The most important concept in investing is to determine which companies are most efficient at using their asset base to earn profits for us, the shareholders. Earning profits should not be a short-term fad. Profits should be examined as to the level of the return on assets and the consistency of those returns. In other words, an efficient company can earn more with a certain asset base than the competition, and the most efficient company can do so consistently year after year after year.
Remember that little lemonade stand you set up in front of your house? Then one day your competition set one up right across the street. Somehow, you had to come up with a method in order to be more efficient than the competition. After all, if you were more efficient, you could price your product lower than the competition and still generate the same or greater profit.
Possibly you had a better and more efficient lemon squeezer (like mom), which would net you more juice per lemon. Maybe you had a competitive advantage in that you were set up under the only shady maple tree on the street. People wanted to stop at your stand because it was 100 degrees in the sun and you had the monopoly on shade. Maybe you allowed your workers (little brother and sister) to share in the profits of your lemonade stand. Always remember: Ownership is a very powerful incentive.
Get the picture? Sure you do. But how in the world do you look at two similar companies such as Pepsi and Coke and determine which company has the most efficient lemon squeezer or which company is operating under a shade tree during the summer? Going even further, how in the world can you compare two totally different companies in totally different industries such as Netflix and General Mills? Most analysts will tell you to pick a company in each industry so you will be very diversified in your holdings. I can tell you right here and now that there are some industries you just should not be part of. Not if you want to make money, that is.
Before we go on, I want you to be aware that I firmly believe in the “Beach Factor.” The Beach Factor means that you can perform your work so efficiently that you have time to go to the beach. The Beach Factor is, of course, synonymous with free time. I recently bought a beautiful hammock, which is set up under that shade tree where the old lemonade stand stood so very many years ago. The hammock keeps calling my name so softly, “Come here and rest. Come here and take your mind off the world.”
See? That’s the Beach Factor. So keep in mind as we proceed through this book that we are fine-tuning your stock selection skills so that you, too, will have time to go to the beach. By the time you finish this book and become familiar with our computer program, you too will have the Beach Factor concept embedded in your life forever.
What’s does that mean? Invest like Warren Buffett and live like Jimmy Buffett? Yes, that’s the place we want to get to.
As you can see throughout this book, I usually succeed in bringing concepts and examples down to my level of thinking, which is somewhere between daydreaming at the beach and the real world. I lean more toward the former than the latter because it’s much more fun. The reason I say this is I don’t want you daydreaming as I go through some very simple concepts because the very simple concepts are all part of the larger picture.
Clean Surplus is a very simple type of accounting. But please don’t allow yourself to be turned off by the word “accounting.” I know it brings back bad memories for some of you. Remember Accounting 101? I know, I know: not if you don’t have to. And those of you who never had an accounting course, please don’t worry. What we are about to discuss is hardly what you would associate with serious accounting. Trust me on this one; this is going to be easier than reading a good sea story.
I’m going to introduce you to Clean Surplus toward the end of this chapter. But it will be so very subtle that you won’t even know you’ve been exposed to it. You will learn this concept and not even realize it until I jump up and tell you. Just remember that I really do believe in the K.I.S.S. principle.
Question: What is an efficiently operated company?
Answer: It is a company that earns a very high return on the money invested into it (Clean Surplus owners’ equity), and does so consistently year after year.
Before I go on, I want you all to understand that we use “book value,” “asset base,” and “owners’ equity” to mean the same thing, at least for now. They really are not the same, but for now, just let it be.
Think of your bank account. Bank A consistently pays you 10 percent interest on your money year after year. Bank B pays you 10 percent one year, 8 percent the next year, 5 percent the following year, and 10 percent the year after that (Table 3.1).
Table 3.1 Which Bank Is Efficient?
| Year | Bank A | Bank B |
| 4 | 10% | 10% |
| 3 | 10% | 5% |
| 2 | 10% | 8% |
| 1 | 10% | 10% |
Bank A is considered efficient because it earns a high and consistent rate of return on our invested money year in and year out. Bank B is not only relatively inconsistent in its returns, but is less efficient in the use of its assets because, overall, Bank B returns less on our invested money than does Bank A.
You see, investors like a high rate of return, and even more than a high rate of return, investors want a consistent rate of return. After all, this is why people invest in bonds.
In order to go on with this book you must answer the following question correctly. The question is into which bank would you entrust your hard-earned money? Hey, correct! You’ve earned the right to continue. See? I told you this would be easy.
Just jumping ahead a bit, the analysis of the bank example is exactly how we’re going to analyze stocks. Don’t believe me? Read on.
