Mailbag: incl. Investing in an accelerating world. May 21, 2023

39:02I mean, that's, you know, at one level I'm trying to make as much money as I can as an investor, but I also want to do that in a world that, you know, I kind of feel good about living in and living for the kids. So I'll probably, I broadly agree with both of you just with those couple of wrinkles just thrown in in terms of how I'd probably position it inside a bigger conversation. Yeah, I mean, it doesn't, I think you're right in terms of the immediacy of the impact, but you just, you want, you want a pretty well-designed system so it can at least be more adaptive and i think we've got to get rid of this notion that prices are something that should be controlled it's very understandable but very dangerous thinking um prices should change in response to the supply demand imbalance that is what money money is a correct i've said before it's a global coordination mechanism that's how capitalism works but that's literally how it works right if it creates super profits someone comes in and does more stuff the price comes down but i mean part of the supply response for email is actually people will come and do those things i'll see opportunities jeff bezos famous line your margin is my opportunity that's that's precisely what's that when people get out of the way profiteering it's like they're not profiteering they always profiteer that's literally the business model is i will charge as much as i can every single time i get away with it yep at some point companies are air quotes profiteering because they can other times prices don't change over a decade and and they can't and that's that's just how it works yeah i i i think so we've got to get rid of this fallacy of control we can't control it's too big it's too nebulous you know so let's set the phrase you say put the appropriate guardrails in place and let markets do what they do if i'm selling a bunch of umbrellas and i i'm selling them for 10 bucks an umbrella and then one day it's just really rainy and i put my price up to 20 bucks people go that's really unfair it's like no it's not that's that is absolutely the exact economic outcome you would expect when supply stays constant and demand goes through the roof.

40:54At the same time, in a free and open, efficient market, others will look at that and go, well, I've got some umbrellas as well. I'll sell them for 15 bucks. And we as consumers win through all of that kind of stuff. But without that price change, we don't signal the supply response, right? Like it is really, really, really important. And so I just can't emphasize it enough. I think we lack such a basic understanding of what actual money is and what it does and the problems that it solves that we get too stuck in things that sort of at surface level, it might appear fair or not. But it's actually just key to the whole system functioning.

41:33Yeah. Let me quickly, I don't want to keep doing this one, but let's just one more. I think the umbrella example is even better, mate, than you pointed out. You did a great job. There's one more than that, which is the umbrella is there and there's inequality in the world, which makes this difficult. but but leave that aside just for half a second and people say you can't do that i agree but let's just do it for a sec um prices also mean that scarce resources get allocated to those who value them most highly yep so i've got an umbrella i don't need another one or you know what if the umbrella is 20 bucks i'm gonna i'm gonna save what i would have spent 10 bucks on an umbrella at 20 bucks no get stuff i'm gonna go walk in the rain because that's worth more to me that's a really good economic decision you say no way scott you haven't got hair but i've got hair I want to keep my hair dry I'll pay the 20 bucks for the umbrella that's exactly what should happen people make those decisions as we go and by the way if you left it at 10 bucks you'd still sell the exact same number as umbrellas and you'd sell out because you haven't got as many because everyone wants one so who wins in that case well you still sell the same number of umbrellas so the same number of people still get wet there's no reasonable economic exchange at that point where it literally is we've talked a million times about opportunity costs that's exactly what this is it's I'm going to save the money and save the 10 bucks thank goodness because i would have spent 10 but you know what i got home and i saved 10 bucks i saved 20 because you're going to charge me 20 bucks for the umbrella i said no so i feel good because i'm wet but i saved a few bulb you're saying well i really want the umbrella i would have paid 30 but 20 is pretty good okay that that's a good deal i really want to stay dry got an important job interview on the week on the way home i'll do whatever i need to do and that's it's fundamental to the economic system the rationing of demand is exactly what capitalism does beautifully and for all of its failings and there are millions it is as Churchill said the least worst the best system except for every other system that's been tried that's so the worst system except for every other system that's been tried that's the very point that's why it works you can't and you've got to be careful with equality so I mean such a noble goal right you know we should all have the same it just it just like that's just not this nature of things um where I'm very strong on I think we should have equality of opportunity like I shouldn't be disadvantaged because I'm a female I'm not white and daddy didn't have a big trust fund and I got to go to the best you know best private schools or all whatever that that's what sticks in my craw I think there is always going to be unequal society I think to us to some it's a question of degrees but to some bit of degree it's kind of important for incentives and to make people take risks and and get out of bed and work hard and all of that kind of stuff.

