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QUALIPORT
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"Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return. The worst business to own is one that must, or will, do the opposite -- that is, consistently employ ever-greater amounts of capital at very low rates of return." -- Warren Buffett. The Qualiport has long focused on incremental return on shareholders' equity. Regular readers, however, will have noticed some watch list firms registering dismal performances in this key area; Emap (LSE: EMA), Metal Bulletin (LSE: MTLB), Renishaw (LSE: RSW) and Scottish Radio (LSE: SRH) have all put in mediocre reinvestment performances in recent years. So why do they remain of interest to this portfolio? Well, as somebody once said, 100% of your investment return comes from what happens in the future. Basics To recap, return on equity measures the amount of profit generated for every £1 retained in the business. For long-term investors, the less funds needed to increase profits, the better. 'High return' businesses generate excess cash, leaving more scope for healthy dividends, share buybacks, acquisitions and so on. On the other hand, 'low return' companies guzzle cash, so leaving little for shareholders. The disappointing profit reinvestment performances from some of the watch list shares stem largely from three basic issues: * Goodwill: Under-performing goodwill (i.e. an acquisition) is a frequent cause of dreary return on equity performances. Read more | more. * Exceptional items: Much as some boardrooms would like to, shareholders can't ignore chunky exceptional items and write-offs. Read more. * Difficult trading: Profits may be temporarily depressed due to wider economic problems. In the current corporate climate, dismissing companies that have put in poor return on equity achievements of late would probably rule out almost everything in the market. Only the likes of Capita (LSE: CPI), which continues to churn out 30%-plus annual earnings growth, would be left for consideration. Unfortunately, such shares tend to have ratings that reflect the great financial record and offer little 'obvious' value. Therefore, it can pay to look beyond recent reinvestment under-performances and consider companies that, while subdued at the moment, possess the inherent characteristics of an above-average return on equity business. You see, these shares could prove to be an attractive long-term bet, not least because the market is more likely to undervalue them during their current period of underachievement. What sort of characteristics should be looked for? Among the key points are: The four watch list shares mentioned earlier fit these criteria in the main, though Scottish Radio probably fails on the third. Art form Successful stock picking is more of an art than a science. Like it or not, every investment decision involves a certain amount of subjectivity. Legendary investor Ben Graham once said that you didn't have to know the exact weight of a man to tell if he was overweight or not. It's the same with shares and return on equity. You may not be able to get a clear reading from the return on equity scales right now, but just like evaluating a person's calorie intake and exercise regime when it comes to detecting obesity, reviewing certain accounting/business characteristics can help pinpoint fundamentally attractive return on equity companies. In most cases, the arrival of a fair economic wind will be all that's required to confirm such judgements.