Drivers of ROE in the Context of Portfolio Management

Posted on Posted in Portfolio Management, Think Differently, Warren Buffett

Someone on the Corner of Berkshire and Fairfax board recently posted this comment referencing Buffett’s well-known piece on inflation from 1977.

In the article, Buffett describes the variables that drive a company’s return on equity. There are only five ways that a company can improve returns:

  1. Increase turnover
  2. Cheaper leverage (reduce interest charges)
  3. More leverage (increase the amount of assets relative to a given level of equity)
  4. Lower income taxes
  5. Wider margins

Notice three of the five drivers of ROE have to do with taxes and leverage. So the pretax returns (as opposed to capital structure variations) are really driven by just asset turnover and profit margins.

Some executives at the DuPont Corporation also noticed these drivers in the 1920’s when analyzing their company’s financial performance. They broadly categorized the drivers as turnover, margins, and leverage. For now, I want to leave leverage out of it and think about turnover and margins.

Portfolio Turnover

I wrote a post a while back discussing the misunderstood concept of turnover in the context of portfolio management. Specifically, the topic of realizing gains (and paying those dreaded taxes). Basically, the idea of short-term capital gains is taboo among many value investors.

I think it’s very important to try and be as efficient as possible with taxes. However, I think that tax consideration is only one of (not the only) factor to consider.

We could take Buffett’s five inputs that increase or decrease a company’s ROE and apply them to the portfolio. Basically, as investors, we are running our portfolio just like a business. We have a certain level of equity in the portfolio, and we are trying to achieve a high return on that equity over time. The exact same factors that Buffett talks about above apply to our portfolio. Those five factors are the inputs that will increase or decrease our portfolio ROE (aka CAGR) over time.

Notice that taxes is one of the (but not the only) factors.

Turnover is also one of the (but not the only) factors.

Michael Masters is not a value investor, but he runs a fund that has produced fabulous returns over the past 20 years or so (from what I’ve read, north of 40% annually). You can read about him in the book Stock Market Wizards by Jack Schwager.

Now, I don’t understand his specific strategy, and I’m not suggesting it’s one that should be cloned, or copied, etc… I’m just focusing on the turnover concept here. Masters, according to the interview, runs a strategy focused on fundamental catalysts, and holds stocks an average of 2-4 weeks. When he was running a smaller amount of money, he was compounding at 80%+ per year.

Of course, he was paying a lot of taxes. His investors—the ones in the highest tax bracket—might be “only” netting 40% or so after tax. But who would be upset with paying a lot of taxes if it means achieving a 40% return on the equity in your capital account?

Obviously an extreme example, but the concept illustrates the point that just because you hold stocks for years and years and pay very low taxes doesn’t mean that your after tax ROE will be any better than an investor who pays a lot of tax and achieves a much higher pretax return.

I think it’s very difficult to compound capital at 20% or more without some amount of turnover in the portfolio. This doesn’t mean I’m promoting higher levels of activity. I’m not. I think making fewer decisions is often better, and trying to do too many things is very often counterproductive. I’m just saying that the math suggests that some level of turnover is needed if your goal is to compound capital at north of 20% over time.

This is one of the reasons I love bargains and deep value special situations in addition to the compounders.

As I’ve said before, very few companies compound their equity and earnings at 20% or more over years and years. Those that do often are priced expensively in the market. But to achieve portfolio returns of 20% without paying taxes, you’d have to not only properly identify these companies in advance, but you’d have to have the foresight to invest your entire portfolio in them.

How Did Buffett and Munger Achieve Their Results?

It’s a difficult proposition to be able to seek out in advance the truly great compounders that will compound at 20%+ for a decade or more, and that’s why investors who focus on bargains and special situations often are the ones with the extreme performance numbers (like Buffett doing 50% annual returns in the 50’s, Greenblatt doing 40% annual returns in the 80’s and 90’s, etc…).

It’s unlikely to do 20% annual returns by buying and holding great businesses for a decade without selling. It’s basically impossible to do 30%+ without ever selling.

Charlie Munger has promoted the idea of low turnover—and I think his reasoning (as usual) is very sound, but I think he was using the Washington Post as an example–and I think that might be (dare I say) somewhat biased in hindsight. But if you’re looking for decent after tax returns, he’s right. If you can find a company that compounds at 13% per year for 30 years, you’re going to achieve good after tax returns on your capital. But, I think finding the Washington Posts of the world are easier said than done in hindsight, especially when thinking about a 30 year time horizon.

Another example I’ve discussed before is Disney. Buffett bought Disney for $0.31 per share and sold a year later for a 50% gain in the mid-60’s. He laments that decision as a poor one, but in fact his equity has compounded at a faster rate than Disney stock over time, making his decision to sell out for $0.50 a good one. And that is an extreme example using probably one of the top 10 compounders of all time. Not every stock is a Disney, thus making the decision to sell at fair value after a big gain in a year or two much more likely to be the correct one.

