John Chew on High ROE

Very interesting post by John Chew: Important Read on Franchise Investing and Investing “Gurus”. Sketch notes follow.

On von Mueffling: there are a group of companies where the moat is a network. Names we own in this area are Right-move. If there is a dominant portal then there is a winner-take-all phenomenon. The stronger these portals get, the bigger the network effect and the higher the prof-its.

Aside: I hear that Terry Smith owns some shares in AFN (ADVFN), the shares bulletin board. That’s not a recommendation on my part, BTW. AFN doesn’t seem like his usual investment, it trades on a PBV of nearly 7, and we’re still waiting for it to make a profit, even after a decade. Like I say, not a typical Terry Smith investment. Caveat emptor on that one, methinks.

There is a reason why large cap pharmaceuticals trade at low PE multiples and a reason why trades at a very high PE multiple. Respect the market.

On Tano Santos:  His work indicates that the best opportunities are not in the high-ROE companies with the lowest PE multiples – these companies usually have some structural problem such as a lack of growth, or in the case of large cap pharmaceuticals, patents that are expiring. Tano‘s work suggests that the best place to be in high-ROE investing is in names that are neither super-expensive nor super-cheap, where the market has a hard time trying to figure out what the right price is. This is where the best in-vesting returns can be made.

I [Tanos] think that there are many more value traps to-day.

In high-ROE investing your time horizon really should be infinite. The fantasy is that you never ever sell any of your holdings. If a company generates very high ROEs and does good things with its cash flow such as reinvesting in the right projects or buying back stock, they will continually grow earnings. Your price target, which you base on next year‘s earnings, will always be increasing so you will reset your price target and continue to hold the stock.

The most common mistakes that people make in high-ROE investing is confusing high operating margins and high ROEs with a moat. If it smells like a commodity business but the returns are higher than a commodity business, it is likely still a commodity business.

ROE can be misleading if the ROE is not sustainable. Always normalize earnings. Technology can disrupt an ROE. At the same time, you can have industries that go from low ROE to high ROE through consolidation. A good example of this is the US aluminum can industry, which was highly fragmented in the early 1990s. However, for every example like this I can give you another where an industry goes through consolidation but the return profile does not improve.

The way many companies destroy high ROE is through making expensive acquisitions.

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About mcturra2000

Computer programmer living in Scotland.
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