On the face of it, there’s nothing similar between cigarettes, software, and oil. The three are completely different sectors with totally different regulations, rivals, profit margins, and customers. Yet, there are three outstanding companies from these three sectors that exhibit very similar traits. These traits are worth paying attention to because they can spell big profits to investors. The companies that I’m about to discuss are the cigarette maker Lorillard (NYSE:LO), the software giant Microsoft Corporation (NASDAQ:MSFT) and the oil behemoth Exxon Mobil Corporation (NYSE:XOM).
The secret sauce of the three giants
The common denominator of these three totally unrelated companies is their outstanding capital efficiency. All three are leaders in their respective sectors, have great management and a proven track record of performance in good and bad times. But the hallmark of these three is their ability to generate an exceptional return on their assets, earn a high dollar per each unit that they sell, and most importantly – make sure that this excess cash returns to shareholders in the form of dividends and share buy backs. In short, all three are extremely capital – efficient businesses.
How to measure “capital efficiency”
There are three main parameters to use when calculating how efficient a business is with its capital.
Parameter #1: Return on assets (ROA)
The first parameter is the company’s return on assets. When a company consistently achieves a high return (more than 10%) on its assets – it means that it knows how to deploy cash effectively. It implies that capital expenditures (on a new factory, for example) will only be made if the company is certain that the asset will achieve a high enough return. Shareholders will always be protected against unnecessary expenditures. Lorillard (NYSE:LO), Microsoft Corporation (NASDAQ:MSFT), and Exxon Mobil Corporation (NYSE:XOM) post a ROA of a whopping 38%, 11% and 14%, respectively. This compares to a ROA of only 5% for the average S&P 500 company.
Parameter #2: Profit margins
The second parameter is the profit margins. High profit margins are a great indication that the company is able to charge a “premium” for its product. Some companies are only able to generate a few cents of profit for each dollar of sales. But not our famous trio. Lorillard (NYSE:LO), Microsoft Corporation (NASDAQ:MSFT), and Exxon Mobil Corporation (NYSE:XOM) post a whopping 25%, 22% and 11%, respectively. It’s worth noting that Exxon Mobil Corporation (NYSE:XOM) is a bit lagging in this parameter due to the heavily regulated oil industry in which it operates.
Parameter #3: True shareholder yield
When I calculate shareholder’s true yield, I like to take a company’s gross profits (after the cost of sales is deducted) and compare that with the amount of capital that’s returned to shareholders each year in the form of cash dividends or net share buybacks. So for example, if a company earned $10 billion in gross profits and returned $4 billion to shareholders, I’d say it had a capital efficiency of 40%. That’s a fantastic capital-efficiency ratio, which few companies can achieve consistently. Our trio have performed exceptionally well in that very important aspect. In 2012 alone – Lorillard (NYSE:LO) made $2.4 billion of gross profit. From this gross profit, it paid $807 million in cash dividends and an additional $573 million in net share buy backs. This translates to a whopping 58% shareholder yield. That’s a sky- high return. Microsoft Corporation (NASDAQ:MSFT) and Exxon Mobil Corporation (NYSE:XOM) also post exceptionally high yields, yet much lower than Lorillard (NYSE:LO)’s, of 17% and 19%, respectively.