ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.



Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

• In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
• To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
• If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  

But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.

Why Return on Equity Matters

Let's say you want to open a whole chain of restaurants.

In the early years of building your business empire, you will be adding to your capital base aggressively.  

But because of the costs of opening restaurants, you will probably take losses; most companies in their formative stages lose money.  

If after a few years you have sunk $500,000 into your restaurants but are losing $50,000 annually, your return on capital is negative 10%.

It is not necessarily bad for a company to earn a negative return on equity - if it can earn a high return in the future, that is.

An investor will stomach a negative 10% ROE for his restaurants if he believes they can earn much higher returns in the future.

The trouble is, in a company's rapid-growth phase, when returns on equity are most often small or negative, it is tough to separate a good business (one that can earn a high ROE) from a bad business (one not able to).  After all, each is losing money.

Analyzing such companies means asking questions like

• "Is this a company with enough pricing power to eventually command a premium price for its product?"
• And "Is this a company with enough of a cost advantage that it can undercut the competition?"

It means, in other words, asking whether the company's business can either generate a high net margin (profit/sales) or a high asset turnover (sales/assets), the two key components of a high return on capital. 

ROE - Key Performance Indicator for Company Management

Introduction of ROE

Return on Equity (ROE) is a term important in shares/equity investment. The simple formula for ROE is Net Profit / Shareholdings. In short, it is measured by how strong is the top management to produce profit based on current shareholdings. In DuPont formula, it is calculated as Net Profit Margin * Asset Turnover * Equity Multiplier. I will explain to you the components one by one:


Simple DuPont Formula Explanation  

1. Net Profit Margin (Net Profit / Revenue) - This is one of the very key indicators to measure company performance. A good company with 'Monopoly' status always have a better profit margin as compared to the peer companies. It can be achieved by Economy of Scales or through operation efficiencies. When you notice that the company's profit margin is increasing, perhaps you can check whether it is due to a new product launched or operation efficiencies or due to cost control improvement etc. 
2. Asset Turnover (Revenue / Asset) - It is an indicator to show whether the company is capable to have a better turnover by selling more products with limited asset available. A low non-current asset based company can perform better than a high non-current asset based company due to its bargaining power against customer.
3. Equity Multiplier (Asset / Equity) - Sometimes a good ROE can be due to high equity multiplier. It means that the company has bigger borrowing from bank/payable/bond holders to achieve higher asset. In finance industry, the leverage can be as high as 10 times and above. You must compare the equity multiplier with its peer companies. Normally if company can achieve optimal capital structure, the WACC can be the lowest. Thus, investor can achieve higher returns.

Things to take note



It does not necessary mean that you can achieve a good returns by investing in high ROE company. However, if you can find out a company is having higher and consistent ROE as compared to
its peer company in same sector, it means that this company's management is better to produce better returns as compared to rest. You must also take into considerations the other figures such as Price per Earning ratio, Dividend yield etc.

Conclusion


By comparing ROE with peer companies, you also must take note that whether the company manipulate its annual report.  It is also good that you can do a relative comparison on P/E ratio and Dividend Yield while making investment decisions.  With a good and consistent ROE, the longer you hold the investment the better the profit you can forsee in the long run.


http://www.jackphanginvestment.com/2011/04/roe-key-performance-indicator-for.html

The Mark of a Good Business: High Returns on Capital

The Mark of a Good Business: High Returns on Capital
Written by Greg Speicher on October 19, 2010

Categories: Buy Good Businesses, Warren Buffett

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett, 1992 Berkshire Hathaway Shareholder Letter

A good business is one that can earn very high returns on capital. Rarely can such a business invest all of its capital back into the business. One way to find companies that can is to look for companies that have grown book value at a high rate on a per share basis.

A business can still be a good investment if it can’t reinvest all of its earnings back into the business. An example is American Express. Prior to the 2008 economic crisis, Amex was earning over 30% on equity but was only reinvesting about a third of its earnings back into the business. The remaining two-thirds were paid out in the form of dividends and share repurchases.

There are numerous ways to measure return on invested capital. None of them is perfect. Any of the various metrics and ratios investors use to analyze a business are abstractions and, as such, typically tend to oversimplify the economic reality of the business. They are short-cuts we use to point us in the right direction so we can spend our precious time researching businesses that offer the most opportunity.

