The importance of high ROE when selecting your stocks for the long term (Warren Buffett)

In his newsletter to Berkshire Hathaway's shareholders in 1987, Warren Buffett wrote a brilliant piece on his focus on return of equity in his selection of his companies.  Here are some of his notes.


1.   Only 6 out of 1000 had ROE > 30% during previous decade

In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade.  The best performer among the 1000 was Commerce Clearing House at 40.2%.

(Comment:  6 in 1000 is 0.6%)


2.  Only 25 of 1,000 companies had average ROE > 20% and no year with ROE < 15%, in last 10 years.

This Fortune study also mentioned that only 25 of the 1,000 companies met two tests of economic excellence -

• an average return on equity of over 20% in the ten years, 1977 through 1986, and 
• no year worse than 15%.

These business superstars were also stock market superstars:  During the decade, 24 of the 25 outperformed the S&P 500.

(Comment:  25 in 1000 is 2.5%)

3.  Companies with durable competitive advantage

These companies have two features.

• First, most use very little leverage compared to their interest-paying capacity.  Really good businesses usually don't need to borrow.
• Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seen rather mundane.  Most sell non-sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). 

The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics.  

(Comment:  About 20 of 1,000 companies in KLSE, that is, 2%, are investable for the long term.)

4.  Quoting Buffett from his 1987 letter to shareholders of Berkshire Hathaway:

"There's not a lot new to report about these businesses - and that's good, not bad.  Severe change and exceptional returns usually don't mix.  Most investors, of course, behave as if just the opposite were true.  That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change.  That prospect lets investors fantasise about future profitability rather than face today's business realities.  For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be."

Reference:

http://www.berkshirehathaway.com/letters/1987.html