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I'd like you remember this sentence for the rest of your investing career:
>*The best-performing stocks are companies that generate high returns on capital without putting themselves at risk of financial distress*
I came across [this chart](https://imgur.com/a/f0ccNiC) that tracked performance from 1985 to 2024 across companies in the S&P500, ranked from high to low quality. There are some key takeaways that will be mind-blowing to some of you, especially if you're new to investing or only invest in ETF's.
Why do certain businesses perform well and others don't as a stock on the stock market?
Well, not all "quality" metrics are created equal. The top performing businesses have all the boxes ticked that will give you high returns on capital.
* ROIC (Return on Invested Capital)
* Interest Coverage (ability to pay interest)
* ROA (Return on Assets)
* ROE (Return on Equity)
* Debt Coverage
Why this matters so much is because it answers a couple of questions.
1. How much and efficiently a company turns capital into profit?
2. How good the business is at making money?
3. How resilient the company is when the economy is going bad?
Like, and this is a very simple example, if a business doesn't have any debt it's tough to get out of business. It doesn't have to pay interest so, it can reinvest it's capital into the business. Which will create more assets and more equity. At some point, they can't grow fast enough with their own capital so they start using debt to fund that growth. As long as it is conservative they will keep compounding.
Now you might think, and what about revenues and margins and all that because if nobody is buying anything from the business, the business goes out, right?
And you are absolutely correct. We need sales as a business to grow. So, we still look at sales, margins and eps growth for sure. But those are not that important as the "top tier" I shared. Because, these can be manipulated. Don't only look at one area of the business. Combine them instead.
Let me give you an example to put this into perspective. Visa is 19% of my portfolio and the biggest weighing.
* ROIC is 29%.
* In the past ten years we see an upward trend from low 20's to high 20's.
* Anything above 15% is excellent. Also, the reason we look at past performance is because ROIC becomes a better indicator of quality instead of a one time off performance.
* Interest Coverage is 38%.
* In the past 5 years it improved from 27% to high 30's.
* This ratio is important because it determines how easily a company can pay interest expenses on outstanding debt. The higher the ratio, the stronger the company's financial strength is.
* Also, look at maturity dates. If, the next maturity date is 2 years out, the business has plenty of time to pay that debt off. If more than half is due next year or so, and they can not cover it with their outstanding cash or free cash flow... well, the business might be in trouble.
* ROA is 21%.
* Improved from low 10's to low 20's.
* This shows the efficiency of a business in generating profits. Only compare with peers.
* ROE is 52%.
* Improved from low 20's to low 50's.
* This metric shows how well a business uses it investing money to generate earnings (growth). Looking for at least 15%.
* Debt to equity is 0.52
* Has been hovering around this number for a very long time
* Know that when a company has a lot of financial leverage, it can boost ROE which is a bad sign. You want high ROE companies with low leverage.
So, the story we get told by the fundamentals here is that the company improved it's business, whilst keeping leverage at the same level as roughly ten years ago. Revenue kept growing, margins are flat or slightly improving, and free cash flow keeps growing as well.
Bottom line, according to the numbers this is a top notch business. No matter of what the headlines are saying. Do this check up with every business you'd like to buy and consider a margin of safety and you'll do well as an investor.