Be Like Buffett — A Beginner’s Guide To Quality Investing: Shire plc, Abcam plc, Avon Rubber plc, ITV plc & Dunelm Group plc

As promised, I’m following up on part one in this two-part article as I scour the market using Stockopedia to find businesses that would in theory appeal to the master investor, Warren Buffett.

Last time, we filled the portfolio with these five quality stocks:

  • Next;
  • Brooks Macdonald Group;
  • Telecom Plus;
  • Rotork;
  • Elementis.

Now to add the final five:

Looking across this beginner’s portfolio, there should be plenty of familiar names, some not so. But more importantly – why do I think that these 10 shares will outperform the FTSE 100, my chosen benchmark, over the next five years?

Return on Capital Employed – ROCE

One way to spot a quality company is to check for its ROCE (return on capital employed), calculated as operating income (more or less earnings before interest and tax) divided by capital employed, which is defined as: fixed assets + working capital or, said another way, total assets minus total current liabilities.

A high double-digit figure often means that the company has a defensible edge versus its competitors (e.g. a strong brand or a unique product). However, because ROCE measures return against the book value of assets, it’s worth being aware that depreciation can flatter ROCE even though cash flow is constant. With this particular screen, the five-year average ROCE is used to weed out shares that have done well for one or two years and then fizzled out.

Sitting at the top with a ROCE of 58.5% is Next, while Elementis is currently at the bottom with 19.5%. Investors should remember, though, that this is still an impressive figure in itself and more than holds its own in the Chemicals sector.

Return on Equity — ROE

Return on equity reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. In this screen, the average ROE over the last five years has been used, again to weed out anomalies.

Widely used by investors, the ROE ratio shows the return being generated for every pound of equity on the balance sheet. It should be thought of as the ‘internal return’ that the company generates, and should not be mistaken with the market returns that shareholders may attain. 

It varies by industry but ROEs of 15% or over are usually considered desirable. High ROE numbers sustained over the long term can, in many cases, indicate a company has a sustainable competitive advantage. Such companies tend to sell at higher valuation multiples. A few examples here are:

  • Dunelm – ROE = 43.6%
  • Abcam – ROE = 28.6%
  • Brooks Macdonald – ROE = 27.2%

The impact of leverage is one of the disadvantages of focusing on ROEs as it can skew ROE upwards – this is why I have used the above three examples, as they all have net cash at the end of the last reporting period, thus making the figure that more impressive.

Here’s the finished product

Abcam 198 997.97
Avon Rubber 123 1000.18
Brooks Macdonald 56 995.55
Dunelm 112 993.83
Elementis 398 998.41
ITV 380 999.15
Next 13 987.35
Rotork 439 997.87
Shire 18 958.15
Telecom Plus 101 995.66

So there you have it, a quality beginner’s portfolio in two simple steps. Whilst the stock screen uses and blends more metrics than I have space for here, I hope that I have given you an insight into the world that, arguably, all investors should flock. Over the next few years, I hope to prove that these 10 stocks can outperform the market – let’s see how we get on!

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Dave Sullivan owns shares in Dunelm and Next. The Motley Fool UK has recommended Elementis and Rotork. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.