Return on Incremental Equity

I like to look at the total amount of equity that has been added to a business over the past decade and then calculate the return on that additional investment. This approach also allows me to calculate what percentage of the company’s earnings was reinvested, which in turn is useful in forecasting the future growth in earnings.

I typically use Value Line when I do this because the layout is very conducive to this type of analysis. It is one reason why investors like Buffett, Munger and Li Lu like Value Line.

It is useful here to remember Buffett’s reminder that it is not necessarily a cause for celebration if a business grows its earnings year after year. The same thing happens to a savings account if you add more capital each year, which does not make a savings account a good investment. It’s the return on this additional capital that determines whether something is a good investment or not.

To illustrate, let’s look at Johnson & Johnson (JNJ). In 2000, JNJ had shareholders’ equity of $18.8 billion. At the end of 2009, its shareholders’ equity had grown to $50.6 billion. We can calculate that, since 2000, JNJ invested $31.8 billion back into the business.

During that same time, earnings grew $8.1 billion, from $4.8 billion in 2000 to $12.9 billion in 2009.
By dividing the additional earnings of $8.1 billion by the additional $31.8 billion in capital, we can see that JNJ earned a return of 25.5% on its investment, which is very good.

It is also useful to look at what percentage of its total net earnings JNJ reinvested back into the business. The reason is that this is suggestive of how much of its future earnings JNJ is likely to reinvest. By multiplying the rate of reinvestment by the return on that investment, we can then calculate an expected growth rate for earnings.

Since 2000 through 2009, JNJ earned a total net profit of $89.7 billion. Since we already know that JNJ reinvested $31.8 billion over that same time period, we can calculate that JNJ’s rate of reinvestment is 35.5%.

If JNJ can continue to earn 25.5% on equity and reinvest 35.5% of its earnings, earnings should grow at about 9% (.255 x .355).

Keep in mind that this does not include dividends or share repurchases. The latter would cause earnings per share to grow at a faster rate. Also, it does not include an analysis of where JNJ is selling in relation to its intrinsic value which could have a material impact on the expected total return. Finally, this type of analysis works best with a stable business that enjoys durable competitive advantages, such as JNJ.

Another example is Southwest Airlines which is a successful airline that operates in the highly competitive and capital intensive airline industry. Between 2000 and 2009, Southwest’s shareholders’ equity increased by $2 billion. Earnings were $140 million in 2009 compared to $625 million in 2000 and have generally bobbed around over that time period. The return on that additional $2 billion has been relatively poor.

Calculating the return on incremental equity over a long-period of time should prove a useful tool in your analysis of prospective investments. Coupled with the rate of reinvestment, it can also allow you to get an idea of how fast a company can be expected to grow its earnings.


You can also use this approach to invert an expected rate of earnings growth to examine what combination of ROE and rate of reinvestment will be required to produce it.

In succeeding related posts, I’ll look at Buffett’s use of return on average tangible net worth and Greenblatt’s use of return on tangible capital employed to determine whether a business is good.

http://gregspeicher.com/?p=1660

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The Mark of a Good Business: High Returns on Capital (Part 2)
Written by Greg Speicher on October 26, 2010 -
Categories: Buy Good Businesses, Warren Buffett

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.” – Warren Buffett 1992 Berkshire Hathaway Shareholder Letter

Last week, I wrote a post that looked at return on incremental equity. The post explained a way to measure return on incremental equity over a multi-year period. It also considered how, in a stable business with a durable competitive advantage, the return on incremental equity and can be used, in conjunction with the rate of reinvestment, to predict the growth in earnings.

Today, I am writing about another tool used by Buffett to measure the returns on an investment: return on average tangible net worth.

Beginning with the 2003 Berkshire Hathaway letter to shareholders, Buffett began providing a simplified balance sheet of the manufacturing, service and retailing operations segment, a widely diversified group which includes building products, carpet, apparel, furniture, retail, flight training, fractional jet ownership and distribution.

Buffett breaks out the four broad segments of Berkshire – insurance, utilities, finance, and manufacturing, service and retailing operations – because they each have different economics which are harder to understand if considered as one undifferentiated mass. This is obviously useful to remember when analyzing a business with two or more disparate operating segments.

