Does top dollar mean top performance?

In The importance of return on equity we looked at how to calculate return on equity (ROE) and touched on a few successful companies that scored well on that count. Here we'll explore exactly why that is the case. In particular, why buying excellent companies - even at prices that may seem expensive in the short term - is one of the best long-term strategies for investing in the share market.

We have already emphasised the point that a great company will earn substantial returns on capital and warned how some companies generate a high ROE through gearing (borrowing). This is why you should look at another ratio, return on invested capital (ROIC) - the money that shareholders and debtholders have stumped up - before making your decision.

Supermarket comparison

Crunching a few numbers and analysing the business carefully will tell you whether a high ROE is the result of superior business economics or merely pumped up by the use of debt. The key question is: does the business have a sustainable competitive advantage?

A comparison of Woolworths and Foodland illustrates this point nicely. Woolworths' large market share gives the company what Adam Smith called economies of scale.

It can drive harder bargains with suppliers, take advantage of distribution efficiencies and, due to its market size, still charge a premium. Look what happened to the price of milk after deregulation as an example.

Foodland, on the other hand, prior to the recent Franklins deal, held strong positions in Western Australia and New Zealand, resulting in an unimpressive single digit ROA. But a high level of gearing transformed the ROA into a higher than average ROE.

Woolworths, by comparison, has produced a strong ROA over time and a great ROE as well. There is some powerful logic why that is so.

Bargain price

A share cannot return more than the underlying business over the extremely long term (say 15 or more years). If you own shares in a company earning 6% on its capital, as an investor you won't do much better than that over the long term. Even if you buy the stock at what seems like a bargain price, mathematics wins out in the end.

On the flip side, consider a company that earns 20% on its capital (and retains a good portion of earnings rather than paying high dividends) over many years. Even if you buy it at a fancy price today, you'll most likely do well over time. The value of the business will catch up and eventually overtake the price you paid.

This logic lies behind our positive recommendations on quality stocks. These companies usually carry valuations that scare many investors but the lesson is that it's usually a good idea to pay up for quality in the stock market.

For some reasons why high quality businesses thrive, head to Good things happen to great businesses.