Want your stock picks to beat index funds? Look at companies with one key metric.

By Philip van Doorn

A long-term analysis on returns on invested capital shows that the best financial operators tend to beat the S&P 500's returns

Long-term investors have been well served by index funds, which often charge very low fees and can be hard for active portfolio managers to beat. But some investors want to select individual stocks for portions of their portfolios. While it can be very difficult to pick those, a long-term look at quality financial performers might be an excellent way to begin your own research.

Your objective needs to be at the heart of your decision. For example, if you are looking to build up a stream of dividend income from stocks, investing in companies that have increased their dividend payouts might be a good approach.

If your objective is growth, you might go for a quick killing by trying to pinpoint the next hot trend, or set of trends, that other investors haven't identified and bid up yet. Good luck with that.

A broad indexing approach has worked well. For example, the S&P 500 SPX has returned 554% over the past 20 years through Feb. 9, for an average annual return of 9.8%, according to FactSet. (All returns in this article include reinvested dividends.) In a note to clients on Feb. 12, Ned Davis Research analyst London Stockton wrote that a look at nearly 100 years of market data showed that the S&P 500 had an average annual return of 10.2%, "excluding costs." He added: "During this time there have been no negative 20- or 30-year periods, with 96.6% of 10-year periods positive."

One easy way to ride along with the U.S. benchmark index has been to hold shares of the SPDR S&P 500 ETF Trust SPY, which has annual expenses of 0.0945% of assets under management and has returned 542% over the past 20 years, with an average annual return of 9.7%. There are also newer S&P 500 index funds with fees lower than those of SPY.

For individual stocks, a company's return on invested capital can shed light on how strong operating performance over the long term can be correlated to good stock performance.

A 20-year screen

A company's return on invested capital is its net income divided by the sum of the carrying value of its common stock, preferred stock, long-term debt and capitalized lease obligations.

ROIC is an annualized figure that highlights how efficiently a management team allocates capital - in other words, how well it makes use of the money investors have provided to run the business. It isn't necessarily a fair way of looking at performance, because different industries are naturally more capital-intensive than others. But we don't need to be fair when taking a broad look at the stock market.

The carrying value of a company's stock may be much lower than its current market capitalization. The company may have issued most of its shares many years ago at a price much lower than today's price. If a company has issued a large amount of newer shares recently, or at relatively high prices, its ROIC will be lower. If a company has low debt, its ROIC is higher. If a company is being forced to increase borrowings, especially as interest rates are rising, its ROIC will go down.

We recently included five- and 10-year lookbacks at ROIC as part of an analysis of the largest 10 components of the S&P 500 by market capitalization, in order to isolate which ones might represent the best value for investors.

But today we are taking a more extreme approach, looking back 20 years.

FactSet calculates companies' ROIC each quarter for rolling four-quarter periods. Since many companies have fiscal years that don't match the calendar, the most recent ROIC calculations encompass each company's past four quarterly financial reports.

For a 20-year screen of the S&P 500, we began with the current ROIC figures, then went to those of four fiscal quarters ago, then eight quarters and so on, to have 20 12-month ROIC snapshots for our 20-year averages.

Among the S&P 500, 20 years of ROIC data is available from FactSet for 342 companies, and 20-year total returns are available for all but six. FactSet might have 20 years of ROIC data even for a company that hasn't been publicly traded for 20 years: For example, Alphabet Inc. (GOOGL) went public as Google Inc. in August 2004.

For the remaining 336 companies in the S&P 500, these 20 have had the highest average returns on invested capital over the past 20 years:

   Company                          Ticker   20-year average ROIC  10-year average ROIC  Return, 20 Years  Avg. 20-year return  Return, 10 Years 
   VeriSign Inc.                     VRSN                  241.9%                460.9%            1,166%                13.5%              277% 
   Accenture PLC Class A             ACN                    54.0%                 39.9%            2,167%                16.9%              451% 
   AutoZone Inc.                     AZO                    36.7%                 40.3%            2,884%                18.5%              401% 
   HP Inc.                           HPQ                    36.6%                 63.7%              306%                 7.3%              190% 
   Idexx Laboratories Inc.           IDXX                   36.3%                 47.6%            4,379%                20.9%              863% 
   Paychex Inc.                      PAYX                   36.3%                 38.3%              531%                 9.7%              306% 
   Yum Brands Inc.                   YUM                    33.0%                 40.3%            1,464%                14.7%              204% 
   Apple Inc.                        AAPL                   33.0%                 37.5%           55,015%                37.1%            1,055% 
   Colgate-Palmolive Co.              CL                    32.6%                 29.9%              382%                 8.2%               73% 
   S&P Global Inc.                   SPGI                   32.5%                 32.9%             1514%                14.9%              510% 
   Monster Beverage Corp.            MNST                   32.5%                 24.1%           51,682%                36.7%              388% 
   TJX Cos. Inc.                     TJX                    31.1%                 28.1%            2,086%                16.7%              281% 
   Ross Stores Inc.                  ROST                   30.9%                 28.9%            2,235%                17.1%              364% 
   Rollins Inc.                      ROL                    28.9%                 26.7%            2,601%                17.9%              491% 
   Lockheed Martin Corp.             LMT                    28.8%                 29.9%            1,408%                14.5%              262% 
   FactSet Research Systems Inc.     FDS                    28.7%                 26.9%            2,279%                17.2%              414% 
   C.H. Robinson Worldwide Inc.      CHRW                   28.4%                 24.5%              455%                 8.9%               80% 
   Tapestry Inc.                     TPR                    28.0%                 11.7%              225%                 6.1%               21% 
   NVR Inc.                          NVR                    27.3%                 27.3%            1,461%                14.7%              527% 
   Automatic Data Processing Inc.    ADP                    27.3%                 33.6%            1,062%                13.0%              374% 
   S&P 500                           SPX                 554%                 9.8%              237% 
   SPDR S&P 500 ETF Trust            SPY                 542%                 9.7%              235% 
                                                                                                                                 Source: FactSet 

Click on the tickers for more about each company, fund or index.

Click here for Tomi Kilgore's detailed guide to the wealth of information available for free on the MarketWatch quote page.

Total returns and average annual returns are included at the bottom of the table for the S&P 500 and SPY, for comparison. Among these 20 companies, 15 have beaten the S&P 500's 20-year return. Apple Inc. (AAPL) has had the best 20-year and 10-year returns. For 10 years, Apple's return has been double that of the second-best performer on the list, NVR Inc. (NVR). And Apple's 10-year average ROIC has been higher than its 20-year average ROIC.

Mastercard Inc. (MA), with a 20-year average ROIC of 37.6%, would have made the top 20 list, but the company only went public in May 2006. The company's average 10-year ROIC has been 46.2%. The stock has returned 538% over the past 10 years.

VeriSign Inc. (VRSN) had has the highest ROIC by far among the S&P 500. The company has an exclusive right, granted by the Commerce Department, to maintain domain registrations for ".com" and ".net" internet addresses. During an interview in September, Brad Klapmeyer, a managing director and senior portfolio manager at Ivy Investments, said VeriSign's arrangement with the Commerce Department had changed in recent years to allow greater flexibility with pricing, and that the simplicity of the company's business meant it needed little invested capital to fund its operations.

Don't miss: This fund manager stopped worrying about economics. Now he is outperforming the stock market

-Philip van Doorn

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02-17-24 0757ET

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