Original Sin

One of investing's original sins is summed up perfectly by the phrase: “past performance is not indicative of future results." That remains true in every facet outside of the value vs. growth one too. I lean too much towards "value" even if they are attached to the hip and fail to understand how important ROIC/ROC is vs. FCF. I know the Munger quote:

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result."

But knowing is not understanding. I am finally understanding with a thought bringing the numbers to an understandable limit. If a company has a fcf of 10% and just pays it all out in dividends, the return is 10%. If the company has a fcf yield of 10% and is rebuying stock with the free cashflow, you can compound at 1.1^n. If a company only has a fcf yield of 5%, but it manages to retain 50% while deploying at a ROIC of 30%, the return is 20%. Its fcf will grow .75% a year (30% of 2.5%). Its return is theoretically 5% fcf + .75*20 (.75 growth and 20 is the valuation of the growth) 15% for a total of 20%. Eventually the growth will be exhausted and its fcf yield will have to equal all the return as nothing can grow infinitely. The bond rate is a good rate to discount a company's fcf yield to. Until I actually used numbers to fill in the quote that I knew, I did not understand ROIC is not just a proxy for a durable competitive advantage, but can provide details about the future if its retained earnings can be deployed at the ROIC rate. It is easy to hunt for fcf yield, but combining it with ROIC will be measurably more powerful. I am starting to look at the distributors in the "real asset" space in FERG(plumbing/HVAC), MAS(plubmbing/paint), amd POOL(pool supplies). Their ROIC seem to be good even if their fcf are in the low single digits. I am not sure MAS can deploy their capital in the future as much as FERG or POOL even if its higher fcf yield makes it attractive. UNH might be getting interesting as healthcare is robust and a space that is not going away. NVO always stares at a patent cliff, but its ROIC is high as well. Again, ROIC might not be important though because if there is nowhere to deploy retained earnings, then the future dictates that only fcf matters as ROIC would be a measure of past employed capital.