Back to Munger’s Washington Post example… I like to consider his audience. I don’t necessarily think he was saying this is the highest way to achieve attractive investment results. My guess is he was trying to convey the importance of long term thinking and lower turnover. However, when Munger ran his partnership, he was trying to compound at very high rates, and for years did 30% annual returns. He didn’t do this by buying and socking away companies like the Washington Post. He may have had a few ideas like that, but he was a concentrated special situation investor who was willing to look at all kinds of mispriced ideas.

Buffett/Munger of Old vs. New

I think there is a disconnect between the Buffett/Munger of old, and the Buffett/Munger of today. Their strategies have obviously changed, and their thinking has evolved. But their best returns were in the early years when they could take advantage of the (often irrational) pricing that Mr. Market offered.

They were partners with the often moody Mr. Market back then and they took advantage of his mood swings. When they came into the office and Mr. Market was downtrodden, they’d buy from him. And on the days when Mr. Market was excited and overly optimistic, they’d sell to him.

Their bargain hunting days provided them and their investors with 20-30% annual returns.

They made a lot of money.

They paid a lot of taxes.

As they compounded capital, they began to evolve. Buffett and Munger both have discussed this, but they both have said with smaller amounts of capital, they’d invest very differently. Buffett bought baskets of Korean stocks in his personal account in 2005 when some were trading at 2 times earnings with net cash on the balance sheet. He’s also done arbitrage situations, REIT conversions, and other things in his personal account that provided attractive, low-risk returns (and very high annualized CAGRs).

By the way, this is not an indictment against compounders. As I’ve mentioned before, my investments tend to fall into one of two broad categories: compounders and special situations/bargains.

I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses—and everyone knows they are great).

But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it.

I’m not sure if this post really has a hard conclusion and maybe this is more of a ramble than anything else. I’m not sure how to sum it up, so I’ll just stop here. These are just observations I have had, and the COBF post on Buffett’s 1977 piece (which is a great piece to read if you haven’t) prompted some of these thoughts which I decided to write down and share.

I think it’s important to understand the drivers of investment results (portfolio returns on equity) are the exact same factors that drive the ROE of a business.

Feel free to add to the discussion if you’d like.

Have a great week, and for the golf fans, enjoy the US Open.

16 thoughts on “Drivers of ROE in the Context of Portfolio Management

  1. Excellent Article,

    its a shame that Buffett does emphasize this method of investing as much as the “compounder” buy and hold.

  2. Hello John,

    Great write up as usual.. My thinking..

    I think in value investing community people to much talk about holding for ever or holding for more than 5 years etc etc.. Big Investors talk about it because it make perfectly sense for them at this stage of their career.. Why Portfolio turnover matters?

    You bought a stock which you think will double in a Year( I know you cannot think that short term but that is not point here you may think it will double in 2-3 years but just for the sake of simplicity we will take one year).. This mean expected CAGR is 100 %.. Now it increased by 90 % in 6 months so x become 1.9 x in 6 months.. Now I am assuming that underline business has not changed over this 6 months period so why you should hold this stock for 6 more month?
    it can be multi bagger over period of next 10 years.. So what? we have to take decision at the end of 6 months when risk reward ratio as per our analysis say it cannot give more than 20% annualized return from there onward and on the other hand some other cheap stock are waiting for us… Even if one stock which we just sold after earlier will become multi baggar does not mean law of probability say us to hold it.. if do the same thing over and over again in multiple bets risk reward ratio is in our favour.. And as value investor each one of us are looking for risk reward ration and not holding period.. If holding period make risk reward better than it is ok… But we should keep in mind risk reward is the process we should purse and holding period is outcome so holding period should not be given importance over risk reward…

  3. Great article. I think dividend yield is a big element in Buffet / Munger style investment. For instance, if you purchase a stock for $5 a share with a yield of 3%, and if that stock were to spurt to $50 a share in 5 years and the company opted to maintain that 3% yield that would equate to 30% annual return on the initial investment. At such a happy return prudence will warrant that you keep holding on

    1. Hi Neal,

      Thanks for the comment. This is something I’ve had discussions with others before. I hear that argument a lot regarding dividend yield on purchase, but I don’t agree with that logic. I understand where the argument is coming from, but it doesn’t make sense. If you have a stock that you bought at $5 and it is now at $50, who cares what it is yielding on your purchase price? Your equity is now $50 per share, not $5… so you’re equity is now only yielding 3%, not 30%. In other words, you can sell that stock at $50, and you have $50 of cash that you could potentially deploy into some other stock (either with greater capital appreciation potential or higher yield). To me, what it was yielding on a price that you paid in the past in meaningless. It’s 50 bucks of capital that you should allocate to the highest possible risk/reward candidate you can find at the present–which may or may not be the stock you currently own…

      Anyhow, that’s just my 2 cents. Thanks for the comment, and thanks for reading.

  4. Great post John. I couldn’t agree more with you on this statement:

    “I actually enjoy investing in compounders the most, since they do the work for you. But bargains are the ones that often get more glaringly mispriced for a variety of reasons (not the least of which is the fact that the compounders are great businesses—and everyone knows they are great).

