Here at OppenheimerFunds, a few of our portfolio teams have come up with catchy ways to communicate their investment philosophy or focus themes.

For example, our International Growth team uses the acronym “MANTRA,” which stands for Mass Affluence, New Technologies, Restructuring, and Aging, to describe their thematic approach to investing. MANTRA does a good job of describing where the portfolio managers are focused.

 

Our Global Opportunities Fund manager uses “MULD” (Massive Upside, Limited Downside) to describe the types of stocks in which he seeks to invest.

 

The Value Fund team, on the other hand, does not have a memorable acronym or catch phrase that adequately describes our investment philosophy (although we’re open to suggestions). Simply put, we believe companies that experience an Unanticipated Acceleration in Return on Invested Capital (UAROIC) are positioned to outperform the broad equity market.

We know, UAROIC doesn’t exactly roll off one’s tongue. While we may not have a pithy catch phrase that neatly encapsulates our philosophy, we can explain here exactly why we believe this approach has the potential to be so powerful. We will tackle each part of UAROIC – we mean the philosophy – in turn.

Unanticipated…

This is perhaps the most important aspect of the process. Before we can determine if something is unanticipated, we must first assess what is, in fact, anticipated. Because a company’s current share price reflects the market’s expectations of future profitability, our research focuses on quantifying those expectations. There are shorthand methods to understand expectations, including valuation measures such as price-to-earnings (P/E) ratios and price-to-book ratios, which can give us a back-of-the-envelope idea about expectations and serve as a useful starting point.

Expectations analysis, however, must not start and end with these traditional measures. To quantify expectations of future profitability, we must relate these measures to a company’s return on invested capital (ROIC) profile. In other words, how much is the market willing to pay per unit of profitability?  We can then compare that with valuations the market places on other companies with similar profiles or that operate in similar businesses. This process is more easily said than done and requires a deep fundamental understanding of the business model and components of ROIC. Once we have identified what is anticipated, we can move on to assessing the future.

Acceleration …

Once we have a deep understanding of a company’s business model and have confirmed that, to the best of our knowledge, the current price does not discount improvement in ROIC, we shift to the next question: What may cause profitability to accelerate in the near future?

Near-term acceleration can be driven by cyclical forces, product cycles, restructuring, cost cutting, new management teams or any number of other factors. Our process seeks to identify companies that may undergo this kind of positive change within the next 6-12 months.

In Return on Invested Capital.

There are many ways to measure a company’s profitability. Earnings-per-share (EPS), earnings growth, profit margins, return on equity (ROE), and ROIC all attempt to measure how profitable a company is or will be. We believe ROIC is the best measure for our purposes because ROIC incorporates all of the capital a company uses to generate cash flow. In other words, ROIC measures the productivity of the combination of the income statement and the balance sheet.

When trying to identify changes in ROIC, we are guided by what we see as the three ROIC drivers: Sales, Margins, and Turns. All three components can have a direct impact on the cash flows a company generates.

Sales are straightforward. We want to find companies that we believe are positioned to generate better-than-expected sales growth given their current asset base. In other words, companies with pricing power and/or improving end demand.

Margins are one of the most widely used measures of profitability and can give us important insight into ROIC changes. Improving margins can be driven by many things, such as new products, a turn in the cycle, or cost cutting. This can have a direct impact on the direction of ROIC.

Turns are the final important driver of ROIC. In our view, turns do not receive sufficient investor attention. Asset turns represent the revenue generated per dollar of invested capital. This, to a large extent, will be a function of a company’s business model. For example, a high-turnover business such as a food retailer can have very high asset turns, generating multiple dollars of revenue per dollar of invested capital, while more capital-intensive businesses such as utilities might only generate cents on the dollar. The important point here is that it is not the starting point that matters, but the change: Companies who can do more with less can see their asset efficiency and, as a result, ROIC improve dramatically.

Bringing It All Together

Now that we’ve laid out our investment philosophy, the question that follows is: Does it work?

With the help of our friends at Credit Suisse, we investigated the impact of ROIC change on stock prices. What we found is that, on average, the top 20% of positive changes outperformed the overall market by almost 10 percentage points per year. (Exhibit 1)

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This study measured the performance of companies’ actual change in ROIC over the course of any given year. We obviously don’t know which companies will accelerate ROIC the most, but we believe it provides evidence that our investment philosophy, if done successfully, may help lead to outperformance.

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