Investing in extraordinary businesses

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#1
Business Times - 08 Jun 2011

Investing in extraordinary businesses


Any market-beating technique should contain this one essential ingredient: a focus on the return on equity

By ROGER MONTGOMERY

BEATING the market is rather simple, especially when the index you are trying to beat is composed of mediocre businesses whose only qualification is their size. To win, buy extraordinary businesses at prices below their intrinsic value and hold them until they either cease to be extraordinary or cease to be reasonably valued. The amazing thing about this approach is that it is simple and it works.

In the short run, the stock market swings from wild enthusiasm to irrational bouts of depression and despondency. Over the long run, however, it has been my experience that prices follow intrinsic values. And if your intrinsic values are based on the performance of the business, then over the long run, price must follow that performance. Your job then is to establish what makes an extraordinary business.

And, of course, opportunities to buy these extraordinary businesses cheap are presented 'in bulk' when fear and pessimism is greatest. In preparation for these inevitable extremes, it is worth establishing what an extraordinary business looks like.

How many times have you heard a commentator on the radio or television referring to earnings per share or dividends per share? Investing magazines and tip sheets are replete with these statistics. But they don't hold the key.

While many professional investment advisers and 'tipsters' will tell you to watch earnings or growth or dividends, these measures also fail to take into account something business owners worry about constantly.

You see, earnings and dividend growth only report what is coming out of a business; they are not concerned with how many dollars are required to produce that profit and dividend.

Business owners think about how many dollars they are required to invest in the business, to get those dollars of profit out. Given that the stock market is a place to buy pieces of businesses, you should be concerned with how many dollars need to be injected, in order to generate that dollar of profit.

That is what a ratio called 'return on equity' measures. A high rate means that profits are high compared with the amount of money being invested in the business. A company with equity earning a high rate of return can be likened to a bank account earning a high rate of interest.

Imagine I offered you the opportunity to invest in two start-up businesses, that will each produce a profit of $1 million next year, and profits that will rise by $1 million each year thereafter. The difference is that the first business requires you invest a total of $5 million in brand development, machinery and staff. And that's it. The second business requires an initial investment, in the same things, of $50 million.

The business that requires the lower investment or commitment from you - the business that produces the higher return on your equity - is the one to own.

I have found the best performing stocks over the long run are backed by underlying businesses that sustain high rates of return on equity. Indeed, simple arithmetic can show you that if you buy (and later sell) a share of a company, on the same price earnings ratio, that retains all its profits, your return will equal the return on equity of the company. Therefore, it makes good sense to focus on businesses with high rates of return on equity rather than earnings growth.

Even a company with high earnings growth will produce substantial losses for its investors, if return on equity is declining. An Australian childcare company that had global growth aspirations, called ABC Learning Centres, was just such a business. Years before its collapse, the company had been simultaneously reporting rising earnings but returns on equity that were declining precipitously.

Between 2001 and 2007, ABC Learning reported earnings that grew from virtually nothing to almost US$150 million. Return on equity over the same period, however, had fallen from over 30 per cent per annum to less than 8 per cent.

The company's declining return on equity reveals that growth in earnings was achieved only because shareholders kept shovelling more money into it. You can do the same, if you tip more money into a regular bank account. There is nothing special about that.

By 2006, the returns the business reported, on the nearly US$2 billion that shareholders had stumped up to help the company grow, were just 5 per cent. This was even less than the returns available from a bank deposit at the time. And bank accounts have a lot less risk.

You wouldn't invest $2 billion into a business if all you could expect was 5 per cent. If you aren't prepared to own the whole business for a long time, you shouldn't be prepared to own even a few shares for a short time.

Ultimately, these low returns will be reflected in low returns to shareholders, and the collapse of ABC Learning provided the lowest possible return.

Return on equity tells us many things about a company. Firstly, high rates of return on equity can suggest sound management. While high sustained returns on equity are more likely to be the result of a great business than great management, they may indicate a combination of both - a great vessel and a great skipper.

Secondly, a high return on equity may indicate there is something unique that prevents others from competing directly or successfully with the business. This is known as a sustainable competitive advantage. Apple has it. Consider how quickly the iPad was sold out in Singapore and elsewhere - and it arrived late in Singapore with 'the mother of all backlogs'. Apple's products and the user experience are unique, but more importantly, there's an almost religious fervour when it comes to the brand. This is impossible for another company to buy - even with billions of dollars. Extraordinary! The result is high rates of return on equity and a rising Value.able intrinsic value.

