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How are the returns on your equity?

How are the returns on your equity?

Through the volatility of recent weeks, we have managed to produce a return profile with significantly less variability as well as a substantially smaller adverse impact on our clients’ wealth. 

I say this not to boast but to posit the idea that there is merit in discussing a particular and powerful metric.

As an aside, I believe the contributors to this profile have been a focus on high quality businesses, a margin of safety in the difference between price and valuation, and the ability to hold large amounts of cash when attractive opportunities are unavailable.

For today’s discussion, we’ll put aside our more complete definition of an extraordinary businesses; one with bright prospects for sales and profits, high rates of return on equity - driven by sustainable competitive advantages, solid cashflow, little or no debt - and are run by first-class managers that think like owners and treat their shareholders as such.

A good business to own is one that produces growing profits. That seems obvious. Indeed it was what the vast majority of analysts and equity investors are looking for.

Perhaps less obvious, however, is that the best business to own is the one that also requires the least amount of capital to be invested in it to generate those profits. There is a yawning chasm in the worth of a business that grows and requires lots of additional capital, and the business that grows and doesn’t need any additional capital.

A perfect business, then, might be one that requires no staff and thus has no labour costs, no machinery and so does not require any equipment to be maintained or replaced; and no inventory, so there’s no need for trucks, warehouses or stock management systems and no chance that you will be left holding products that are obsolete of out of fashion. All of these things, if required by a business, mean that there is less cash to distribute to you or less cash available to be invested elsewhere. First prize, therefore, is a business that generates very high returns with all of those profits available to be distributed or reinvested as you, the owner, sees fit.

Perhaps the single most important factor in the identification of a wonderful business is a number, a simple ratio, return on equity, and when it comes to return on equity, it is worth remembering the actress Mae West, when she said, “too much of a good thing is wonderful”. Return on equity is a measure of the earning power of a business and is an essential ingredient in establishing its economics. While accounting focuses on providing an estimate of the business’s performance and position, the economics reveals the true picture. Warren Buffett has always said he looks for business with great underlying economics.

And before diving into this discussion on return on equity, it is worth noting that the wealthiest man alive today, Warren Buffett, is an enormous fan of return on equity as demonstrated by this - one of many - statements he has made on the subject: “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.”And this: “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.”

The return on equity ratio tells us many things. First, it is a measure of the quality of a company’s business. Many people wrongly believe that strong growth in profits over the years is an indication of a superior business. It isn’t. Companies like ABC Learning displayed strong growth in earnings yet still collapsed. ABC Learning had low and falling returns on equity. Economic returns, as measured by return on equity, are a better indication of business quality than earnings growth. Return on equity helps tell us which companies display “good” growth. Think of return on equity as a filter, sorting the wheat from the chaff. The next time a broker calls with an idea, or the next time you call a client with that idea, find out what the return on equity has been and what it is forecast to be. A company with strong earnings growth prospects and high rates of return on equity is the sort of business in which you should buy shares. A company with similar earnings growth but declining or low return on equity is not the sort of business in which you want to buy shares.

If you weren’t living in a cave in the second half of this century’s first decade, you’d have heard of ABC Learning Centres.

The company’s reported profits revealed spectacular growth, and this is what many investors, analysts and commentators focus on. In fact, it was not unusual for sell-side analysts to slap “strong buy” recommendations on ABC Learning Centres’ shares during the period of strong earnings growth.

But ABC’s earnings were growing because more and more money was being tipped into the company by shareholders. More and more money had to be tipped in, in order to make these growing earnings. You can get more earnings each year if you tip more money into a regular bank account. There is nothing special about that, and so it is the same for a business. The growth in earnings that ABC Learning Centres achieved was only obtained because shareholders kept on shovelling more and more money into the savings account. Because the company was asking shareholders for more and more money to help it “grow”, the profits coming out of the business, when compared to the money going into it, showed the returns the business was generating were declining, as Chart 1 displays.

Chart 1.  Declining Returns

declining returns

By 2006, the returns the business was generating, on the nearly $2 billion that shareholders had stumped up to help the company grow, were about five per cent. This was even less than the returns available from a bank TD at the time, which harbour a lot less risk than a listed business.

Would you put $2 billion of your money into a business if I told you that the best you could expect was five per cent? Of course you wouldn’t. And if you aren’t prepared to own the whole business, you shouldn’t be prepared to own even a few shares. What’s really interesting is that the stock market can sometimes be a bit of a slow learner, and while share prices tend to follow returns on equity rather than the earnings, it can take a long time.

So in 2006 there was plenty of warning that a) the shares were unjustifiably high, and that b) the research reports touting “strong buy” should be ignored and ABC Learning shares avoided. And if you owned any shares, there was plenty of time to sell and avoid a permanent impairment of your wealth.

Second, high rates of return on equity can also suggest sound management. But don’t immediately assume that it is sound. A great managerial record is often the result of the boat the managers get into – the quality of the business. Indeed, high returns on equity are more likely to be the result of a great business than great management. Nevertheless, a business generating high rates of return on equity may indicate a combination of both - a wonderful vessel and a great skipper.

Third, high returns on equity may further be an indication that the business is operating as a monopoly or in an industry with high barriers to entry or something unique that prevents others from competing directly or successfully with the business – known as a sustainable competitive advantage.

Fourth, the return on equity can also tell us whether the company should reinvest its profits or pay the earnings out as a dividend. Because this decision is made by management and the company’s board of directors, return on equity can help show us which teams understand how to allocate capital properly, and therefore those that treat their shareholders like owners.

Fifth, return on equity can tell us something about whether the auditors and the board of directors are realistic when it comes to what they think their assets are worth on the balance sheet. If the return on equity is consistently very low, it may suggest that the assets on the balance sheet are being valued artificially high. Investors lose millions when companies announce write-downs, and write-downs usually follow a period of low returns on equity - for example, after the company paid too much for an acquisition and the promised “synergies” failed to materialise. If a company makes a big acquisition and projected returns on equity are very low, it’s usually wise to sell your shares.

Finally, return on equity is also an essential ingredient in establishing the true worth of a company and its shares. Ultimately, investing is all about buying something for less than it is truly worth. Do this consistently, over a long period of time, and you cannot help but beat the markets and the majority of other investors. And at the heart of working out what a company is truly worth is the return on equity ratio.

Because return on equity can tell us so much, it is a very powerful ratio and is essential for success in the stock market.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!