How to avoid the money pits

THE crucial factor that separates the very best from the rest.

I HAVE previously shown how easy it can be to beat the stockmarket indices, which we have done at Montgomery Investment Management, and to identify extraordinary businesses.

Now we are going to drill down a little to identify the crucial factor that separates the very best companies from the rest.

When Singapore sovereign wealth fund Temasek purchased shares in ABC Learning Centres at about $7.40 five years ago, I went on the record with a valuation that was much, much lower. Indeed for the ABC's The 7.30 Report I said: "For the Singaporean sovereign wealth fund ... this is going to be a soul-searching experience." Then, when Myer floated in 2009, I again suggested investors were better off avoiding the offer because the value was lower. More recently, when Collins Food Group listed, I thought investors would be better off zipping their wallets. On each occasion the share price tanked.

Readers may remember I suggested avoiding QR National. I don't believe the band has stopped playing there, and investors were better off taking what stock they could get in the GR Engineering float, but you cannot win them all. We missed out on 41 per cent by not buying QRN but we did make 120 per cent buying GNG, which floated at the same time.

You can make a great deal of money in the stockmarket buying extraordinary companies cheaply. But you can undo all the hard work by investing the remainder of your funds in the many examples of money pits that are landmines ready to go off in your portfolio.

To protect my own portfolio from permanent capital loss, I use a very simple tool that is easy to replicate. The key is understanding the difference between profits and returns.

In the stockmarket, investors frequently look at earnings and there certainly are many variants to keep you occupied. There are earnings per share, net profit after tax, earnings before interest and tax, as well as earnings before interest, tax, depreciation and amortisation. Then of course there's cashflow, free cashflow, operating cashflow and dividends. Many, if not all, of these items are important, but far more important is something else.

When you are a stockmarket investor you tend to focus on what is coming out of the business earnings and dividends, but when you own a business you care not only for what comes out of it but how much you have to put in to get profits and dividends out.

I don't focus so much on the dollar of profit coming out of a business but on how many dollars must be invested to get that dollar out. I focus on the most important ratio in assessing the economic superiority or otherwise of a business. It's a ratio and it compares the profit with the equity that has been contributed by the business's owners. The ratio is called return on equity, and when it comes to returns we should remember Mae West's observation that too much of a good thing is wonderful.

Return on equity is simply the profit or cashflow dividend by the equity. If you had a bank account with $1 million of your equity invested and each year $50,000 interest was generated, the return on your equity would simply be the $50,000 income divided by the $1m equity, or 5 per cent.

If there were two bank accounts and one yielded a 5 per cent return on equity while the other produced 20 per cent, you would naturally be attracted to the higher return. If I auctioned the two bank accounts, the account generating the higher return would achieve a much higher price.

That's the first lesson. Returns on equity are important because they help to determine the true value of an enterprise. But, perhaps more important, there is an economic reality that many investors don't understand, which ultimately determines the performance of their share portfolios. Return on equity is more important than even earnings growth in assessing the quality of a company. This is because only a company with a high rate of return on equity can turn a dollar of retained earnings into at least a dollar of long-term market value.

Stockmarket investors receive returns from two sources capital gains and dividends. If a company's management pays a dividend, each dollar is worth a dollar to you (indeed, thanks to franking it could be a great deal more). As a shareholder, however, you also have a stake in every dollar of profit retained: that is, the dollars that are not paid out to you as a dividend.

The problem with these retained profits is that it is not always clear if a company should retain them. If the company generates a return on equity that is, for example, less than what can be earned in a much lower risk bank account, the company should not retain those profits. That seems obvious, but only when a company can turn a dollar of retained earnings into more than a dollar of capital gain should it retain those profits. The mathematical fact is that only a company that retains a profit profitably can turn retained dollars into long-term capital gains.

You only should buy companies with high rates of return on equity. So take a look at the stocks in your portfolio and ask not whether their earnings per share or dividends per share are rising but whether the return on equity is.

Roger Montgomery is the founder of Montgomery Investment Management and author of Value.able: How to Value the Best Stocks and Buy Them for Less Than They're Worth.

www.rogermontgomery.com