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Strategies & Market Trends : Buffettology -- Ignore unavailable to you. Want to Upgrade?

To: Tomato who wrote (424)	10/17/1998 12:17:00 AM
From: James Clarke	Read Replies (4) \| Respond to of 4691

ROE is my favorite analytical tool because this ratio captures so much about a business. In the long run, ROE is going to determine how a stock appreciates, but you still have to buy it at the right price. The relationship between ROE and growth is very tight. A low ROE company can grow earnings, but only if it raises outside capital. A high ROE company can grow earnings without raising capital. That makes all the difference between a good investment and a bad investment over time. Return on Equity is also the measure of a business's franchise - its barriers to entry. A business with no barriers to entry, a commodity business, should earn 10-12% on equity over a cycle. If it earns more than that, and has no proprietary advantage, somebody is going to enter the business and drive down returns. Why can businesses like Coke or Wrigley or Merck consistently earn high ROE over time? Because there are huge barriers to entry in these industries, and these are exceptionally good managements who know how to take advantage of those industry characteristics. It is usually not the company - it is the industry. Occasionally you will find a gem of a company in a lousy industry that earns high returns, but that takes superstar management. But take the cereal business. Kelloggs is run by morons, but they still make 30% on equity because they are in a business where you just can't miss - although they're trying hard these days. The way I look at it is this. A high ROE for a few years makes me skeptical. A consistently high or consistently low ROE is very meaningful to me. But before I go further, I want to be able to explain why the ROE is where it is. That is where models and formulas and ratios are useless. Read Buffett's descriptions of the businesses he owns. There is usually a very simple reason why ROE is so high, and Buffett will not buy a company unless he understands that reason and firmly believes that it is sustainable in the long term. One big caveat. The denominator of ROE is book value. Some companies have taken so many bogus writeoffs that book value is meaningless. General Motors for example has a very high ROE, but only because it has written off all its book value. In this case the high ROE is in no way a sign of a good business. Good businesses don't write off their past earnings. Hope this is helpful. As ROE is the core concept of Buffett investing, this is probably worth some more discussion.