When he reports on the results of the manufacturing, service and retailing operations segment, Buffett focuses on the return earned on average tangible net worth, which for example in 2003, was in Buffett’s words “a hefty” 20.7%.

To calculate tangible net worth, take the equity on the balance sheet and subtract goodwill and other intangible assets. Buffett averages the tangible net worth that is on the books at the beginning and end of the year so as not to upwardly bias the return if the earnings were in part the result of a large injection of capital into the segment during the year.

On average, the segment enjoys very strong returns on average tangible net worth, typically in the low 20’s. This is highly meaningful because it not only shows the excellent economics of these businesses, but also it shows the returns that can be expected from additional capital that is invested into these businesses.

Here is the simplified balance sheet for the years since Buffett began providing it along with the calculations.
Here are some additional observations.

Buffett also provides the returns on Berkshire’s average carrying value. This is the same calculation as return on average tangible net worth without subtracting goodwill. Berkshire had to pay a substantial premium over book value to purchase these businesses given their excellent economics. Over the long-term, the return on incremental equity will be the major determinant of Berkshire’s returns on these investments as the retained earnings become an ever larger portion on the capital employed. As an investor, you want to pay close attention to both the premium you pay to buy a great business and the returns on incremental capital.

Omitting goodwill and intangible assets from the equation is appropriate because Berkshire will not need to pay a premium on incremental capital employed in the existing businesses. Berkshire does, however, need to pay a premium going forward to acquire businesses to add to this segment. This is evident from the goodwill and intangible assets line item which has grown from $8.4 billion in 2003 to $16.5 billion in 2009. Overall, to put that in context, Buffett invested an additional $15 billion in that segment over the same time period.
In analyzing an investment, you want to consider whether future growth will come from acquisitions, in which case you can expect additional goodwill, or organic investment, in which case the returns on tangible net worth would be a more appropriate metric.


Unfortunately, from the standpoint of providing opportunities for Berkshire to deploy capital going forward, some of Berkshire best businesses, which are found in this segment, are both small in scale as compared to Berkshire as a whole and require very little incremental capital.

Finally, it is fairly clear that this segment’s earning power has been materially impacted by the recession. If it is able to return to pre-recession levels, this group should earn net income of approximately $3 billion.

http://gregspeicher.com/?p=1708

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.

Warren Buffett believes that the return that a company gets on its equity is one of the most important factors in making successful stock investments.

DEFINING EQUITY

Benjamin Graham defines stockholders equity as:

‘The interest of the stockholders in a company as measured by the capital and surplus.’

CALCULATING OWNER’S EQUITY

Investors can think of stockholders equity like this. An investor who buys a business for $100,000 has an equity of $100,000 in that investment. This sum represents the total capital provided by the investor.

If the investor then makes a net profit each year from the business of $10,000, the return on equity is 10%:

10,000 x 100
  100,000

If however the investor has borrowed $50,000 from a bank and pays an annual amount of interest to the bank of $3500, the calculations change. The total capital in the business remains at $100,000 but the equity in the business (the capital provided by the investor) is now only $50,000 ($100,000 - $50,000).

The profit figures also change. The net profit now is only $6500 ($10,000 - $3,500).

The return on capital (total capital employed, equity plus debt) remains at 10%. The return on equity is different and higher. It is now 13%:

6,500 x 100
 50,000

The approach to financing its operations by a company can obviously affect the returns on equity shown by that company.

WHY WARREN BUFFETT THINKS THAT RETURN ON EQUITY IS IMPORTANT

Just as a 10% return on a business is, all other things being equal, better than a 5% return, so too with corporate rates of returns on equity. Also, a higher return on equity means that surplus funds can be invested to improve business operations without the owners of the business (stockholders) having to invest more capital. It also means that there is less need to borrow.

WHAT RATE OF RETURN ON EQUITY DOES WARREN BUFFETT LOOK FOR?

This is a fluctuating requirement. The benchmarks are the return on prime quality bonds and the average rate of returns of companies in the market. In 1981, Buffett identified the average rate of return on equity of American companies at 11%, so an intelligent investor would like more than that, substantially more, preferably. Bond rates change, so the long-term average bond rate must be considered, when viewing a long-term investment.

