Separating wheat from the chaff?

What do you use as your first filter when adding a new business to your portfolio?

For me it’s simple…Return on Equity (ROE). From my time on Strawman I realise the first filter is very different for each investor. For some it might be ‘a long runway for growth’ and for others ‘the next big thing’. For some it might be very low risk business with a good fully franked dividend?

For the largest part of my investment decisions ROE is the first cut, and the higher the ROE the better! So I start by looking for businesses where analysts are forecasting ROE to be more than 20% in the foreseeable future. However, not all my investments IRL have forecast ROE greater than 20%!

There are plenty of businesses on the ASX that have ROE greater than 20%, so it shouldn’t be that hard for me to load up my portfolio…Right?

Well, it seems everybody wants a business with a very high ROE and generally none are cheap. So the question is, what is a fair price to pay for a business based on its future ROE?

I heard recently that Buffet said something like: if you hold onto a business for long enough YOUR returns get closer to the ROE of that business. I haven’t proved this but It does makes sense to me.

Let’s do a few examples for businesses that reinvest all their earnings at different ROEs using an online compound interest calculator.

To make it really simple we will invest $1 for 10 years at five different ROEs ( 5%, 10% , 20%, 40%, 80%) allowing the net profits to compound annually at the same ROE.

Here are our total returns after investing $1 for 10 years:

At 5% interest = $1.63

At 10% interest = $2.59

At 20% interest = $6.19

At 40% interest = $28.93 and

At 80% interest = $357.05

Example of $1 invested at ROE of 5% for 10 years https://www.calculatorsoup.com/calculators/financial/compound-interest-calculator.php

Now I haven’t found too many banks that will pay me 5% interest on my investment, let alone 80%. But I do know there was at least one business on the ASX with a ROE of over 90% in FY22 (Lovisa, ASX:LOV). What’s more, analysts are forecasting earnings that will put Lovisa’s ROE over 100% going forward?

Now, if investing were only that simple I could put all my money in Lovisa and let it compound forever!

OK, let’s look at Lovisa with its big ROE of > 90%. This represents over 90% return on YOUR EQUITY in the business (Book Value). Yesterday you could have bought one Lovisa share for $22.73. How much equity do you get in Lovisa for your $22.73 per share? Just $0.60, yes that’s right, 60 cents per share! So there’s the catch!

There is so much completion in the market to own a high quality, well-run business that investors are willing to pay 38 TIMES the EQUITY they will own in Lovisa. The million dollar question…Is Lovisa worth 38 times Equity. What multiple of the Book Value in Lovisa can you afford to pay and still get a very good return? What is a really good return on your investment? What are the risks if Lovisa’s ROE drops to 70%? So many questions. Too many questions to explore before breakfast…and I need to oil our deck this morning! But, I WILL BE BACK in the near future to explore some of these questions.

Cheers,

Rick

Disc: I sold all my Lovisa shares recently…but perhaps I should have held?

I’ve just put together a spreadsheet for the McNiven StockVal formula. @PortfolioPlus asked if I had one. I do now (screenshot below).

If you would like to try it, please DM me with your email and I will share a time limited OneDrive link so you can download and try it. The grey columns contain formula so don’t change these. Some of the grey columns are hidden. You can play around with all the other columns including the Required Annual Return so that the current valuation matches the current price. I usually start with a Required Annual Return of 10% which is generally my minimum buy requirement.

cheers

Rick