44:02Now, if I'm guaranteed, think of it from a game theory lens, if I'm guaranteed to get the same amount as everyone else, just to take it to a stupid extreme here, there's no upside in me ever taking risk or working harder than the other person or doing anything like that. So it's sort of, it seems very, what a markets guy would say. And while I'm not that, I think everything should be, well, I do too, but it's just not how the universe sort of works. And you can imagine a, you know, hyena on the Serengeti saying, it's not fair that the lion has sharper teeth. And it's like, well, guess what? That's just the world as it is, not as how you would have it.

44:38So I think we need to get past that. Where we need to be very ideologically driven though is to make sure that everyone at least has the same chance to succeed in same opportunity. And where capitalism fails and where it gets the right criticism is when we lean into crony capitalistic tendencies where we have industries that enjoy certain protections and exploit that to their own advantage that shouldn't happen. That's where I'm going to get as angry as anyone else. And I've got to say, at some level, an appropriate safety net for those who do fall through the cracks for reasons that are too various to list.

45:13100%. All that kind of stuff. 100%. And we can be less unequal. I think, I hate binaries as I know you do, mate. And the question isn't equal or unequal, or equality or inequality. it's not a case of either everyone's got exactly the same or it doesn't matter yeah what we're saying is there is a point you know is it obscene that ceos get paid tens of millions of dollars and someone's on you know 17 an hour yes that's absolutely obscene is that appropriate no it's not appropriate does ever should everyone therefore get 28 50 an hour no matter what they do how hard they work or what value they add no and so there's there's different you know the opposite of there is no the opposite of inequality is inequality and vice versa in in any in any real sense other than other than pure pedantry.

45:53There is, inequality will always be there. We can be more responsible on how we share what we have in an appropriate way. Taxation is important. Welfare is important. Job opportunity is important to your point, mate. Those are really important outcomes. Yeah. Hey, let's go to a question from Jackson, which is really interesting to me. He says, G'day, Scott and Andrew. I have a question pertaining to the public rise of activist short-selling. It seems many short-sellers keep producing reports with ongoing success. I've since done some research into these businesses and wonder if the same kind of thing happens in Australia with ASX listed companies.

46:32Now, he's done really good research, actually. He says, in my research, I noticed an information sheet 255 published in May 2021 on the ASIC website. I'm curious if this was in response to events that occurred. Why did ASIC feel a need to publish this information sheet? I quite like the idea of activist short-selling, he says, as a method of accountability for business. Other investment managers in Australia that engage in activist short-selling are regulators good enough at their job that there are far less opportunities for this kind of practice. Super curious to hear your thoughts, ideas and objections.

47:00Thanks, Jackson. What do you reckon, mate? Well, you go first. I always go first. You go. All right, fair. I should say, so this information sheet is one put out and I'll just literally list what ASIC say it is. It's an information sheet that briefly explains what activist short-selling is, describes the impact, provides an overview in the regulatory framework, recommends better practices for activist short-sellers, and list some of the actions we may take in response to these campaigns. I think it's very fair to say that there have been activist short sellers who've targeted Australian companies.

47:29Many of those, by the way, from overseas where ASIC doesn't have jurisdiction. This is where the international law gets really messy really quickly. Very difficult to police for ASIC, for example, an Asian or American or European-based short seller who says, I think you should go short on, you know, Page and Phillips Incorporated. Here's why it's a terrible business. The whole thing's a fraud. It's terrible. The accountability to that is very, very hard for us to support. So that's, and there were some external, I think this one was probably, I shouldn't describe too many motives, but I think it's likely this was in response to a couple of very high profile activist short selling campaigns during 2021.

48:10So you're probably right, Jackson that's what it's for in terms of the idea I really dislike activist short selling and it's generally and I get I get accused of being biased and all sorts of stuff and that's fine knock yourselves out um mathematically there is no difference between going long and going short every time you as a shareholder sell your shares you are effectively saying you don't think it's going to be as good as the person who buys them uh and if you think you're any good at identifying companies whose future value should be higher, there is some intellectual honesty which says the same analysis or analytical techniques should also be able to tell you where a business is likely to be lower quality, and therefore the share price might fall over the long term.