    But I don’t have a dogmatic approach to investing, and I will look for value wherever I can find it.”

    I think a lot of value investors either restrict themselves only to good businesses, or at the other extreme, under-appreciate a truly good business. But to really earn extraordinary returns, I think one has to remain flexible.

    That’s essentially the point I was trying to get at in this article, which is one I hope to update with some further thoughts one day:

    And it’s also why as much as I’d love to be investing in more compounders, I’m still crawling around Australian mining services stocks today!

  5. Hi John,

    I love your blog. I have learned a lot about value investing from your posts. I had a question on one section of the Buffett article about pensions.

    “Of course, there is a marvelously precise figure in many annual reports each year, purporting to be the unfunded pension liability. If that figure were really believable, a corporation could simply ante up that sum, add to it the existing pension-fund assets, turn the total amount over to an insurance company, and have it assume all the corporation’s present pension liabilities. In the real world, alas, it is impossible to find an insurance company willing even to listen to such a deal.”

    Is Buffett saying that companies will under-report their unfunded pension liabilities and not to trust them? How do you go about analyzing this?

    Thanks and keep up the great work!

    1. Hi Bryce,

      That’s what it appears to be, but I don’t recall that passage, and so I’d have to read the article to get the full context.

  6. Hi,I think old Buffett and Munger made money as you said,but they made so great that that they get bigger to make that decisions.Buffett some time 2000s that if you give me less money I will get 50 percent compounding.But I think long term investment is with High Roe companies,but beginners must make their money by special situation and deep value ones.

  7. Excellent article!

    There is a cult of value investors with poor math skills that are always talking about buying long term quality companies and its nice to read a post that set the record straight.

    Yes, buying long term quality compounders is a great thing and done really well, its a way to perhaps earn 12% after tax over a long-term – which would put you in the upper percentiles of all investors, but that’s not how Warren and Charlie invested back in the day when they made twice that. Cigar butts, special situations, and safe arbitrages are still the way to go for long term compounding for personal accounts. Berkshire isn’t buying IBM today because it will return 18% per year for 20 years, but because the universe of stocks available to move the needle at Berkshire is so small that IBM is the best they can find.

    If you want to earn over 18% per year for 20 years, it starts by only buying stocks that can appreciate over 23-25% over the next year pre-tax to net over 18% post tax and with only the rarest of exceptions are you going to find them in the SP500 and even rarer by holding them for 20 years. If you hold a special situation or cigar butt for 6-12 months you can get a nice return, but hold them for 5 years and the returns will revert to the mean. Look at the people who are making the high returns, and they are not investors with just ten long-term quality investments held for 20 years in their portfolio, rather they are people who have some measure of turnover.

    Someday I will probably switch over to long term quality, but the driver will be reducing the amount of time I spend per day on investing and not maximizing my return.

  8. love reading your blog john. one of the top of my list worldwide.

    there is always the temptation for buying cheap stocks but so so on the quality of business.
    after a few burns with not so good companies i preffer find qualities business that i can invest big portion of my portfolio in it. but on the other side i m not fall in love in stocks and hold forever, if i dont see potential to double the stock in 2-4 years i will not buy it as quality as it can be. if it go up soon like u wrote and i can make quick 50-100 % i will sell with a smile and go for the next one.

  9. I think that you are right to give CTM equal billing. Despite his modesty, CTM was a superb investor in his own right.

    For instance, if you look at the numbers in the famous “Superinvestors of Graham and Doddsville” article, for the years during which WEB and CTM each ran their own partnerships, CTM outperformed WEB. Of course, WEB folded his partnership early, so his record was not blotted by the trauma of 1973-74. And WEB’s results tended to be more consistent. However, in terms of compounded average annual return during the period 1962-69 before fees and taxes, CTM was well ahead of WEB.

  10. I also think that in the microcap/ small cap area, you can hold stocks for long time if the business gets better and better,
    so if the upside remain high, even if u made good return already, you can still hold it for long time so I can’t say I will not hold a company for long time no matter what.

  11. Hi John, thanks for your post. I have seen you mentioned ” special situation” for a couple of times. Could you please elaborate on this? What kinds of situations are regarded as special situation? How do you find it out? Thanks, John.

    1. Hi Zejia,
      Special situations come from all over. I find them just by paying attention to the corporate news, reading the paper, etc… I’ll have to write a post about my strategies at some point, but they basically involve the situations that many other investors talk about such as corporate situations like spinoffs, mergers, liquidations, asset sales, etc… They could also be news events, earnings announcements, litigation, regulatory issues, etc… These situations could also be strange odd-ball investment situations that come about just by paying attention to the securities markets. The idea is to locate a potentially mispriced security where the corporate situation or event often acts as a catalyst that will realize the valuation gap.

      1. Thanks John. Does it means that you have to bet on something, say for example a stock that will be involved in spinoff, or will be an acquisition target? I am not sure if “bet” is an appropriate word. Look forward to your post on this topic. Best, Zejia

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