In 1972, Buffett implied that a rate of return on equity of at least 14% was desirable. Although, at times, Warren Buffett has appeared to downplay the importance of Return on Equity, he constantly refers to a high rate of return as a basic investment principle.

COMPANY RATES OF RETURN ON EQUITY

It is significant that the majority of companies in the Berkshire Hathaway portfolio in 2002 all had higher than average returns on equity over a ten-year period. For example:

Coca Cola	45.05
American Express	20.19
Gillette	40.43

INVESTMENT DANGERS

There can be dangers in averaging returns over a long period. A company might start with high rates which then fall away, but still have a healthy average. Conversely, a company might be going in the opposite direction. As Warren Buffett looks for predictability in a company’s earnings, one would imagine that he would favour companies who increase their ROE or which have consistent levels.

COMPANY ANNUAL RATES OF RETURN

Compare the annual rates of return on equity of the following companies, using summary figures provided by Value Line.

Year	Coca Cola	Gap Inc	Wal-Mart Stores
1993	47.7	22.9	21.7
1994	48.8	23.3	21.1
1995	55.4	21.6	18.6
1996	56.7	27.4	17.8
1997	56.5	33.7	19.1
1998	42	52.4	21
1999	34	50.5	22.1
2000	39.4	30	20.1
2001	35	4.3	19.1
2002	35	13.1	20.4

RETURN ON CAPITAL IS VERY IMPORTANT

The example early on this page shows that debt financing can be used to increase the rate of return on equity. This can be misleading and also problematical if interest rates rise or fall. This is probably one reason why Warren Buffett prefers companies with little or no debt. The rate of return on equity is a true one and future earnings are less unpredictable. A careful investor like Buffett would always take rates of return on total capital into account. The average rates of return of capital in the companies referred to above in Berkshire Hathaway portfolio are:

Coca Cola	39.12
American Express	13.68
Gillette	25.93

A comparison of the rates of return on equity and capital for these three companies is significant and the reader can make their own calculations.

http://www.buffettsecrets.com/return-on-equity.htm

A key to beating the market is to invest in companies with strong returns on capital when they trade at low P/E's.

You wouldn't know it from looking at Acme's stock price, however. The company trades with a P/E of just 11, despite excellent returns on equity. To see the company's valuation in perspective, consider the P/E ratios of the following companies with similar returns on equity over the last five years (see chart).

Acme is not as recognizable as the rest of the names, but this is precisely why investors are offered this company at a discount. Many would argue that because the company is small, its riskiness is higher than the companies above. While that may be true to some extent (for example, three customers each exceed 10% of Acme's sales), the upside is also higher as the company has room to grow. Acme has an on-going goal of generating 30% of its sales from products developed in the last 3 years. This is something that the large companies listed above would have great difficulty achieving.

In his book, The Little Book That Beats The Market, Joel Greenblatt discusses how the key to beating the market is to invest in companies with strong returns on capital when they trade at low P/E's. Acme fits this description well.

Of course, investors cannot buy simply on the basis of a company's P/E. Further investigation of a company's risks and opportunities is necessary, as well as a careful reading of the company's notes to its financial statements.

http://www.gurufocus.com/news.php?id=86069

Buffett (1992): His thoughts on issuing shares.

His thoughts on issuing shares.  He concentrated most of his investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals.


Here are the investment wisdom Warren Buffett doled out through his 1992 letter to Berkshire Hathaway's shareholders.

Up front is a comment on the change in the number of shares outstanding of Berkshire Hathaway since its inception in 1964 and this we believe, is a very important message for investors who want to know how genuine wealth can be created. Investors these days are virtually fed on a diet of split and bonuses and new shares issuance, in stark contrast to the master's view on the topic. Laid out below are his comments on shares outstanding of Berkshire Hathaway and new shares issuance.

"Berkshire now has 1,152,547 shares outstanding. That compares, you will be interested to know, to 1,137,778 shares outstanding on October 1, 1964, the beginning of the fiscal year during which Buffett Partnership, Ltd. acquired control of the company."

"We have a firm policy about issuing shares of Berkshire, doing so only when we receive as much value as we give. Equal value, however, has not been easy to obtain, since we have always valued our shares highly. So be it: We wish to increase Berkshire's size only when doing that also increases the wealth of its owners."