48:53And if you're right about that, shouldn't I be able to profit from that? That's the argument that's made. In a theoretical world, that's absolutely spot on. I've said before, I've annoyed some short sellers, some particularly high profile ones in the past, saying I would ban short selling given the choice and i would ban short selling largely for market i'll say protection reason we just finished talking about you know what safety nets and other things should be in place um here's here's the here's the thing if i say tomorrow hey i reckon page incorporate's a fantastic business and i think the future's really bright and i i plus that everywhere page incorporate shares probably up half a percent if i put out a report tomorrow says philips incorporated is an absolute fraud the whole thing's a debacle there's empty offices there's not as many outlets as they say they've got no relationships with any retailers a large swathe of the market says oh where there's smoke there's probably fire i better sell my shares just in case the shares plummet 10 15 20 30 percent the short seller who's betting on that already because they've already got their position before they put the report out says beauty thank you very much and then sells or actually buys back the shares but closes the short position and makes their 30 profit and goes well that was a good day's work wasn't it now maybe they're right and maybe it is to your point a method of accountability for business or maybe they're wrong but actually doesn't matter by then because they've already wandered away with their proceeds and my issue is that because humans feel fear far more impotently than greed because these reports are designed, I'm not going to quote any particular provider so I can say this, designed to create fear and panic and capitalize on exactly that, that gets really, really, really uncomfortable to be close to what some, if it was done in a larger degree, might be called market manipulation.

50:44That is an unreasonable, unfair attempt to manipulate a share price to gain something, not just be being right. And I guess my point is, if you want to be a short seller, shut up about it. if you need to be activist, in other words, if you need to make your case publicly, why are you doing that? You're not doing it for any other reason than to try and specifically create the effect that you know you will create by virtue of what you're doing. It's far more a marketing document to my mind than a genuine information report. And so I don't think it actually adds anything to market operation. And so I would absolutely, tomorrow, ban short selling.

51:21I don't think it adds anything i i am i'm pretty purist on this the market is a place to swap ownership stakes it's not there for derivatives trading or options trading or short selling or cfds or any of this rubbish that gets created where we we take the respectability of a stock market and then throw a casino over the top and say but it's shares so therefore it's not gambling it's actually investing i'm a sophisticated investor i can make these decisions and take these chances so i'm pretty i'm pretty direct on that one um i have a feeling andrew disagrees with me so i'm look for here yeah i'm all for it um free market of ideas and opinions have at it you know um where i draw the line is where there are falsehoods if you come out and simply give a series of facts uh i don't know there's anything wrong with that um some short sellers are uncovered all kinds of frauds and scams that are hurting a lot of people you know i'm glad that they there were people who went through the weeds and discovered it and, and, and told everyone about it.

52:22Yeah, I know they're making a buck of it out of it as well. So, but, but I think, I think it can be a force for good. And I think it can put companies, you know, a bit more on notice to say that, you know, if, if, if you, uh, if you've cooking the books, you're doing something dodgy, there's a lot of smart people out there running, watching you very publicly. So I don't, I don't, I don't mind it too much. I don't even think it really matters that much. I mean, WiseTech had a big short report. Was it WiseTech? I think it was WiseTech. Yeah, a couple of them actually. Yeah, shares are at record highs now, right?

52:57So they're all freaked out and moved on. It's like, well, who did it hurt? It hurt the person who panicked, you know? But if there's not activist short sellers out there causing panic, well, I don't know, draw something out of a hat. There's a thousand things that are going to do that. So markets are always going to be uncertain and volatile. So again, if they're out there just preaching falsehoods, then you know that's a different story it's like calling crying out fire in a in a in a building when there's not a fire is that that that is very um unethical and i agree with you there but if you're just sharing i mean long long only investors put out reports and stuff all the time i get i get the behavioral difference i do yeah that honestly it's mainly the behavior if if if if the response to short reports was was equal in size to the response of lungs i would actually have no problem with it it's not it i think in this case i am policing the effects not the act necessarily for exactly those reasons we just always like when we saw a long report that sent the share price rocketing compared to a short report that sent the share price down hugely i also admit that yeah i think markets are very adaptive um as well so i think it's it feels like a more particularly here more of a recent phenomena i feel it's a trick that you can only do a few times you can imagine after a while you just get hardened that's another bloody short report with their you know seeking to uh serve their only their own self-interest you know um i held i still got a few shares in um nanisonics for years and years they were one of the most shorted stocks on the market just like what how does that make sense and people pay attention to that and it suffered for a bit they went from eight bucks all the way down to gosh three dollars or so didn't bother me at all because there was no there's no clear thesis behind it and that's cool you've got to be used to as an investor that people are going to have different opinions and that they're going to everyone's going to talk their book it's fine but but i just i rest the entire enterprise on that the truth will eventually out and yeah so i just i don't have i don't have too much of a problem with it yeah no fair enough i yeah i actually i don't care personally um i own i own still shares in corporate travel management they had oh they had a big yeah yeah was it 2018 19 something like that something like that great example i don't really care right what what what annoys me i think is i'm you know i'm annoyed on behalf of other people and i think that's my my general thought the the reality of um what it does to people i just i just think it's it's just it's yucky right and doesn't again if you want to go short go short yeah and do your thing you know when you make the i i really struggle to believe that anybody who does it publicly is not trying to to engineer a share price response that's the bit that annoys me is not that you know and you can argue some longs are too but the reality is it doesn't doesn't work so it's harder to make that case maybe with some small cap dodgy stuff you could make an argument that you know hot copper pump and dump thing or whatever but a genuine a genuine research firm who says i think bhp is great i think their profit's going to be great i think it's a really really great company i love the shares you buy some shares up half a percent it's like okay when someone says bhp is an entire fraud in fact the you know such and such a mine doesn't exist and whatever else so again you're right about the falsehood stuff i shouldn't use that example but the the activist the activism is intended to create a a very specific response on the share price by definition that's the bit that really gets in my i just i honestly i get that i get that it annoys you i get that it annoys me is that manipulation is not what it is i mean yeah If there's laws against market manipulation, if your entire point of making these things public is to precipitate a response, I don't honestly know how...

