Investing in extraordinary businesses

Published June 8, 2011

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.

Roaring business: A screen projection of the OS X Lion at the Apple Worldwide Developers Conference in San Francisco on Monday. Apple has a sustainable competitive advantage - something unique that a high return on equity may indicate. Apple's products and the user experience are unique, and there's an almost religious fervour when it comes to the brand

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.


To win at this game, 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.


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