My brother pulled me aside the other day and said, "I'm starting a business. It's a sure thing. Gimme $1,000, and I'll cut you in on 10% of the action."
"What will I do with 10% of the action?" I asked.
"You'll be able to sell it later for much more," he said.
"Why would anyone buy my 10% for more than $1,000, seeing as you'll probably just turn my investment into a correspondingly enormous bar tab?"
"Nah," he said, "This business is going to rock. Soon it'll be producing profits that will provide its owners an excellent return on their investment. C'mon, you're a Rule Breaker investor -- take a chance."
I pointed out that "Rule Breaker investor" is not synonymous with "chump." He wasn't the first person to make this mistaken assumption. Rule Breakers don't invest in any old venture on the blind hope that it will pay off someday. We may buy stocks that aren't currently producing profits, but we want the same thing that any investor wants: Future profits that will provide us with superior returns, discounted for the amount of time it takes to earn them.
As it happens, I had $1,000 to put into long-term savings. I figured I had a few choices: I could put it into a government bond and earn a sure 5.5%; I could put it in an S&P 500 index fund and figure I'd get an average annual return of about 10% over the long haul, but maybe less; or I could give it to my brother, in the hopes that his business would pay off enough that, even if he didn't just hand me dividends, other people would want to buy my share for more than I put in -- and it had better be significantly more, since he's clearly a bigger risk than a good ol' index fund.
I'm an open-minded guy, so I decided to hear him out. "What's this idea that's going to give me the return I want -- and I'll tell you up front that, for this kind of investment, I want an average annual return of about 60%, so that I can get my 10x/5y."
"Well," he said, "Land rights on the moon are at a 30-year low now. I'm going to take the $10,000 I raise and buy a plot of oceanfront land."
"Oceanfront?" I asked.
"On the Sea of Tranquility. Then I'm going to build a cabin on it and rent it out on a weekly basis -- and this is the clever bit -- over the Internet."
"The land costs $10,000?" I asked. He nodded. "So you're going to need more capital later to build the place and provide transport. Where is that money going to come from?"
"I'm going to go public to raise funds," he said. "That'll be your opportunity to sell."
I rolled my eyes. He obviously didn't get the whole Rule Breaker thing. We don't hope to take advantage of a stupid market overpricing our stocks. We expect a direct relation between our companies' return on equity (ROE) and our own. Don't think that you can escape all financial analysis in Rulebreakerdom. The difference with us is that we don't look for companies that have strong ROE, but that will have strong ROE once they mature.
A quick refresher on ROE: It is the ratio of annual earnings to shareholder equity. It lets you know the percentage of shareholders' dollars that come out of the company in the form of net income in a year. If the return on equity is 20%, for instance, then twenty cents of assets are created for each dollar that was originally invested.
The ROE equation (earnings/equity) can be broken into three equations by adding sales and assets to both the numerator and the denominator:
earnings sales assets ROE = -------- x -------- x -------- sales assets equity
You may recognize profit margins (earnings/sales) and asset turnover (sales/assets) in that equation. That's why we look for top dogs with sustainable advantages. Top dogs are the ones who typically have pricing power, which translates into high profit margins, and/or efficient operations, which translates into high asset turnover. They maintain these things in the face of competition -- inevitably attracted by high margins and light business models -- through their sustainable advantage.
As our companies mature, then, we expect them to develop a strong ROE. Take eBay (Nasdaq: EBAY) for example. Over the last year and a half, eBay has strengthened its ROE (calculated on a run-rate basis):
Q4'O0 Q3'00 Q2'00 Q1'00 Q4'99 Q3'99 9.6% 6.4% 5.1% 2.9% 2.3% 0.6%
We expect that trend to continue, as the company increases its margins and returns on fixed assets. It happens that our ROE number is a bit skewed because eBay has so much cash, which ends up in the equity side of the equation. If we calculate its return on invested capital (ROIC), which is the ratio of after-tax operating income to invested capital (excluding most of the cash), we find faster improvement:
Q4'00 Q3'00 Q2'00 Q1'00 Q4'99 Q3'99 11.6% 5.7% 3.8% 0.4% 0.3% -2.4%
That's the trend we want to see. We don't want to see the kind of trend that we have at Amazon.com (Nasdaq: AMZN), where shareholder equity has turned into $1 billion in shareholder deficit, making it impossible to calculate ROE.
Amazon has to start generating some positive returns on our investment -- at least enough to make its interest payments. We, like all investors, depend on a company's returns to create our returns. We venture into unknown territory by forecasting financial strength before it materializes, but it has to materialize eventually.
So I told my brother to get stuffed. I didn't see how he would have pricing power or generate a worthwhile return on the capital he'd need to employ. Why would I take a huge risk with him when I had little hope of outstanding returns?
What returns can you hope for from the latest stock-market venture du jour?
Brian Lund lives far away from his family and is sure that they never read his column anyway. At the time of writing, he owned eBay. See his profile for a complete list of his holdings. The Motley Fool is investors writing for investors.