In searching for the key to successful investing, all roads lead back to Warren Buffett, who once said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” That simple investment philosophy has propelled him through more than seven decades as one of the greatest investors of all time. However, executing that philosophy is not as simple as it sounds. If it were, there would be many more Warren Buffetts walking around.
I believe one of the keys to Buffett’s success is his insistence on investing in high-quality companies with predictable growth prospects. However, a great company does not necessarily make a great investment unless it can be purchased at a great price. One of the biggest challenges investors face is filtering information about a company to make that determination. The key to successful investing is to determine which data should be considered above the rest.
Earnings Growth And PE Tell A Small (But Not Always Accurate) Part Of The Story
For example, many investors look at a company’s earnings as a gauge of growth potential. But earnings are nothing more than an accounting measure. Some look beyond earnings to earnings growth, earnings per share growth or valuations based on earnings per share. But those are just one-dimensional measures of near-term stock performance.
Many investors and investment professionals use a company’s price-earnings (PE) ratio as an approach to valuing stocks. However, PE ratios are often based on flawed accounting earnings and don’t account for the cost of capital. Conventional wisdom says that companies with high PE ratios have high growth potential, and companies with low PE ratios have low growth prospects. While PE ratios can add a second dimension to the process of valuing a company, they’re easy to manipulate, leading investors to mistakenly classify underperforming stocks as cheap and outperforming stocks as expensive.
Cash flow is a direct and more accurate measure of the health of a company than relying on earnings-based measures or ratios. It reflects what the company has to spend or invest. Earnings don’t capture the changes in working capital and can be an inaccurate measure because they are easily, and often are, manipulated to make the company’s profits look better. There is also no standard definition of earnings, while cash is cash and is not easily manipulated.
ROIC Is The Truest Measure Of A Company’s Long-Term Growth Potential
The factor that really begins to separate a quality company from the rest is its return on invested capital (ROIC). ROIC is more a three-dimensional measure of how much cash a company generates in relation to the amount of capital tied up in its business.
ROIC is calculated by dividing a company’s operating profit by its operating capital (physical assets plus net working capital). The higher the operating profit relative to operating capital, the higher the return on operating capital and vice versa. An increasing ROIC indicates that a business is getting better because the more cash it can generate, the more it can invest in the business each year.
Companies with a high ROIC are able to generate higher profits at less cost. They don’t need to rely on significant physical assets, which require greater capital. For example, mining companies rely on their physical assets — their mines — to generate profits. However, the costs of acquiring the mines, excavating them and maintaining them have to come from their operating cash flow or balance sheet, creating a significant drag on the company’s financial resources.
Compounding Is The Key To Long-Term Growth
For quality companies, the ability to compound their growth is the key to building shareholder wealth at superior rates of return over time while limiting downside risk. The challenge for investors is, out of thousands of public companies in the global markets, relatively few have the capacity to consistently compound returns while providing a measure of capital preservation during challenging economic or market conditions.
A company has the capacity to be a “compounder” when it has sustainable ROIC as a result of recurring revenues generating high gross margins with low capital intensity. Compounders built on dominant and durable intangible assets possess the pricing power to protect their margins when costs rise while recurring revenues support the level of sales. That’s why compounders tend to outperform other companies in economic downturns. With their steady operational cash flow and no excess leverage, their profits are less sensitive to economic conditions.
Even Fund Managers Don’t Always Get It Right
When you invest with a fund manager, you expect them to use their sophisticated tools and analytics to delve into key metrics such as ROIC to find great investments. But, unfortunately, that’s not always the case.
Some fund managers come under pressure to improve portfolio returns immediately, so they sometimes diverge from their investment process. That often leads to selecting companies in industries known for poor returns. The hope is they can latch on to a company whose fortunes will suddenly change — either through a cyclical change or an event such as a management change or a takeover by another company.
The problem is that as fund managers hold on to a lower-quality, cyclical business waiting for an event that could boost its fortunes, the company will likely continue to destroy value. When fund managers or investors act on what they don’t know about a company, it often results in a bad outcome.
Conversely, when fund managers focus on key metrics that drive a company’s long-term performance and act on what is knowable, the outcome is more predictable. That’s especially true when you invest in companies that consistently generate returns well above their cost of capital (as indicated through their ROIC). There’s no hoping for a takeover, changing business cycle or management change because you know the company’s intrinsic value is constantly growing. All you need to do is hold on for the ride.
The key to successful stock investing is to identify these high-quality companies, purchase them at a reasonable price and hold them for enough time to allow them to compound their growth while preserving your capital.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.