In his 1984 shareholder letter, Warren Buffett wrote, “Time is the friend of the wonderful company, the enemy of the mediocre.” In other words, business quality makes a big difference in investment returns. It sounds rather elementary, but so many investors focus on price that they miss out on the quality aspect of owning a business. While a company may be cheap, it may not necessarily be worth owning, and while something may be worth owning, it may not necessarily be cheap.
The easiest way to judge quality is to look at Return on Equity, a topic I’ve written about extensively in prior notes. Return on equity is important because it signals the amount of earnings (or cash) a company produces for its shareholders, and the efficiency with which it’s produced. Ultimately those earnings motivate the share price higher or lower over time. Companies with higher and stable return on equity are the wonders Buffett is talking about.
Time is a friend because it allows for those wonderfully compounding cashflows to work in the investor’s favour, so the longer an investor can hold a compounder the better. However in holding mediocre companies with lower return on equity, time has the opposite effect – it compounds mediocre results, leading to lagging performance over the long run.
The chart below illustrates just how much quality matters. We’re going to measure the performance of three real businesses over the last fifteen years. The green line is a wonderful consumer staples company we hold in the Growth Portfolio with return on equity averaging 13% per year over the last 15 years. The blue line is a retailer with an average return on equity of about 4% per year (close to that of the general market). Finally, the red line is a mining company averaging -14% return on equity per year. The scale along the right hand side measures the share price performance of each of these businesses – the high quality consumer staples compounder is up about 4000%, the average business is up about 500%, while the bad business up only 23%. Why is the bad business still up even with negative return on equity, you might ask? Inflation.
Price is obviously an important factor in making an investment decision. But over the long run the effect of buying at a good price is dwarfed by the effect of buying a good business.
Like Warren Buffett and the Rolling Stones, you want to be singing Time is on My Side.
I’m taking an early weekend next Friday so you can expect the next note May 28. Wishing all the Canadian readers a happy Victoria day long weekend next week!