All Cap Index & Sectors: ROIC Remains High in 2Q22

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Return on capital employed (ROIC) rose in 2Q22 to its highest level since 1998 for the NC 2000. Seven sectors in the NC 2000 also saw a year-over-year (YoY) improvement in ROIC. This improvement is due to increases in both net operating profit after tax (NOPAT) margins and the change in invested capital.

The NC 2000 consists of the largest 2000 US companies by market capitalization in my company’s coverage universe. Items are updated quarterly (March 31, June 30, September 30, and December 31). I exclude companies reporting under IFRS and non-US ADR companies. Metrics calculated using the SPGI methodology, which sums individual NC 2000 file values ​​for NOPAT and invested capital. See Appendix III for more details on this “aggregated” method and Appendix I for details on how I calculate the WACC for the NC 2000 and each of its sectors.

This report is an abridged version of All Cap Index & Sectors: ROIC Remains Inflated in 2Q22, one of my quarterly reports on fundamental market and industry trends. This report is based on the most recent audited financial data available, in most cases the 2Q22 10-Q. Price data as of 8/12/22.

NC 2000 ROIC up in 2Q22

The NC 2000 ROIC increased from 9.3% in 1Q22 to 9.4% in 2Q22. The NC 2000’s NOPAT margin held steady at 12% from 1Q22 to 2Q22, and invested capital movements increased slightly from 0.77 in 1Q22 to 0.78 in 2Q22.

Two important observations:

  1. As expected, inflation continues to push margins as today’s profits are calculated based on current prices for revenues, but historical prices for cost of goods sold. This effect lasts as long as inflation is high, but reverses once inventory costs exceed the prices charged to customers.
  2. The WACC has risen less than AAA corporate bond yields over the past year. That slowdown means companies have shortened the maturities of their outstanding bonds to take advantage of the steepness of the yield curve for maturities shorter than five years. Shortening maturities could lower the cost of debt and WACC in the short term, but it exposes companies to soaring borrowing costs if interest rates continue to rise.

The “record” return on capital is a mirage and the upward trend in ROIC could be reversed soon, as I saw with the ROIC of seven sectors falling quarter-over-quarter in 2Q22.

Key Details on Selected NC 2000 Sectors

The energy sector performed best in the second quarter of 2022 as measured by the change in ROIC, with an ROIC increasing 266 basis points. In the first half of 2022, energy companies benefited from high energy prices and strong economic activity, but those two factors can only coexist so long before inflation ruins the party. That process will take place in the third quarter, as high energy prices are fueling tighter monetary policy and fears of a recession.

The biggest loser in the second quarter was previously one of the market’s biggest winners from the COVID era. ROIC for the technology sector fell 71 basis points quarterly in 2Q22.

Below I highlight the industrial sector, which had the second largest Chamber of Commerce change in ROIC in 2Q22.

Example sector analysis: industry

Figure 1 shows that the industrial sector ROIC increased from 7.3% in 1Q22 to 7.6% in 2Q22. The industrial sector’s NOPAT margin increased from 9.0% in 1Q22 to 9.3% in 2Q22, while the exchange of invested capital held steady at 0.82 in 2Q22.

Figure 1: Industrials ROIC vs. WACC: Dec 1998 – 8/12/22

The August 12, 2022 measurement period uses price data from that date for my WACC calculation and includes the financials of 2Q22 10-Qs for ROIC, as this is the earliest date for which all 2Q22 10-Qs for the NC 2000 components were available.

Figure 2 compares the trends in NOPAT margin and invested capital for the industrial sector since December 1998. I sum the individual NC 2000/sector constituent values ​​for turnover, NOPAT and invested capital to calculate these statistics. I call this approach the “Aggregate” methodology.

Figure 2: Industry NOPAT Margin vs. IC Turns: December 1998 – 22/12/08

The August 12, 2022 measurement period uses price data from that date for my WACC calculation and includes the financials of 2Q22 10-Qs for ROIC, as this is the earliest date for which all 2Q22 10-Qs for the NC 2000 components were available.

The Aggregate methodology provides a clear view of the entire industry, regardless of market cap or index weighting, and is consistent with how S&P Global (SPGI) calculates metrics for the S&P 500.

For additional perspective, I compare the Aggregate method for ROIC with two other market-weighted methodologies: market-weighted metrics and market-weighted drivers. Each method has its advantages and disadvantages, which are described in the appendix.

Figure 3 compares these three methods for calculating industrial sector ROICs.

Figure 3: Industry ROIC Methodologies Compared: December 1998 – 22/12/08

The August 12, 2022 measurement period uses price data from that date for my WACC calculation and includes the financials of 2Q22 10-Qs for ROIC, as this is the earliest date for which all 2Q22 10-Qs for the NC 2000 components were available.

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Brian Pellegrini are not remunerated to write about a specific stock, style, or theme.

Appendix: Analyzing ROIC with different weighting methods

I derive the above stats by adding up the individual NC 2000/sector file values ​​for earnings, NOPAT and invested capital to calculate the presented stats. I call this approach the “Aggregate” methodology.

The Aggregate methodology provides a clear view of the entire industry, regardless of market cap or index weighting, and is consistent with how S&P Global (SPGI) calculates metrics for the S&P 500.

For additional perspective, I compare the Aggregate method for ROIC with two other market-weighted methodologies:

Market Weighted Statistics – calculated by market capitalization of the ROIC for the individual companies relative to their sector or the total NC 2000 in each period. Details:

  1. Company weight is equal to the company’s market capitalization divided by the NC 2000/its sector’s market capitalization
  2. I multiply each company’s ROIC by its weight
  3. NC 2000/Sector ROIC is equal to the sum of weighted ROICs for all companies in the NC 2000/each sector

Market-weighted drivers – calculated by market cap weighting of the NOPAT and the invested capital for the individual companies in the NC 2000/each sector in each period. Details:

  1. The company weight is equal to the market cap of the company divided by the market cap of the NC2000/its sector
  2. I multiply the NOPAT and the invested capital of each company by its weight
  3. I add up the weighted NOPAT and the invested capital for each company in the NC 2000/industry to determine the weighted NOPAT and the weighted invested capital of the NC 2000/industry
  4. NC 2000/Sector ROIC equals weighted NC 2000/sector NOPAT divided by weighted NC 2000/sector invested capital

Each method has its pros and cons, as described below:

Aggregated method:

Advantages:

  • A direct look at the entire NC 2000/industry, regardless of company size or weight.
  • Corresponds to how S&P Global calculates statistics for the S&P 500.

cons:

  • Vulnerable to the impact of companies entering or leaving the group of companies, which could have an undue impact on overall values, despite the rate of change of companies remaining in the group.

Market Weighted Statistics method

Advantages:

  • Takes into account the size of a company relative to the total NC 2000/industry and weights the stats accordingly.

cons:

  • Vulnerable to outsized impact of one or a few companies. This excessive impact usually only occurs for ratios where unusually small denominator values ​​can produce extremely high or low results.

Market-weighted drivers method

Advantages:

  • Takes into account the size of a company relative to the total NC 2000/sector and weighs its NOPAT and invested capital accordingly.
  • Mitigates the potential excessive impact of one or a few companies by aggregating values ​​that determine the ratio before calculating the ratio.

cons:

  • Can minimize the impact of period-to-period changes in smaller companies as their impact on the total sector NOPAT and invested capital is smaller.

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