I am convinced that owning companies that generate high returns on equity is vital to growing your wealth handsomely over time. High returns on equity offer a business the capital to reinvest in itself and to strengthen its competitive moat. This means that future earnings can grow at incredibly high rates. All we need to do is buy a piece of them. So last week I started a pilgrimage in search of ASX companies with huge returns on equity based on industries that performed the best in 2017. To be honest I was disappointed with what I…
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I am convinced that owning companies that generate high returns on equity is vital to growing your wealth handsomely over time.
High returns on equity offer a business the capital to reinvest in itself and to strengthen its competitive moat. This means that future earnings can grow at incredibly high rates.
All we need to do is buy a piece of them.
So last week I started a pilgrimage in search of ASX companies with huge returns on equity based on industries that performed the best in 2017.
To be honest I was disappointed with what I found.
I was expecting to find truly outstanding returns; the kind of returns where I could use words like ‘monster’ or ‘whale’, or perhaps ‘Herculean’ to describe their greatness. But the best I got was a 32% return on equity from natural health company Blackmores Limited (ASX: BKL).
Many of the industries I would have naturally associated with high returns on equity, like healthcare and software, sat further down the list.
I expect this is because, as average returns, the few companies with strong moats and super-star performances get down weighted by the large number of less profitable or loss-making imitators.
So running amuck from the data I took a more ‘bottom up’ approach to find four top businesses operating in industries outside of last year’s highest performers:
|Local company||Company ROE||Industry||Industry Average ROE (adjusted for R&D)|
|Amcor Limited (ASX: AMC)||69%||Packaging & Container||14%|
|CSL Limited (ASX: CSL)||48%||Drugs (Biotechnology)||6%|
|Cochlear Limited (ASX: COH)||41%||Healthcare Products||9%|
|Pro Medicus Limited (ASX: PME)||
|Heathcare Information and Technology||
Source: Damodaran Online, Company annual reports
What links companies like CSL Limited (ASX: CSL) and Amcor Limited (ASX: AMC) is that they have a moat of some kind: they can offer leading products backed by intellectual property, efficient production or significant pricing power.
But most importantly, they have the ability to use the significant cash they generate to reinvest back into their businesses.
Clearly, this has a strong correlation with share price movement. Pro Medicus Limited (ASX: PME) sells medical imaging software with ‘sticky’, growing revenues which have low roll out costs. Positive, growing cash flows has helped transform the share price from $0.43 to $8.40 in five years.
Effectively deploying capital at high rates of return over long periods of time should see the business continue to compound, along with shareholder wealth.
If we can find and buy businesses with this potential today, I think we have a good shot of being handsomely rewarded down the line.
Here are three companies I think could have such potential today.
We're living in one of the most exciting times in investing history. Innovation and a booming culture of entrepreneurship are constantly creating new companies with the potential to make forward-thinking investors very rich. Now more than ever, one small, smart investment could make a huge difference to your wealth.
That's why at The Motley Fool we've been scrutinizing the ASX to uncover the kinds of companies that we believe could turn into the next Cochlear or REA Group.
We've found three exciting companies that we believe re poised to perform in the new year. Click here to uncover these ideas!
You can follow him on Twitter @Regan_Invests.
The Motley Fool Australia owns shares of and has recommended Blackmores Limited and PRO Medicus Ltd. The Motley Fool Australia has recommended Cochlear Ltd. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.