DKAM-final newsletter5-a

2 2 2 ROE REPORTER | DKAM Flux Capacitor In 1955, Doc Brown fell off the toilet and hit his head on the sink in order to realize that the Flux Capacitor was the key to time travel. Fortunately, we didn’t need to do anything of the sort to understand the key to stock picking because Warren Buffett already did it for us. Only two years after Doc’s “discovery,” Warren Buffett, along with friends and family, invested a total of $105,000 in his limited partnership. This would ultimately propel him to great success as Warren had created his own DeLorean. Warren’s DeLorean is powered, not by a flux capacitor and plutonium, but by the compounding effect of retained earnings and ROE. Physicist Albert Bartlett put it this way: “The greatest shortcoming of the human race is our inability to understand the exponential function.” The counter intuitiveness of compounding is responsible for the majority of disappointing trades, bad strategies, and successful investing attempts. Good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that kill your confidence when they end. It’s about earning pretty good returns that you can stick with for a long period of time. That’s when compounding runs wild. In order to time travel, the DeLorean relies on the Flux Capacitor, which itself relies on plutonium for energy. In our world, superior stock picking relies on compound growth, which itself relies on Return on Equity. Return on Equity, our proxy for growth, is the best metric to evaluate stocks versus any of the value-based calculations like Price to Sales, Price to Earnings, Price to Book, Enterprise Value to EBITDA etc. We think Warren Buffett would agree with us, even though most people think he’s a value investor. We think he’s instead a growth investor who buys excellent businesses at prices that make business sense, instead of simply seeking bargains. For example, Buffett invests in Coca- Cola at 24x Price to Earnings, Moody’s at 17x EV/EBITDA and Costco at 29x Free Cash-Flow*. Multiples like these would make a value investor blush. Good thing Buffett’s not a value investor and neither are we. ROE is also a superior metric to picking stocks based on sales growth or earnings growth. Sales growth isn’t a good proxy for value creation and earnings growth isn’t a good proxy for sustainability of growth or measuring operating efficiency. ROE is a culmination of all the ratios and metrics we really care about: sales growth, margins, taxes, earnings growth, interest payments, and so on. _______________________________ * Each of these companies has an ROE of 25%-30%.