Contrast Apple with SingTel, Singapore Airlines and the banks. These are trophy stocks of Singapore's Blue-Chip Club, but are they truly extraordinary businesses? With return on equity of 6-16 per cent over the last 10 years, these businesses may be good but perhaps not extraordinary. For example, despite Vodafone's best efforts, SingTel remains Singapore's preferred carrier and this is reflected in an average return on equity for SingTel of 16 per cent for the last decade. But the Australian luxury accessories brand Oroton - who has just opened its first Singapore store at Marina Bay Sands - has recently achieved a return on equity of greater than 80 per cent.

Extraordinary stockmarket returns, over the long run, require extraordinary returns on equity. When it comes to determining an appropriate rate of return on equity to look for, remember that, as the sexy actress Mae West once observed: 'Too much of a good thing . . . is wonderful.'

Thirdly, return on equity can also tell us whether the company should reinvest its profits or pay the earnings out as a dividend. Companies generating high rates of return on equity should keep the money, while those generating low rates of return on equity pay dividends. 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.

Fourthly, 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 balance sheet assets are worth. 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 writedowns because promised 'synergies' from acquisitions fail to materialise. If a company makes a big acquisition and projected returns on equity are very low, it's usually wise to take advantage of any enthusiasm and 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. And at the heart of working out what a company is worth, is the return on equity ratio.

Seek out and invest in companies that can sustain high rates of return on equity over a long period of time, and you cannot help but beat the markets.

In my next column I will explain why debt not only increases the risk of a company but causes it to be mispriced in the market.

The writer is founder of Montgomery Investment Management Pte Ltd, a Sydney-based investment manager. His book, 'Value.able - How to value the best stocks and buy them for less than they're worth', is available exclusively online at www.RogerMontgomery.com/bt
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#2
Quote:Investing in extraordinary businesses

Any market-beating technique should contain this one essential ingredient: a focus on the return on equity

By ROGER MONTGOMERY

I wonder this roger montgomery is in anyway related to curtis montgomery(Wallstraits founder)
Since they sing about the same tune...haha..
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#3
Quote:To win, buy extraordinary businesses at prices below their intrinsic value and hold them until they either cease to be extraordinary or cease to be reasonably valued.

Easier said than done. It is not that difficult to identify a great business. It is not that difficult to identify a cheap business. Unfortunately both characteristics are seldom available in the same business.

Quote:Ultimately, these low returns will be reflected in low returns to shareholders, and the collapse of ABC Learning provided the lowest possible return.

ABC Learning collapsed because it was a fraud. It booked subsidy payments from developers as revenues, hiding the underlying operating losses. ABC Learning has since become a case study for CPA Australia. Fraud is a separate issue from any discussion on return on equity. Poor choice of example.

Quote:Firstly, high rates of return on equity can suggest sound management.

In my experience ROE is determined first by industry and then modified by management skill. A peer comparison of just 5 companies in any given sector will make it clear that there is such a thing as the industry rate of return.

Better managed companies do better, some by a meaningful margin. But you don't get someone making 40% returns when everyone else is making 20%, unless the 40% guy is using tons of leverage - or is a fraud. Someone making 10% when everyone else is making 20% with the same capital structure is probably incompetent or also cheating in some way e.g. overpaying connected persons.

Quote:For example, despite Vodafone's best efforts, SingTel remains Singapore's preferred carrier and this is reflected in an average return on equity for SingTel of 16 per cent for the last decade. But the Australian luxury accessories brand Oroton - who has just opened its first Singapore store at Marina Bay Sands - has recently achieved a return on equity of greater than 80 per cent.

My point exactly. Luxury retailers and telcos generate different rates of return. They also happen to sell at different prices.

Quote:Companies generating high rates of return on equity should keep the money, while those generating low rates of return on equity pay dividends.

It is generally only the companies who generate high ROEs who can afford to pay a generous dividend. And normally they pay a dividend because they generate cash in excess of requirements i.e. if they reinvested the extra money their ROEs would go DOWN.

Pretending that high ROE companies can reinvest their excess cash at the same high rates is just nonsense.

Quote:Secondly, a high return on equity may indicate there is something unique that prevents others from competing directly or successfully with the business. This is known as a sustainable competitive advantage. Apple has it.

Apple has Steve Jobs, who is mortal and will die one day. For now the "cult"-ure of Steve Jobs is a great asset, but it can't last forever. And even under Jobs, in 1997 Apple was struggling and took a US$150m investment from... Microsoft.

Quote:Seek out and invest in companies that can sustain high rates of return on equity over a long period of time, and you cannot help but beat the markets.

In the entire article he only mentions the other crucial factor once: price. Pay too much for even the best business and you will come to grief.

I wonder how much the writer actually understands about investing, and what his investment record actually is.
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#4
He will be dead wrong for S Chips if he use ROE to solely justify his investments. ROE should be used just a screen filter. E reason behind generating that ROE should be e paramount.
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#5
(08-06-2011, 11:24 AM)d.o.g. Wrote: It is generally only the companies who generate high ROEs who can afford to pay a generous dividend. And normally they pay a dividend because they generate cash in excess of requirements i.e. if they reinvested the extra money their ROEs would go DOWN.

