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A Metric To Find Investments Warren Buffett Would Love

Warren Buffett’s currently the fourth richest person on the planet. His personal wealth is estimated at around US$59 billion with most of his fortune tied to his 20% stake in American conglomerate Berkshire Hathaway.

In the mid-1960s, Buffett took over the reins of Berkshire, which was then a faltering textile company. He bought shares in it because he thought it was statistically cheap. But, Buffett soon started to allocate the capital that Berkshire produced to acquire partial stakes (through shares in the public stock market) or entire ownership of companies with powerful economic moats.

And by doing so, he grew Berkshire’s book value from US$19 a share in 1964 to US$114,214 at the end of 2013. That’s an annual growth of rate of 19.7% for 48 years and an astounding one any way you slice it.

Thing is, how does Buffett do it? He’s never been shy about sharing his secrets, but there are also others who have tried to unravel his methods. One such person’s Robert Hagstrom, who penned his studies into the book The Warren Buffett Way.

In it, Hagstrom tries to boil down Buffett’s preferred criteria for selecting investments into the following statement: “A simple, understandable business with consistent earning power, good return on equity, little debt, and good management in place.”

In particular, a consistent display of a good return on equity (though it’s subjective, a rule of thumb for a ‘good’ return on equity would be 15% or above) on clean balance sheets with little debt is a sign that a company might possess a strong economic moat and help point toward potentially attractive investment opportunities.

Over the past six years since the start of 2008, Super Group (SGX: S10), Vicom (SGX: V01), and Raffles Medical Group (SGX: R01) have beaten the Straits Times Index’s (SGX: ^STI) share price returns by a huge margin.

Company

Jan 2008

Today

% Change

Super Group

S$0.78

S$3.68

372%

Vicom

S$1.80

S$5.80

222%

Raffles Medical

S$1.49

S$3.31

122%

Straits Times Index

3,461

3,069

-11%

Source: S&P Capital IQ

As it turns out, these three shares had turned in a consistently high return on equity when compared to the market average.

Return on Equity

Year

Super Group

Vicom

Raffles Medical

Straits Times Index^

2008

10.5%

25.1%

14.9%

11.8%

2009

15.3%

27.3%

16.1%

13.2%

2010

19.2%

25.9%

16.9%

16.8%

2011

17.8%

25.4%

16.2%

15.1%

2012

20.6%

23.8%

15.7%

13.7%

2013*

24.0%

23.2%

15.6%

10.6%

*Figures for Super Group and Raffles Medical in 2013 are for the 12 months ended 30 Sep 2013

Source: S&P Capital IQ; ^Bloomberg

In addition, Super Group, Vicom, and Raffles Medical had also carried very little debt on their balance sheets over the past few years, suggesting the presence of good economic characteristics in their businesses. That also goes some way in explaining their long-term market beating returns.

Foolish Bottom Line

All told, a company’s return on equity can be a very useful tool in finding great investing opportunities when used wisely. But it should also be noted that the metric is a backward looking one at the end of the day.

It’s a company’s future performance that drives its share price returns going forward, and investors have to dig deep to ascertain whether the special sauce that allowed the company to earn such high returns on equity in the past can be maintained for years into the future.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Berkshire Hathaway, Super Group, and Raffles Medical Group.

See all posts by Ser Jing Chong
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