What Type Of Stock Might Warren Buffett Like?
David Bassanese | Nov 14, 2018 12:04
Originally published by BetaShares
Financial research suggests that so-called “quality” companies, i.e. those with high return on equity (or “ROE”), tend to be able to produce market-beating shareholder returns. But as this note demonstrates, it’s not enough to simply rank companies based on their current ROE – rather consideration must also be given to the likely sustainability of their ROE over time.
h2 Why ROE sustainability is the key to quality share price performance/h2It stands to reason that companies with a high ROE should be able to produce relatively good shareholder returns over time. After all, if a company can generate high profits relative to its invested equity, it will be well positioned to provide either attractive dividends and/or high earnings growth through the re-investment of retained profits.
That said, as seen in the chart below, it is not enough to simply identify companies with a high ROE over the past year. Indeed, what has mattered historically for market-beating share price performance is a company’s ability to sustain a high ROE over time. Indeed, the chart demonstrates that for companies with a relatively high ROE in any given year, the strongest subsequent share price performance was attributed to those that sustained a high ROE in the following two financial years.
So far so good. But once we’ve identified companies with a higher-than-average ROE, how can we judge the likely sustainability of their ROE over time?
It turns out there are several tell-tale signs.
Firstly, companies should not have achieved their higher-than-average ROE by being overly reliant on leverage. After all, companies with low leverage (i.e. debts relative to equity) are less likely to be affected by changing market conditions and so are more likely to maintain their high ROE over time.
Another useful indicator is a company’s ability to generate strong operating cash flows – perhaps a better underlying measure of sustainable earnings – relative to their assets over time.
Finally, companies with a track record of earnings consistency (or low variability in earnings) are likely to sustain consistent growth and achieve a higher ROE.
These considerations happen to be in keeping with one of doyen investor Warren Buffett’s key strategies in picking stocks, namely, to look for companies able to sustain a high and reasonably stable ROE over time without undue reliance on debt.
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