Warren Buffett and Return on Equity

Death of the Compounding Engine

First, the business must have earnings. Secondly, the business must have the ability to generate those earnings using a reasonable base of equity. This results in a high return on equity. Thirdly, the business must have the ability to retain the earnings at the same high rate of return. If a business cannot retain the earnings then the compounding engine is destroyed.

Let Me Have a Dollar

If I had a magical process for investing capital at a high rate of return, let’s say at 20%, and you invest $5 with me, at the end of the year I will have made you $1.

You will now be faced with three options:

1. You can take the $1 in which case you can spend it or invest it elsewhere, perhaps in a llama farm
2. You can leave the $1 with me and allow me to reinvest it for you.
3. Or together, we can use the $1 to buyout existing shareholders.

The first questions that should come to mind, if you leave the money with me to reinvest, is “are our children learning” and will I have the ability to continue generating the 20% rate of return? Secondly, if you take the $1, what rate of return can you expect to achieve… in the llama farm? The answer to the first question is found in two components:

1. The track record of ROE in my business.
2. The historic retained earnings off of my business’ balance sheet.

If historically, my business has retained earnings and the ROE has remained strong, averaging 20%, then by all appearances, the business has the ability to “put the $1 to good use”, reinvesting it at the high rates of return on equity. If on the other hand my business has historically retained earnings (plowed them back into the business for expansion/new business projects, llama farms, etcetera) yet the return on equity has steadily dropped over the years, then it appears that I have poorly allocated retained earnings into low returning investments and I do not have the capability to effectively expand the business or at the very least, the core, original business has begun to suck wind. Either way, you will see this as a drop in ROE and perhaps a paltry, anemic ROE track record.

Back to our original options which truly exist within the context of two scenarios:

1. I have the ability to reinvest the $1 earnings at a 20% rate of return.
2. I do not have the ability to reinvest the $1 earnings at a 20% rate of return.

What would you do with the dollar in each case?

Under scenario A, if you take the $1 away from me, then in the context of an optimal investing strategy, you must find another investment that generates a 20% or greater return in order to beat what I am delivering for you, unless of course you just want to go purchase, let’s say a dozen Krispy Kreme donuts, sit on the couch and pig out, in which case this is a moot discussion.

Under scenario B, if my track record is sub-par or mediocre at best, then you should take the $1 and invest it elsewhere if you can beat my return. Let’s say I generate a 4% on a regular basis and your local bank is offering a CD paying 5.5%. In this scenario, you would be better off (by 1.5%) to take your dollar and invest it at the bank. As a matter of fact, I would strongly argue that if the ROE track record of my business has been subpar, then you should give serious consideration to yanking your entire investment and moving it elsewhere, preferably to a company with a strong record of return on equity. This is exactly what Warren Buffett did when he learned that the original Berkshire Hathaway textile business had poor underlying economics.[i] He began buying better businesses.

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[i] Schroeder, Alice. The Snowball. 1^st ed. New York: Bantam, 2008. Print.