Thursday, March 18, 2010

Inexpensive stock? If return on capital is low...it's probably not.

Well, at least over the long term.

One of the things that matters a whole lot in investing is return on capital (ROC) and how sustainable it is over time.

"If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result." - Charlie Munger in a 1994 speech 

"Time is the enemy of the poor business and the friend of the great business. If you have a business that's earning 20% to 25% on capital, time is your friend. But time is your enemy if your money is in a low-return business." - Warren Buffett at the 1998 shareholder meeting

An investor can always attempt to find mispriced lower quality businesses. The downside is that time is usually not an ally. The investor can own the shares until the price becomes closer to per share intrinsic value. Of course, then that investor has to sell and hunt for something else to buy (another opportunity but also another chance to make a mistake).

Overpay somewhat for a low ROC enterprise (i.e. misjudge current value) and rapidly compounding growth in intrinsic value will not be there to dig you out of the hole.

In contrast, a durable high ROC enterprise can still end up working well in the long run even when a small misjudgment leads to too much being paid.  Misjudge value somewhat and the higher quality business -- at least with the benefit of time -- can still produce an attractive rate of return in the long run. Not true for lower quality businesses.

So the durable high ROC business can help an investor to reduce mistakes and lower risk.

That doesn't mean it's okay to overpay. Whenever possible, an appropriate margin of safety should exist before making an investment but, inevitably, misjudgments get made. If a business has sustainable advantages and quality economic characteristics, those misjudgments should often end up being a whole lot less costly in the long run.

Judging whether a business is in fact going to maintain attractive economics over time is, of course, the tough part.

Adam

This site does not provide investing recommendations as that comes down to individual circumstances. Instead, it is for generalized informational, educational, and entertainment purposes. Visitors should always do their own research and consult, as needed, with a financial adviser that's familiar with the individual circumstances before making any investment decisions. Bottom line: The opinions found here should never be considered specific individualized investment advice and never a recommendation to buy or sell anything.
 
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