Pretending that high ROE companies can reinvest their excess cash at the same high rates is just nonsense.

Hi d.o.g.,

I am curious about the above. For companies which generate high ROE, I guess we have to assume that it is through internal cash flows and not through excessive leverage (as ROE will also rise due to taking on of more debt). However, high ROE companies are automatically assumed to recycle the earnings into business ventures, organic growth or M&A which can then sustain or may even improve the ROE. This is how (I'd assume) they can maintain the high ROE for so long and have such a good track record.

So what you are essentially saying is that high ROE companies normally = generation of excess free cash flow which is NOT required to be retained by the business? I see your point on retention of too much cash as cash offers lousy returns and therefore will lower ROE in subsequent periods.

But why can we not assume that high ROE companies can indeed invest their excess cash to generate higher or similar ROE as what they are currently enjoying? In that case, they would not have to pay out such generous dividends and could, instead, choose to reinvest the cash.

Thanks in advance! Smile
My Value Investing Blog: http://sgmusicwhiz.blogspot.com/
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#6
(08-06-2011, 02:17 PM)Musicwhiz Wrote: But why can we not assume that high ROE companies can indeed invest their excess cash to generate higher or similar ROE as what they are currently enjoying? In that case, they would not have to pay out such generous dividends and could, instead, choose to reinvest the cash.

I'm no d.o.g. but my humble 2 cents is that assuming high ROE companies can continue to attain higher or similar levels of ROE through organic or inorganic growth is to assume that the world will stay the same.

However, we do know the only constant thing is change. Even with the same wonderful management, the business environment may change. Or when the limits to growth in one line of business is reached, executives start to move on to lousy ideas. How many examples have there been of lousy acquisitions (e.g. Coca-cola with Shrimp farming, Osim with Brookstone etc.) because management is flushed with cash and seeking growth? Or it could simply be the case that all the low-hanging fruit has been picked and harder-to-pick fruit is all that's left. Either way, there's a chance that ROE's reduced in the future.

While, high ROE in the past can possibly be a result of competent management. It can also be the result of average management being lucky that the tide was in their favour, who's to say that when the tides turn, these average guys can skillfully avoid the rocks?
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#7
http://boc.quotepower.com/web/bochk/stoc...tStock=536

eg of a firm with quite consistent ROE n close to 100% dividend payout with stable net margin over 5 yrs
To be simple is the best thing in the world; to be modest is the next best thing. I am not sure about being quiet.- G.K. Chesterton

Do not condemn the judgment of another because it differs from your own. You may both be wrong.- Dandemis

The trouble with the world is that the stupid are cocksure and the intelligent are full of doubt.- Bertrand Russell
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#8
sounds similar to Joel Greenblatt's magic formula investing
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#9
Musicwhiz Wrote:However, high ROE companies are automatically assumed to recycle the earnings into business ventures, organic growth or M&A which can then sustain or may even improve the ROE.

These are highly ambitious assumptions.

In business the momentum from a star product can carry the company for several years. In the meantime the company can try to find another star product, but until it does the failing projects will only drain cash.

For example, Microsoft has 2 star products: Windows and Office. Together these generated over 100% of Microsoft's operating cash flow in the last 2 decades. All the other projects like Xbox, Windows CE, Hotmail etc either broke even or lost money. Microsoft shareholders would have been much better off if Microsoft had just paid out the cash. Microsoft is realizing this today and they now pay a dividend.

It has been documented that most M&As fail to deliver the revenue or cost savings synergies envisioned. So not a good use of cash either.

Manufacturing companies can get organic growth to some extent by adding capacity to make more widgets, but there's a limit beyond which you get overcapacity.

Musicwhiz Wrote:But why can we not assume that high ROE companies can indeed invest their excess cash to generate higher or similar ROE as what they are currently enjoying?

So far all the high ROE companies I have come across generate far more cash than they can sensibly use, and they pay some of this excess cash out.

An academic explanation is that as invested capital increases, the incremental rate of return decreases. Therefore a company will invest until the incremental rate of return equals the required rate of return. Any remaining cash is paid out since it can't be employed at the IRR required by the firm. Usually the firm will still keep some cash in reserve, just in case.

A simple example: Suppose you sell roast chicken. You can invest in another oven to roast more chickens, giving you more chickens to sell to generate more sales and profits. But as the supply of roast chicken increases the average price decreases as you are now selling to people who are not as mad about roast chicken as the first customers. So the total returns earned on a percentage basis by the 2 ovens are lower than the returns earned by one oven. The same is true for 3 versus 2 and so on. Eventually the incremental return is not high enough to make the effort worth it and you stop buying more ovens.
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