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How a High Quality Company Can Be a Poor Investment

A company earning good returns on equity while using little or no leverage is one of the key criteria that billionaire investor Warren Buffett looks for in his investments. The reason for doing so is that such a company might have high quality businesses that can generate substantial shareholder value over the long-term.

One such local share that stacks up well against that measure would be the stock exchange operator Singapore Exchange (SGX: S68).

Financial year ended 30 June

Return on equity Cash on hand
(S$, millions)
Total debt

2004

18.5% 460 0

2005

18.7% 120 0

2006

35.4% 400 0

2007

59.5% 753 0

2008

55.5% 822 0
2009 36.6% 645

0

2010 40.2% 685

0

2011 36.0% 693

0

2012 35.2% 698

0

2013 39.0% 763

0

Last 12 months 40.3% 728

0

Source: S&P Capital IQ

In comparison, the Straits Times Index (SGX: ^STI) has a weighted average return on equity of only 14.2% while having a total debt to equity ratio of some 70%. This showcases the quality of Singapore Exchange’s business.

Yet, shares of the company have been a really bad investment for investors for close to seven years. Singapore Exchange had closed at an all-time high of S$16.40 on 8 Oct 2007, translating into a loss of 58% at its current price of S$6.93. The company’s losses are also made worse by the fact that the Straits Times Index is down by ‘only’ 14.5% in the same period.

The company’s experience here highlights two important points for investors.

1. The price you pay for quality matters

While Buffett has high regards for a quality business, he’s also wary of paying high prices for them. At its closing price on 8 Oct 2007, Singapore Exchange was being valued at 34 times its trailing earnings of S$0.48 per share – an objectively high measure.

At such high valuations, the resulting disappointment can be massive if the company fails to deliver upon the market’s high expectations. That’s exactly what happened to Singapore Exchange. With a lower earnings per share of only S$0.31 currently, the market has de-rated the earnings multiple of the company to ‘only’ 22 times.

2. The numbers don’t always tell you the whole story

Prior to 2007, the returns on equity for Singapore Exchange were not shabby at all and in fact, had almost doubled in 2006. But yet, the company’s earnings would start to dwindle steadily only a few years after. Investors who had based their investment decisions on the quality of the company’s financials alone back in 2007 would have suffered.

For those who often run companies through screens in the search for investment opportunities, it pays to remember that any screen would be, at best, only capable of pointing out shares that might have the potential for being solid investments. The numbers don’t always tell us the whole story.

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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 doesn’t own shares in any companies mentioned.