Ever since Buffet has publicly made known ROE as his filter, many investors have been obsessed with finding and investing in high ROE companies. But blindly chasing high ROE may not be good for you. Here’s why... /1
2/ Mathematically, over a long holding period, shareholder return mirrors the ROE. This however makes foll assumptions (a) ROE is sustainable over very long periods ie 20+y (b) revenue growth >= ROE (c) business has no debt (d) surplus can be re-invested at ROE > current ROE
3/ Given the competitive scenario of modern business and the disruption of technology, it is tough to maintain these assumptions over long periods
4/ Tech cos are willing to front load a lot of their lifetime capex in creating markets & customers. Political interventions ensure capital is available cheap to industries not worthy of capital. Customer needs evolve. Nobody knows the future and trees don’t grow to the sky
5/ It requires exceptional management quality to meet all four assumptions not just to know the competitive landscape but also to deploy resources efficiently and ensure that your organisation is on point. If that is not all, managements keep changing
6/ The reason investing is difficult is that getting a call on (a) to (d) right is not easy. Plus one has to overlay this analysis with courage to take calls when the market becomes inefficient to pay a sensible price for such a business
7/ So next time you plan to hold a high ROE company for a long time, do stop and ask yourself if the above conditions are also satisfied. You are probably better off holding a business growing above avg vs peers with decent ROE rather than a slow growing one with v high ROE (fin)
