One of the most important factors while picking stocks is to look at the quality of the business.
What happens when you invest in a low quality business? If the management is able to turn things around and returns improve, it’s another story, but when managements cannot improve already low returns that a business earns and in fact returns fall even further, external financing generally goes up and shareholder returns come down.
The table below lists out companies that started off with low returns on capital employed (ROCE) five years ago but couldn’t improve the quality of the business. Make a note of the debt and stock price returns.
When companies start improving their returns, the opposite happens. External debt often reduces and stock prices move up in a significant manner. See the table ‘Increasing returns on capital’. It lists out companies that reported poor ROCE five years back but have improved those numbers since. Look at the stock prices that have followed the ROCE.
No stock price performance can escape the quality of the underlying business. Whenever picking stocks, keep an eye out for the quality of the business if you want sustained long term outperformance of your investment.
Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 per cent on capital over 40 years and you hold it for that 40 years, you are not going to make much different than a 6 per cent return-even if you originally buy it at a huge discount. Conversely, if a business earns 18 per cent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. So the trick is getting into better businesses.’
See the table ‘High-quality businesses’. It lists out some of the highest quality large businesses you can find today. Keep in mind a high ROCE is just the starting point. There are a number of other factors that you should consider before you make up your mind to invest in any of them.
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