Focus on Return on Equity

The Key to Finding Stocks that Will Make You Rich? Focus on Return on Equity
By Joshua Kennon, About.com

Countless successful investors, businessmen, and financiers have emphatically stated, and proven through their own career, over long periods of time, the performance of a stock most closely correlates with the return earned on shareholders’ equity.

As one well known investor put it, even if you buy a business at a huge discount, if you hold the stock for five, ten years or more, it’s going to be highly unlikely that you will be able to earn more than the ROE generated by the underlying enterprise.

Likewise, even a more reasonable price or a slightly higher price-to-earnings ratio for a better business that earns, say sixteen or seventeen percent on capital, you’re going to have very, very good results over a twenty or thirty year period.

An excellent example is Johnson & Johnson. According to the company’s most recent annual report, “In 2006, we logged our 74th year of sales increases, our 23rd consecutive year of earnings increases adjusted for special charges and our 44th consecutive year of dividend increases. This is a record matched by very few, if any, companies in history.” The firm is diversified throughout the medical supplies, pharmaceutical, and consumer product fields. These include household names such as Tylenol, Band-Aid, Stayfree, Carefree, K-Y, Splenda, Neutrogena, Benadryl, Sudafed, Listerine, Visine, Lubriderm, and Neosporin, not to mention the eponymous baby care products such as powder, lotion, and oil. Compared to the S&P 500, the stock currently trades at a lower p/e ratio, a lower price to cash flow ratio, a lower price to book ratio, and boasts a higher cash dividend yield, all while earning a much higher return on assets and return on equity than the average publicly traded company!

Investing is a game of weighing odds and reducing risk. Can you guarantee that you will beat the market? No. You can, however, increase the chances of that happening by focusing on companies that have comparable profiles – established histories, management with huge financial interest in the company, a history of executing well, discipline in returning excess capital to shareholders through cash dividends and share repurchases, as well as a focused pipeline of opportunities for future growth. These are the stocks that have better chances of compounding uninterrupted, meaning less of your money goes to commissions, market maker spread, capital gains taxes, and other frictional expenses. That small advantage can lead to enormous gains in your net worth; only 3% more each year, over an investing lifetime (say, fifty-years), is triple the wealth!

The biggest challenge is the fact that very few firms are actually able to maintain high returns on equity over substantial stretches of time because of the breathtaking ruthlessness of capitalism. Of course, as consumers, we all benefit from this in the form of a higher standard of living through lower costs, but for owners, it can mean volatility and financial setback. That’s why you must settle inside of yourself the question of exactly how large a company’s competitive “moat” is, factoring that into your valuation. Do you think someone will be able to unseat Coca-Cola as the dominant soft drink company in the world? How about Microsoft? The latter would certainly seem more vulnerable than the former, but both are much better off than a marginal steel company trying to eek out a profit in a commodity-like business with little or no pricing power and few, if any, barriers of entry.

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