When it comes to business strategy, many analysts focus on high gross margins as the key to success. However, this approach may not always lead to higher return on investment (ROIC). In fact, a company with lower gross margins can still achieve higher ROIC if it has a competitive advantage in terms of inventory turns.

This concept is often overlooked by investors who only look at margins and ignore other important metrics such as inventory turns. However, companies like Kmart and Target have shown that higher inventory turns can lead to equal or even higher ROIC on lower margins.

One way to calculate the impact of inventory turns on ROIC is to use the return on inventory investment (ROII) formula. This formula takes into account not only gross margin but also inventory turns. For example, if a company has a gross margin of 20% and an inventory turn of 8 times per year, its ROII would be (20 x 8), which is higher than a company with a gross margin of 36% and an inventory turn of 4 times per year.

The key to success for discount retailers like Kmart and Target was their ability to turn over inventory quickly and efficiently. This allowed them to achieve equal or even higher ROIC on lower margins, making them more competitive in the market.

In contrast, department stores that focused on high-end products and targeted affluent customers struggled to compete with discount retailers. They may have had higher gross margins, but they lacked the efficiency and agility of their competitors when it came to inventory turns.

As Peter Thiel notes in his book 'The Innovator's Dilemma,' companies often focus on moving 'up market' and targeting higher-margin products, rather than exploiting gaps in the market. However, this approach can lead to missed opportunities for companies that are better suited to target lower-margin markets with higher inventory turns.

In conclusion, while high gross margins may be important, they are not always the best indicator of a company's strategy or profitability. Inventory turns play a crucial role in determining ROIC, and companies that focus on efficiency and agility can achieve success even on lower margins. By ignoring inventory turns and focusing solely on gross margin, investors may miss out on opportunities to identify undervalued companies with strong competitive advantages.

Inventory turns formula