The Daily Reckoning UK

How To Out-Invest Bernie Madoff

Sean Keyes

by

Posted 9th February 2017

Imagine I asked you to invest in my hedge fund. There’s no minimum buy-in. And you can withdraw your money at a moment’s notice.

Your first question might be about my track record.

Imagine I showed you this:

 

 

Presented with these ridiculous numbers, you could be forgiven for making a discreet call to the FCA. No fund manager can consistently make 25-35% returns, unless they happen to be Bernie Madoff.

They’re real numbers though – I’ll explain them in just a moment. I got them from the research I’ve been talking about in Risk and Reward over the past week.

They’re part of a report on the greatest stock market investments of all time – companies that returned more than £10,000 for every £100 invested in them.

The report has found 456 of those companies over the last few decades. It’s figured out exactly what the companies have in common. And it’s found the elements which point to the next great £10,000 investment.

The most important number

The numbers I’ve given above are real returns… albeit they’re not from a hedge fund manager. They belong to Gerry Solloway, the CEO of a Canadian financial company called Home Capital Group (HCG).

What you’re looking at is HCG’s return on equity from 1998 to 2012. Return on equity is probably the single best way to judge a company’s performance. It a business’s profits as a percentage of the money invested in it by shareholders. It shows how the business is able to put together raw materials, talent, intellectual property and equipment to create extra value. When you get down to it, the ability to create value by combining different inputs is the reason you buy any stock. Return on equity just puts a number on it. So let’s say you invest £10,000 in a new business venture, and in your first year you make £1000 in profit. Your return on equity would be 10%.

Return on equity is an accounting ratio and it doesn’t literally correspond to the amount an investor makes by holding the stock. But in the long run, the return an investor makes on a company’s stock is close to identical to that company’s return on equity.

Back to the example of the Home Capital Group.  According to Jack Donville at Donville Kent Asset Management, the stock grew 4,900% from 1998 to 2014, when he was making his analysis. Adding in dividends, it’s made an annualised return of 28%. Which is almost exactly the same as HCG’s return on equity over that time.

There’s an important caveat though. Investing doesn’t just amount to finding companies with high ROE, and then sitting back to watch the returns roll in.

ROE says nothing about a company’s stock price. A company might have a high ROE (good) but an even higher stock price (bad). These businesses are great companies but poor investments. Donville cites Microsoft as an example: through the 2000s, Microsoft had a high ROE, but it still made a poor investment because the share price was so high.

It’s about balancing the two objectives. As an investor, you want as much ROE as you can get your hands on per pound you invest in the stock. If you can master that, you’re on your way to finding the next Home Capital Group.

Company #457

The new research I’ve been touting over the last few days has really drummed into me the importance of ROE (at the right price).

What I love about the research is this: it’s full of investing wisdom you may already have heard about; but it puts it in the specific context of finding 100-fold returns. It’s tailor-made for our investing style.

And even better, it points to the next big winners. It studies 456 companies that returned £10,000 and aims to pinpoint company #457.

Click here to read about company #457.

 

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