Inexpensive stock? If return on capital is low...it's probably not.

At least over the long term.

The quotes below aren't new, but each is a slightly different take on essentially the same thing. one of the things that matters a whole lot in investing is return on capital (ROC) and how sustainable it is over time.

"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result." - Charlie Munger

"Time is the friend of the wonderful business. It's the enemy of the lousy business. If you're in a lousy business for a long time, you're going to get a lousy result, even if you buy it cheap. If you're in a wonderful business for a long time, even if you pay a little too much going in, you're going to get a wonderful result if you stay in a long time." - Warren Buffett

"Time is the enemy of the poor business and the friend of the great business. If you have a business that's earning 20%-25% on capital, time is your friend. But time is your enemy if your money is in a low return business." - Warren Buffett


An investor can always attempt to find mispriced lower quality businesses. The downside is that time is usually not an ally. The investor can own the shares until the price becomes closer to per share intrinsic value. Of course, then that investor has to sell and hunt for something else to buy (another opportunity but also another chance to make a mistake).

Overpay somewhat for a low ROC enterprise (i.e. misjudge current value) and rapidly compounding growth in intrinsic value will not be there to dig you out of the hole.

In contrast, a durable high ROC enterprise can still end up working well in the long run even when a small misjudgment leads to too much being paid.  Misjudge value somewhat and the higher quality business -- at least with the benefit of time -- can still produce an attractive rate of return in the long run. Not true for lower quality businesses.

So the durable high ROC business can help an investor to reduce mistakes and lower risk.

That doesn't mean it's okay to overpay. Whenever possible, an appropriate margin of safety should exist before making an investment but, inevitably, misjudgments get made. If a business has sustainable advantages and quality economic characteristics, those misjudgments should often end up being a whole lot less costly in the long run.

Judging whether a business is in fact going to maintain attractive economics over time is, of course, the tough part.

Adam
Share on :
Inexpensive stock? If return on capital is low...it's probably not.
Inexpensive stock?  If return on capital is low...it's probably not.
Reviewed by Pisstol Aer
Published :
Rating : 4.5