company and an individual investor. An individual investor, by definition, will never be too big for the investing universe to maintain his ROIC whereas one of the 100 largest companies in America (or the world) has almost reached the apex. Surely there will be physical limitations to the abilities of the individual investor (there can only be so many yogurt stores in one city) but reaching a point of fulfilling affluence should be easily obtainable without size limitations.

Sadly, Robert Kiyosaki's Cash Flow comes to mind but there is an important example to be made. In the game, you can invest in many different asset classes from securities to major developments. In the game, as in real life, there is a restriction on C, not on R. You only have so much capital to invest. Each step up you make in investable capital, more asset classes become available to you. For the very small investor, common stocks are probably the best opportunity for a good ROIC. As the investor grows, asset classes are unlocked. If you are able to invest in the gas station around the corner with a ten-year ROIC of 50% or a common stock with a ten-year ROIC of 50%, which is the better move? While there are many factors that could effect an individual's appetite for risk such as liquidity or capital appreciation, I would argue that circle of competence outweighs all others combined. You inherently know way more about the economics of your neighborhood than you do of a common share of a large corporation. Its a no brainer. By keeping your money that far within your circle of competence, you are able to eliminate risks inherit with public markets and the corporate governance of a public company.