There are plenty of Warren Buffett quotes we hear all the time. For example, every time there’s a market crash we hear the line “be greedy when others are fearful.” Another quote that pops up a lot is “it’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.”
These are both great tips. However, there’s another line from the greatest investor of all time that’s potentially more powerful from a wealth-generation perspective. It’s not a quote you hear very often. However, it’s one of the secrets to Buffett’s success. Interested to learn more? Read on, and I’ll reveal this valuable piece of stock-picking advice.
The best Warren Buffett tip of all time?
The quote from Buffett I’m talking about is: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed and not the achievement of consistent gains in earnings per share.”
I can understand why this line – which is from the 1970s – isn’t one of Buffett’s most well-known quotes. It doesn’t quite have the same ring to it as something like “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
However, it’s an extremely powerful piece of advice. What Buffett is essentially saying is that the number one thing to look for in a stock is a high level of profitability — a high return on capital employed (ROCE) — and not increases in earnings per share (which most investors focus on).
ROCE is calculated by dividing operating profit by the sum of shareholders’ equity and long-term liabilities. These days, most data providers work it out it for you so you don’t need to calculate it.
Terry Smith follows this Buffett tip
The only investor I’ve heard discuss this Buffett tip is Fundsmith manager Terry Smith. He often mentions it in his letters to investors. He’s also incorporated the advice into his investment process – most of his stocks have a high ROCE. Microsoft, Visa, and Diageo are some good examples.
It’s clearly worked for Smith. Over the last decade, he’s smashed the market, turning £100,000 into more than £500,000. Over the same period, a lot of fund managers have underperformed the market.
Why this tip is powerful
Why is this tip so powerful? Well, it’s pretty simple really. If a company has a low ROCE, below its cost of capital (ie the cost of debt and equity), it’s essentially going to destroy shareholder value over time. However, if it has a high ROCE above the cost of capital, it’ll increase shareholder value over time.
Think about it this way. If you borrow money at an interest rate of 10% per year and make an 8% per year return on it, you’re going to get poorer over time. However, if you borrow money at 10% per year and make a 20% per year return, you’re going to get wealthier. It’s no different with businesses.
Profitability is key
Of course, there’s more to stock picking than just looking at return on capital employed. It’s also important to look at a company’s growth prospects, competitive advantage, balance sheet, management, and other factors.
However, focusing on a company’s profitability is a smart move, in my view. Ultimately, companies with a high ROCE tend to grow much larger over time.