Warren Buffett is one of the greatest investors of all time. According to his 2017 letter to shareholders, between 1964 and 2017 he generated a return of an incredible 2,404,748% for investors, which equates to an annualised return of 20.9% per year. In comparison, the S&P 500 index, with dividends included, generated returns of 9.9% per year. Whereas the majority of fund managers fail to beat the market on a consistent basis, Buffett has smashed the market for over 50 years.
This begs the question: what is he doing that other portfolio managers are not?
Quality investing
We know that Buffett likes to hold stocks for the long term. In his words, his favourite holding period is “forever.” We also know he looks for value. Yet perhaps the most important element of Buffett’s investment philosophy is that he looks for ‘quality.’
Consider this snippet from his 2014 shareholder letter: “Berkshire Hathaway Inc Acquisition Criteria: Businesses earning good returns on equity while employing little or no debt.”
That line above may just be one of the keys to Buffett’s success. It turns out that Buffett pays quite a lot of attention to a company’s return on equity (ROE) ratio while also preferring companies with low debt.
So, what is return on equity and how is it calculated?
Return on equity
Return on equity is a profitability ratio that measures the amount of net income generated as a percentage of shareholders’ equity in the company. Essentially, ROE demonstrates the ability of management to generate a decent return on your money. The formula for ROE is:
Return on equity = net income ÷ total equity
Net income can be found on a company’s income statement. Total equity is found on the balance sheet.
The higher the return on equity, the better. A ROE of 15% or higher is generally considered good. Ideally, you want to see a nice consistent ROE over a 10-year period to indicate that the company is consistently generating a healthy profit with the earnings that management retain.
Low debt
The other key part of Buffett’s criteria above is the focus on low debt. Buffett prefers to see a low amount of debt so that he knows that earnings growth is generated from shareholders’ equity as opposed to borrowed capital.
As such, the debt/equity ratio is another key that Buffett considers carefully. This is calculated:
Debt to equity = total liabilities ÷ total equity
Alternatively, for a more stringent test, the following formula can be used:
Debt to equity = total long-term debt ÷ total equity
Naturally, the lower the ratio, the better. Buffett prefers companies with a ratio under 0.5. Focusing on companies with low levels of leverage has most likely helped him avoid big losses over the years.
Stronger returns
So, if you’re looking for stronger stock market returns, consider adding the two metrics above into your stock selection process. As Buffett’s business partner Charlie Munger says: “If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.”