"Those two objectives do not necessarily go hand-in-hand as an amusing but value-destroying experience in our past illustrates. On that occasion, we had a significant investment in a bank whose management was hell-bent on expansion. (Aren't they all?) When our bank wooed a smaller bank, its owner demanded a stock swap on a basis that valued the acquiree's net worth and earning power at over twice that of the acquirer's. Our management - visibly in heat - quickly capitulated. The owner of the acquiree then insisted on one other condition: "You must promise me," he said in effect, "that once our merger is done and I have become a major shareholder, you'll never again make a deal this dumb."

It is widely known and documented that Berkshire Hathaway boasts one of the best long-term track records among American corporations in increasing shareholder wealth. However, what is not widely known is the fact that during this nearly three decade long period (1964-1992), the total number of shares outstanding has increased by just over 1%! Put differently, the entire gains have come to the same set of shareholders assuming shares have not changed hands and that too by putting virtually nothing extra other than the original investment. Further, the company has not encouraged unwanted speculation by going in for a stock split or bonus issues, as these measures do nothing to improve the intrinsic values. They merely are tools in the hands of mostly dishonest managements who want to lure naïve investors by offering more shares but at a proportionately reduced price, thus leaving the overall equation unchanged.

How is it that Berkshire Hathaway has raked up returns that rank among the best but has needed very little by way of additional equity. The answer lies in the fact that the company has concentrated most of its investments in companies where shareholder returns have greatly exceeded the cost of capital and where the entire need for future growth has been met by internal accruals. Plus, the company has also made sure that it has made purchases at attractive enough prices. Clearly, investors could do themselves a world of good if they adhere to these basic principles and not get caught in companies, which consistently require additional equity for growth or which issue bonuses or stock-splits to artificially shore up the intrinsic value. For as the master says that even a dormant savings account can lead to higher returns if supplied with more money. The idea is to generate more than one can invest for future growth.

http://www.equitymaster.com/detail.asp?date=12/7/2007&story=3

Buffett (1977): ROE is a more appropriate measure of managerial economic performance

Over the past many years Warren Buffett has been dishing it out in the form of letters that he religiously writes to the shareholders of Berkshire Hathaway year after year. Many people reckon that careful analyses of these letters itself can make people a lot better investors and are believed to be one of the best sources of investment wisdom.

Laid out below are few points from the master's 1977 letter to shareholders:

"Most companies define "record" earnings as a new high in earnings per share. Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5% increase in earnings per share. (Comment:  This leads to a drop in ROE).   After all, even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding. Except for special cases (for example, companies with unusual debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital."

What Buffett intends to say here is the fact that while investors are enamored with a company that is growing its earnings at a robust pace, he is not a big fan of the management if the growth in earnings is a result of even faster growth in capital that the business has employed. In other words, the management is not doing a good job or the fundamentals of the business are not good enough if there is an improving earnings profile but a deteriorating ROE. This could happen due to 

• rising competition eroding the margins of the company or 
• could also be a result of some technology that is getting obsolete so fast that the management is forced to replace fixed assets, which needless to say, requires capital investments.

"It is comforting to be in a business where some mistakes can be made and yet a quite satisfactory overall performance can be achieved. In a sense, this is the opposite case from our textile business where even very good management probably can average only modest results. One of the lessons your management has learned - and, unfortunately, sometimes re-learned - is the importance of being in businesses where tailwinds prevail rather than headwinds."

The above quote is a consequence of repeated failures by Buffett to try and successfully turnaround an ailing business of textiles called the Berkshire Hathaway, which eventually went on to become the holding company and has now acquired a great reputation. Indeed, no matter how good the management, if the fundamentals of the business are not good enough or in other words headwinds are blowing in the industry, then the business eventually fails or turns out to be a moderate performer. On the other hand, even a mediocre management can shepherd a business to high levels of profitability if the tailwinds are blowing in its favour.

If one were to apply the above principles in the Indian context, then the two contrasting industries that immediately come to mind are cement and the IT and the pharma sector. Despite being stalwarts in the industry, companies like ACC and Grasim, failed to grow at an extremely robust pace during the downturn that the industry faced between FY01 and FY05. But now, almost the same management are laughing all the way to the banks, thanks to a much improved pricing scenario. Infact, even small companies in the sector have become extremely profitable. On the other hand, such was the demand for low cost skilled labor, that many success stories have been spawned in the IT and the pharma sector, despite the fact that a lot of companies had management with little experience to run the business.