Sorry for the digression away from stocks, but think about bonds for a moment. People buy bonds for steady income. People buy bonds for a (relatively) high rate of return compared to other relatively low-risk investments such as bank accounts and CDs. However, some people want a higher return over the long term, which is why somebody invented the stock market. But if you want to win in the stock market (or successfully analyze a company), you want stocks that generate both a high and consistent return on the equity (money) that investors have put into the company.
You would like your stocks to act like a bond except you want increasing earnings year after year. If the increase in earnings is not consistent, then you are increasing the risk of ownership. The big question is: Why would you want to do that?
The earning capacity of a company (how much in earnings it makes) is a direct function of the size of its asset base and how efficiently that company utilizes that asset base. Let’s begin with the size of the asset base.
Take two bank accounts, each with the same amount of risk, but paying us a different rate of interest. The account with Bank A contains $8,000 while the account with Bank B contains $10,000. We would naturally assume that the account held with Bank B would earn more interest for us as it is working with a larger asset base. However, Bank A is paying out a higher rate of interest to us because it is investing our deposits more efficiently. Thus, it is able to pay us a greater return.
Bank account B has a higher asset base and should earn a greater return for us, but it isn’t because it is not making efficient use of money held in deposits. We see that bank A earns a greater return of $800 on a smaller asset base while Bank B is earning $500 for us on a larger asset base. A closer look reveals that Bank A is earning 10 percent on our invested equity while Bank B is earning just a 5 percent return on equity for us. Even though Bank B has a larger asset base, it is earning fewer dollars for us. Why? Because Bank B is earning a lower percentage return on its asset base than Bank A when it invests our deposited money. It is the ability to measure this percentage return that will mean so much in our analysis as we go on.
If both banks had the same amount in the accounts, Bank B would earn a much lower dollar amount than Bank A as shown next.
The problem we are faced with in security analysis, which will be solved in this book, is how to determine the asset base of large companies and how to determine the percentage return on that asset base. And it’s not the way finance people have been taught in the past. It is the method you will learn in this book that separates the great money managers from all the rest.
Let’s look at two separate bank accounts again as shown in Table 3.2, each with the same initial amount of $100 in each of them. Let’s also assume all interest payments (earnings) are reinvested back into the account. Begin in year one at the bottom of each column and work your way up to year five. The percentages represent return on equity, or ROE.
Table 3.2 Bank A and Bank B—Initial Amount of $100
| Bank A | Bank B | |||||
| Year | Equity | Interest | ROE | Equity | Interest | ROE |
| 5 | $146.00 | $14.60 | 10.00% | $142.45 | $11.40 | 8.00% |
| 4 | $133.00 | $13.30 | 10.00% | $131.29 | $11.00 | 8.50% |
| 3 | $121.00 | $12.10 | 10.00% | $120.45 | $10.85 | 9.00% |
| 2 | $110.00 | $11.00 | 10.00% | $110.00 | $10.45 | 9.50% |
| 1 | $100.00 | $10.00 | 10.00% | $100.00 | $10.00 | 10.00% |
Bank A begins year one with $100. Interest of $10 was earned during year 1 and the entire $10 was reinvested (retained) back into the account. Thus, the following year (year two) begins with the original $100 plus the interest earned of $10 for a total of $110. Year two begins with an account size of $110.
As you can see, our asset base is growing as time goes on. As our asset base grows (because of reinvestment), we would expect to earn even more interest in year two. In year two, Bank A earns $11 in interest for us. Then as the asset base grows each year (because we are retaining everything we earn), we generate a higher and higher amount of interest. Again, the higher amount of interest is due to the increasing size of the asset base.
Ah, but there’s another very important part of this story. In fact, it is the most important part. The very serious question is what percentage return are we earning on our equity, and even more important, is it a consistent return year after year?
To find the answer to this very important question, we simply divide what we made in interest (earnings) for any particular year by the amount of money (equity) with which we began the year.
Looking at Bank A for the first year, we see that we earned $10 on the $100 in the account at the beginning of the year. In order to determine the ROE simply take the $10 earned and divide it by the amount of money ($100) with which we began the year (Table 3.3).
Table 3.3 Bank A in First Year
| Year | Equity | Interest | ROE |
| 1 | $100.00 | $10.00 | 10.00% |
So simply, $10/$100 = 10 percent. This is ROE.
Bank B began year one with the same amount of $100. We earned $10 that year, which gave us a 10 percent ROE, which is the same as Bank A.
In year two, we began the year (in both accounts) with $110. Bank A returned $11, but Bank B returned just $10.45. Bank A’s ROE was 10 percent once again, but Bank B returned $10.45/$110 for just a 9.5 percent ROE.
