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) |
27% |
Heathcare Information and Technology |
9% |
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.
