- Maintain a focus on margins.
- Understand issues like tax treatments.
Return on Capital Employed (ROCE) is traditionally a key metric for evaluating if a company is high quality and its management is performing well. However, there are pitfalls when using ROCE as a guide for picking stocks. Some businesses, such as building contracting, are inherently very capital-light but have low margins, so the high risk and high cyclicality outweigh any apparent benefits in having a high ROCE. For other businesses, it’s always important to maintain a focus on the potential end returns you can realistically target.
Galliford Try (GFRD) – building contractors are risky animals and generate a low quality of earnings. They can look attractive with frequently high cash balances and high returns on invested capital (ROIC) – these are both tricks of the light. GFRD seeks to present itself as a business with a better work profile and using less competitive ways to procure its new work. However, in reality its workloads reflect the wider construction market and its margins, which are low at 2.5 per cent EBIT (earnings before interest and taxation), are only typical for the industry. Trading on a PE (share price to earnings per share) of around 12x, there could be some share price growth if forecasts are met but the consensus is bullish leaving slim room for error.