Let’s jump ahead and look at year five for both bank accounts. Bank A began the year with $146 in equity. It earned interest (earnings) of $14.60 for us that year. We made $14.60 on an asset base of $146 for an ROE of 10 percent ($14.60/$146). This is a very good scenario because we want a high and consistent rate of return from our investments, and Bank A is providing a relatively high and consistent rate of return for us.
Bank B began year five with $142.45 in equity. It earned interest (earnings) of $11.40. $11.40 divided by $142.45 is an 8 percent ROE. We see that Bank B is not providing us with a high and consistent ROE when compared to Bank A.
Let’s take these results and put them into real terms used in the investing world. In year five, Bank A had a 10 percent ROE while Bank B had an 8 percent ROE.
Dear reader, the previous example is so very important because it is the very basic fiber of investing. If you can answer the following questions, you are well on your way to being able to develop your own, above-average performing portfolio. This means that you will outperform 96 percent of the professional money managers over any average 10-year period.
Question #1
Why does Bank Account A have more money in it (equity) in year five when both accounts began with $100 in year one?
Answer
Because Bank A earned a higher and more consistent rate of return. Bank A had a higher ROE than did Bank B.
Question #2
Why did Bank A earn a higher ROE than Bank B?
Answer
Who cares? Ok, you may think I’m being silly here, but really, who cares? Think about banks in real life. One is paying you 4 percent on your savings and another is paying 5 percent. Really now, when was the last time you sat down and asked how the banks were investing their (your) money? As my students would say, like, er, uh, like never!
Hey, wait a minute! Is the example with Bank A and Bank B simple? Of course it is. And do you know what I just did? I just taught you Clean Surplus Accounting. Hellooo! Did you hear me? You just learned Clean Surplus Accounting!!!
And the name is exactly what it means. It’s nice and clean. And the surplus, in its simplest terms, is the profit. And from Clean Surplus, which is how we figured the equity in the bank year after year, we were able to calculate the ROE generated by both banks. And because we were able to calculate the ROE in the same manner for each bank, we were able to determine the most efficient bank. Even more importantly, we now know which bank we should be putting our hard-earned money into.
You see, the ROE that we just configured using, yes, say it again, Clean Surplus Accounting, tells us almost everything we need to know about a bank or a company. If the ROE is high and consistent over the years relative to other banks or companies, we know which of these banks or companies we should be considering for investment of our hard-earned dollars.
Let’s for a moment go from banks to companies and ask what Warren Buffett would begin to look for in a company.
First of all, he would say he wants a company with a high ROE and a consistent ROE. How do we know he says this? In Robert Bruner’s Case Studies in Finance, he (Bruner) tells us that “Buffett sought to judge the simplicity of the business, the consistency of its operating history, the attractiveness of its long-term prospects, the quality of management, and the firm’s capacity to create value.”
Wow, all that? Gee, Professor, how can I determine all of this? I’m certainly no Warren Buffett!
Well, let’s analyze what Buffett said and take this step-by-step and relate these qualities to the ROE from Clean Surplus Accounting. You know, Clean Surplus is the ROE we just figured using our bank examples.
Hey, what about the simplicity of the business? Buffett says he understands ice cream better than he understands computer software. And Buffett is smart. I’m sure he understands computer software.
Yes, but here’s the real story. Buffett understands where the ice cream business will be in 10 years, but he has a hard time trying to figure out what the computer business will be like in 10 years or how the present companies in the computer business will be positioned in the whole scheme of things in 10 years.
So if you take a business that you understand and that company has a high and relatively consistent ROE, you are probably looking at a pretty good contender for your stock portfolio. You will learn more about high and consistent as we go along. After all, selecting stocks for our portfolio is what this book is all about.
The key to investing is really very simple. We want to invest in companies that have a relatively high ROE, and we want companies that have a very consistent ROE.
Didn’t you figure out very quickly into which bank you wanted to invest your hard-earned money? Selecting stocks for your portfolio is almost this easy. I’ll prove to you later on (yes, another sea story) that even a blind person can select good stocks using exactly what you’ve learned so far. Yes, I said a blind person.
Wait a minute, Professor; this chapter was pretty simple. I hear about ROE all the time. Everybody uses ROE. What’s up here?
Well, my dear readers, the entire world has gone in a different direction relative to the calculation of ROE. The entire world uses the traditional accounting ROE and not the Clean Surplus ROE, and this difference in calculating the ROE makes all the difference in the world.
It is the difference between structuring an average portfolio and constructing a superior performing portfolio. It is the difference between buying the S&P 500 Index (in one form or another) or developing a very simple, above-average-performing portfolio and going to the beach. Please remember the Beach Factor.
Between what you will learn from Mr. Buffett and the results you will observe from my research, your investment philosophy will be changed forever. And it will be changed for the better. As I say to both you and my students, this stuff is a piece of cake!