How do you decide what to buy?

I get the question a lot and I think it’s a good one. The answer depends on things like how long I’m planning to hold the stock, whether I see it as a value or a growth play, and where the momentum is in the market.

If I’m looking for a long-term investment, though, I don’t start with any of that stuff of with any of the usual measures such as price-to-earnings ratios, earnings growth rates, PEG ratios, or price to book or price to sales.

I start with ROIC—return on invested capital. I don’t think there’s a single number that tells investors more about whether they want to buy and hold a stock.

It’s also a good basis for lots of other investment decisions such as whether an acquisition is a good deal for shareholders or not. (For more on that see my post https://jubakpicks.com/2010/02/26/can-ceos-destroy-shareholder-value-in-an-acquisition-just-watch-them/ ).

Return on invested capital tells investors how good a job a company is doing at investing their money in profitable opportunities. It tells investors how good the company is at finding those opportunities. And—this is crucial for long-term investors—it indicates how good a job a company is doing at compounding investors’ money be re-investing profits at a high or low rate of return. (ROIC isn’t the most common of financial measures but you can find it on the Internet at sites like that of my partner MSN Money and AOL Daily Finance.)

One of the reason that stocks are such a great long-term investment—if you pick the right stocks—is that companies throw off cash from their operations that then gets re-invested by the company in those operations. Today’s profits compound over time to produce even more profits in the future.

You want to own shares of a company with a high ROIC for the same reason that you want to put your cash in a savings account that pays a high rate of compound interest.

Let me explain how this works and show you how powerful it is by looking at one of the best ROIC stories in Jubak’s Picks, MacDonald’s (MCD). (See my most recent update on McDonald’s https://jubakpicks.com/2010/02/10/update-mcdonalds-mcd-5/

McDonald’s is almost the perfect ROIC long-term holding.

1. The company throws off a ton of cash. For example, in 2008 cash flow from operations came to $5.9 billion. 2007 $4.9 billion. 2006 $4.3 billion. 2005 $4.3 billion.
2. The company has found opportunities to invest a huge hunk of this cash flow. In 2008 the company recorded $2.1 billion in capital spending. In 2007 $1.9 billion. In 2006 $1.7 billion.
3. And it gets a huge return on this invested capital. The company’s most recent return on invested capital was 19.1%. Just a little bit better than your bank gives you on your savings account, right?
4. The company looks to have lots and lots of opportunities for investing its capital in the years ahead. Capital spending in 2010 is projected to increase to $2.4 billion from $2.1 billion in 2009. The company has an ambitious program to expand into China, to refurbish existing restaurants, and to add new items to its menus.

Okay. McDonald’s isn’t perfect for a long-term investor. From that point of view it distributes too much cash to shareholders in the form of dividends. Hey, a 3.4% dividend is nice but I sure can’t find any place to invest it at anything like 19.1%. I can easily fix that problem by reinvesting my dividends, though. A bigger issue is the huge amount of money that the company has spent on buybacks, a total of $11.6 billion over the last five years, according to Morningstar. Add the dividends paid out during that period and the buybacks and it comes to about $20 billion. That’s more than the company’s cash flow from operations after capital spending (called free cash flow.) That means McDonald’s has been borrowing during this period so it can pay out this cash and keep investing in its business. That’s not a huge problem when interest rates are so low and when McDonald’s balance sheet is so strong but some conservative bone in my body doesn’t like the idea of borrowing money just to pay it out again.

You know the saying “The perfect is the enemy of the good”?

Well, it applies in spades to stocks. Investors don’t need to find the perfect stock just the better stock.

So compare McDonald’s to two of its restaurant peers. It beats Burger King (BKC) hands down. Cash flow from operations for Burger King in 2009 was just $311 million and capital spending was only $204 m million. And the company earned a ROIC of 9% in 2009. Not bad but not up to McDonald’s 19.1%.

I’ve been getting a lot of e-mail from investment newsletters pushing Yum! Brands (YUM) as a great fast-food play because of the huge presence that the company’s Kentucky Fried Chicken brand has in China. Looking at the numbers I can understand that recommendation: the company’s ROIC is 21.2%.

But I do have to disagree. Yum! Brands generates a tiny fraction of McDonald’s operating cash flow—just $1.4 billion in 2009 –and runs a capital budget less than half that of McDonald’s at $800 million.

If you do the math, you see that the larger cash flow and bigger capital budget compounds faster over time even at the lower ROIC.

But the comparison with Yum Brands! and Burger King serves as a good reminder to long-term investors that ROIC isn’t a static number. And changes in that number can be a reason for long-term investors and investors with other strategies to buy or avoid the stock.

So for example, you can see signs of a Burger King turnaround in the improvement of ROIC from an average of 5.6% over the last five years to the more recent 9%.

Microsoft’s (MSFT) ROIC shows the interesting trend. From a five year average of 28.6%, itself nothing to sneer at, the most recent ROIC has climbed to 33.9%.

And, of course, ROIC can move in the opposite direction indicating a company that’s in trouble and that investors might want to steer away from. BP, for example, shows a decline in ROIC from 14% on average over the last five years to 10% in the most recent year.

A falling ROIC can also mark opportunity, on the other hand, if an investor believes that the company is ready for a rebound to something like an average return on capital. I pay special attention to this when the company in question is an asset heavy, big capital spender. For example, the one-year ROIC for Transocean (RIG) has tumbled to 9.7% from a five-year average of 12.4. Considering how capital heavy this off-shore and deep-sea oil and gas drilling company is a return to even an average ROIC would produce huge earnings leverage. (See my most recent update on Transocean https://jubakpicks.com/2010/02/24/update-transocean-rig-5/ )

I began this whole journey into ROIC in my February 26 post on mergers by arguing that this measure could help investors tell good mergers –those that promised to create shareholder value—from bad—those that destroyed shareholder value.

I think ROIC can be even more useful in this slow economy where companies are so strapped for profitable growth that buying it seems like a good idea. A company with a historically high ROIC but a currently depressed one is often an attractive target for a larger competitor that has managed to keep its ROIC high even through the crisis.

So, for example, I’d say that Rockwell Automation (ROK) with its five year average ROIC of 14.2% and its recent 5.4% ROIC is an attractive acquisition candidate to a company such as ABB with its five-year average 15.8% ROIC and its more recent 15.7%.

Time to snap up a struggling competitor with a product line that makes a great fit.

A final caveat or two. Don’t ever fall so in love with any fundamental measure so that you forget about price: the goal is to buy a great ROIC at a good price. And never forget about momentum. Many the long-term investor has said, “Oh, price doesn’t matter and I don’t care if a stock goes down for a while because I’m going to hold long enough for it to come back.” Truth is that few of us can hang onto even the best of long-term stocks through a depressing slump that lasts months or even years. (See my post https://jubakpicks.com/2010/02/19/why-even-after-a-70-gain-this-is-still-a-secular-bear-market/ for one depressing possibility.)

No point in putting your sensitivity to pain to the test if you don’t have to. (Which is why I’m going to add ABB and Rockwell Automation to Jim’s Watch List with this column and not make them immediate buys.)

Full disclosure: I own shares in Microsoft and Transocean in my personal portfolio.