It is thus amazing, that although the letter has been written way back in 1977, the principles have stood the test of times and are still applicable in today's environment. We will come out with more investing wisdom in the forthcoming weeks.

http://www.equitymaster.com/detail.asp?date=6/21/2007&story=2

High steady ROE and increasing ROE

Many investors, Warren Buffett himself included, get pretty excited when they see steady ROE over a number of years, particularly when already at a high level, say, greater than 15 percent.


Why?


ROE is defined as net earnings divided by owner's equity. What happens to net earnings, each year, in well-managed companies? They become part of owner's equity as retained earnings. Then, over time, the denominator of the ROE equation goes up, as earnings become equity (unless a portion of earnings are paid out as dividends).


That brings the following important observations:

• Maintaining a constant ROE percentage requires steady earnings growth.


• A company with increasing ROE, without undue exposure to debt or leverage, is especially attractive.

On the surface, a steady ROE would appear to indicate a ho-hum business. Same old, smae old, year in and year out. But the truth as illustrated is quite different. One can be excited that the business is growing to stay the same, as evidenced by a high constant ROE. :-)

ROE vs Earnings Growth Rate (EPSGR)

In fact, over time, ROE trends towards the earnings growth rate of the company.

A company with a 5 percent earnings growth rate and a 20 percent ROE today will see ROE gradually diminishing toward 5 percent.


A company with a 20 percent earnings growth rate and a 10 percent ROE will see ROE move toward 20 percent, as the numerator grows faster than the denominator.


Also read:
ROE versus ROTC
****Stock selection for long term investors

****Stock selection for long term investors

Overview of the the market and stock selection for long term investors

The Market

There is much volatility in the market. This is due to trading activities. The majority of trades are short term trading. Trading has increased in the market due to various factors:

• Increase turnover rates of mutual funds, hedge funds, off shore funds and pension funds.
• Decrease cost of trading.
• Speed of trading facilitated by technology innovations.
• Investing institution and managers are acting more as agents rather than as investors on behave of their clients.

A minority invests based on fundamentals.

Trading can be in derivatives. The nature of derivative securities is based on price or action of another security. Trading in derivatives has too increased.

Is trading a good thing? It does increase liquidity to the market and this is good. However too much trading and speculation has its downsides. This is akin to breathing 21% Oxygen (life-sustaining) versus breathing 100% Oxygen (too much oxygen has the associated danger of spontaneous combustion).

In this market downturn, questions we have been hearing the most recently are:

• Is it different this time?
  
• How long will it last?
  
• Have we seen the bottom yet?
  

Who knows? These questions are important but not knowable, therefore don’t waste time pondering on these.

The questions long term investors should ask are:

• Are you investing in an easy to understand, wide moat and well run business?
  
• Does that business generate consistent cash flows and has a clean balance sheet?
  
• Finally, are you buying at a large discount to what the business is worth?
  

Strategies for selecting stock for the long term investor

Benjamin Graham: "Investment is best when it is business like. "

However, long term investing is not the only way to make money, there are other ways too.


These 4 strategies should aid one’s investment into equities:
1. Select the business that is long term profitable and giving good return on total capital (ROTC).
2. The business should have managers with talent and integrity in equal measures.
3. Understand the business reinvestment dynamics.
4. Pay a fair price for the business.

1. The business to invest in must make money over time.

• Examine how its revenues and profits are generated. 
• How do its products or services contribute to the value of its business? 
• What are its costs? 
• Look for a business that gives good RETURN ON TOTAL CAPITAL (ROTC), not just those with high ROE. 
• Be aware that high ROE can be due to taking on too much debt. 
• Avoid IPOs, start-ups and venture capitals.

2. Look for managers with a good balance of talent and integrity.

• Those with integrity but lack talent are nice people to have as friends, but they may not be able to deliver good results for the business. 
• Those with talent but lack integrity will harm your business and longer term investment objectives.

3. Is the company able to reinvest its money or capital at a better rate over time?

Basically, be conscious of the reinvestment dynamic of the company.

(a) There are companies giving good return on total capital and able to reinvest their capital at better incremenetal rates over time.

