If you could use only one financial metric for investing, which would you choose? You might use gross margin, P/E ratio, or net profit growth rate. These metrics aren’t bad, but none of them goes straight to the underlying logic of investing: How much capital did I put in, and how much can I earn?
If Buffett were to choose, the metric would definitely be return on equity. In Buffett’s letters to shareholders, he repeatedly mentions return on equity. Translated, it means return on equity capital. In China, people often use ROE(return on net assets), but it’s the same idea: the money earned each year divided by your capital. For example, if you invest 100 yuan in a company and it earns 20 yuan in a year, the return on equity is 20%.
To understand return on equity, you need to note three things:
First, return on equity reflects a company’s ability to make money. The higher the return on equity, the stronger the company’s ability to make money. With the same 100 yuan invested, some companies can earn 20 yuan, others only 5 yuan. Which one you’d rather invest in is obvious.
I once took all the companies I’ve invested in over these 16 years—about 30 of them—and made a table of their return on equity from listing to now. I found that companies with good investment returns all share one thing in common: high and consistently stable return on equity.
Second, concentrated investing strategy depends on return on equity. Since return on equity is related to money-making ability, investing should definitely choose companies with high return on equity. I did some statistics: Currently, there are more than 5,000 listed companies in the A-share market. In the past 10 years, companies with return on equity above 10% are no more than 5%; companies with return on equity above 15% are no more than 1%; companies with return on equity above 20% are even fewer, only 0.2%, fewer than 20 companies. If our brains are still functioning normally, we should first look for the best businesses among the highest return on equity companies—that is, among these 20 companies—rather than among the 250. Why? In Buffett’s words, if your income were tied to the grades of your classmates in school, you would definitely choose from the top three students, not from the top ten. Charlie Munger said long ago that in a lifetime, finding three truly good companies is enough. Finding two or three of the best businesses you can understand from among 20 companies is much easier!
Third, companies with high return on equity don’t necessarily have wide moats. The DuPont formula tells us that differentiation, high turnover, and high leverage can all increase return on equity. Among these, differentiation is what Buffett sees as a moat. Just this one point means there are even fewer truly good businesses for you to study. Why can value investing make life worry-free? Because we only invest in the best companies and the best businesses. If there were more than three such businesses, could they still be called the best?
So starting today, stop caring about stock price ups and downs all day, and stop busying yourself with valuing companies all day. Look more at return on equity. Find a few good companies with differentiated competitive advantages, high and consistently stable return on equity, then hold them long term, and you’ll achieve satisfactory investment returns!