We prefer return on invested capital (ROIC) over return on equity as it better reflects the return on the total capital invested. Return on equity can be inflated by using a lot of debt; think financials in the years leading up to 2008. Debt-to-equity is not our preferred metric either as we would prefer net-debt-to-assets to avoid a metric with a potential negative denominator, which could happen due to a lot of share buybacks. One case is Rockwell Automation, where its debt-to-equity ratio is a mammoth 558% due to share buybacks. But if you look at its net-debt-to-assets then the ratio is only 20%, which is still high for a quality company but easily manageable through its cash flow generation. Earnings variability is a good measure unless a big shift in the competitive landscape happens, because then you will be behind the curve as a function of your lookback window to compute this earnings variability; it’s probably better just to analyse the industry outlook and apply that human judgement.
Our preferred method is to look at ROIC/WACC, where WACC is the weighted average cost of capital. If this spread is above one then the company is creating shareholder value. Secondly a good net-debt-to-assets position combined with a strong business moat in an industry with a positive outlook are the next variables we look at. Combining these variables without regard to valuation, we filter the US and European large cap segment top to 25 high-quality stocks that could do well even during a deep recession due to COVID-19. These 25 stocks have delivered on average 10% return this year in local currencies, thus outperforming the overall equity market. However, please be aware that this is not an indication of future performance.