The Key to Finding Stocks that Will Make You Rich? Focus on Return on Equity
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, its 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, youre going to
have very, very good results over a twenty or thirty year period.
An excellent example is Johnson & Johnson. According to the companys
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. Thats why you must settle inside of
yourself the question of exactly how large a companys 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.