• Invest in these companies as they are effectively compounding your money year after year. 
• This is the powerful concept of REINVESTMENT COMPOUNDING seen in some companies, best illustrated by Berkshire Hathaway. (Reinvestment Compounding)

(b) Some companies have good return on total capital but can’t reinvest this at better rate over time.

• For example, a restaurant business may be dependent on the personal touch of the owner. 
• Expanding the business to another restaurant may not generate the same return on capital. 
• In such cases, the worse approach is to grow the business of the restaurant. This is unlike McDonald. 
• Those investing into such businesses should understand that their RETURNS ARE FROM DIVIDENDS and from RETURN OF TOTAL CAPITAL.

(c) Avoid those businesses with no return on total capital but use more capital all the time.

• An example of this is the airline industry. AVOID such investments.

4. Determining the fair price to pay for the ownership of the business is important.

• For the outside shareholder, the investment should earn the same returns as the company’s business returns.
• If the company earns 10% or 12% or 15% per year for 5 years, the outside shareholders should likewise aim to earn a return of 10% or 12% or 15% per year for 5 years by paying a fair price. 
• Paying a PE of 40 for this company may mean not earning such return as the price paid was too high. 
• On the other hand, paying a PE of 10 – 15 gives the investor a better odd of getting this fair return.
• Paying a fair price for owning a business is important. The company earnings maybe as expected but then your returns failed to match these as you have paid too much to own the business.

What about other factors?


The economy, interest rates, fuel prices, commodity prices, foreign exchange, price of gold and geopolitical situations; should not these influence your investing?

Yes, these are hugely important factors. However, they are not predictable and largely out of our control. They are not knowable in advance. It is better to distance oneself from thinking about them when assessing the business to invest in.

Therefore, the approach adopted should generally not be a top-down macroeconomic one, but a bottom-up microeconomic one. “The implication is with the passage of time, a good business over a long period of time produce results to the investor over time.”


Summary

Identify the company that is in a profitable business giving good return on total capital (ROTC).

The managers should be talented and honest, and have the interest of the shareholders.

The business should be able to reinvest capital at higher incremental rates of returns and with discipline. (Reinvestment compounding).

Also, acquire the company at fair price to ensure a fair return. Avoid paying too much for the current prospect of the company, look long term.

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Effectively the above is the same as the QVM approach.


Quality: A good quality company has consistent and/or increasing revenue, profit, eps, and high ROE or ROC.


Value: This is dependent on the price paid to acquire the business. Using earnings yield or PE enables one to determine the fair price to pay for this business.


Management: Look for businesses where the managers have these 2 qualities in the right balance - talent and integrity.


Search out for companies with high ROE or ROTC and low PE or high earnings yield (indicating "cheapness"). Relate the ROE or ROTC to the PE or earnings yield of the business.


A fair price to pay for the business will be the price that guarantees at least a return equivalent to the returns generated by the business you invest in.


Owning a good quality company with talented and honest managers at a good price (fair or bargain price) incorporates all the elements of investing preached by Benjamin Graham, namely the safety of capital considerations, reward/risk ratio considerations and the margin of safety considerations.

Also read: ROE versus ROTC

Best companies to invest in

Positive attributes to look for

So long as ROE is not overly leveraged by too much interest-bearing debt, the best companies in which to invest have a high ROE and a proven ability to reinvest a good proportion of profits without negatively affecting their ROE.

A company with a high ROE that distributes all, or close to all, profits is telling you that while it's a good business, it lacks the opportunity to grow. For instance, the sole local newspaper might be highly profitable by virtue of its monopoly, but opportunities to start a new paper or to buy an existing paper at a favourable price are likely to be rare. Profit growth is therefore limited to circulation growth. Such companies have the investment characteristics of an interest-bearing security - yield, but little or no growth - and must be valued accordingly.

Businesses that have historically long-term high ROEs with a high reinvestment rate have a sustainable competitive advantage that is difficult to duplicate. They have established brand-name products or services, patent rights, an established market niche or an innovative business model.

Although businesses with these qualities will not be selling at bargain prices, we can afford to pay a premium for a great business and still achieve a high return in the long term. The club of great businesses is not a closed shop, so watch out for new additions among smaller, less recognized companies that display these attributes.