56:32If you created that from scratch today and said, I've got this really good idea, here's what we're going to do, I'd actually be like, you can't do that. That's market manipulation. You can't go and say this. You know what I mean? It comes back to the truthfulness. Let's say that tomorrow I find a really big deal with the financials of CBA, you know, and it's factually based. and I tell the world that. I think I'm doing the world a favour. It's going to come out, whether it's me now or someone else later. That's almost the point. Is there really a favour? The shares are still held by somebody. That's the one I actually fundamentally disagree with.

57:06We're saving people with money. It's like, how do you save money? You still send the shares to zero. Yeah, but the money is lost either way. That's my point. It's always the favour. If there was a legitimate issue at play here and it's just a question of when it comes out, it's like, well, don't shoot the messenger, right? Like you've rung the alarm bell appropriately and a lot of people will be caught. There's no social good in that, right? Because the money's lost anyway. Like it's not really. Well, we can pretend the issue's not there, you know, if we want. But the issue is, what I'm saying is it's a fact.

57:36There's a burning platform here and it is going to out at some point. The frauds cannot be perpetuated. They just can't. Exxon was always going to zero once they certain set. Sorry, X-Ros. Thank you. Just for the lawyers out there, he said Enron. Enron. Enron. Enron. That thing was going zero no matter what happened. And at a short seller, proceeded that with a bit of a reply. I don't have an issue with that at all. Fair enough. Fair enough. Hey, let's go. Let's finish off with a question on return on equity. Because we had a really good conversation about this. So we got a response from Brent who says, good morning, gents.

58:21Your recent discussion on the return on equity for CSL really intrigued me. I'm reading a book at the moment giving an example of how low ROE can destroy shareholder wealth. The example shows how a 5 % ROE on cash retained by the company only resulted in a 2.5 % gain in the share price. Whereas a company with a higher ROE, using 20 % as an example, and retains the earnings, was able to grow the share price and shareholder wealth. He makes the point that a company with low ROEs better serves its shareholders by paying out the majority of profits, whereas going with high return on equity with the same PE, of course, better serves its shareholders by retaining earnings.

58:59As for each$1 retained, the share price will grow by more than$1. The latter example of retained earnings sounds very Berkshire Hathaway-esque. I was having a hard time understanding the appeal of a business like Berkshire that doesn't pay dividends to its shareholders. as without a material return on your hand, aren't you just buying a business hoping someone else will pay more for it at a later date? But then on one of my YouTube Warren Buffett rabbit hole voyages, I heard the Oracle say, Berkshire has never distributed anything to its shareholders, but its ability to distribute goes up. So I suppose my question is this, as ROE clearly sounds like a vital metric for any business, why isn't it discussed more often when people are talking about companies?

59:40And secondly, is there a minimum ROI you require when considering an investment? Warmest regards, Brent. Oh, great question. Yeah, I don't know. There's lots of really important things that get ignored. So I don't know why it doesn't get talked about more. I think it gets talked about a fair amount for those that have been practicing this for a bit.

1:00:05So yeah, I agree with Buffett's statements. It's the ability to pay it out that matters more. And we've said before it's silly for him to pay a dividend when he can retain that money and get a 20 % return on it. Like if Berkshire had paid a dividend with a 60 % payout ratio since inception, you know, we probably wouldn't have even heard of it. It certainly wouldn't be the success story that it has been. And investors, even if they'd taken the money, would be worse off because you wouldn't have found a better long-term reinvestment opportunity than Berkshire itself. Yeah, so absolutely. The trouble with it, though, is, again, it's like so many things, it's backwards looking.

1:00:43And those that aren't backwards looking are reliant on guesses. So you're kind of damned if you do, damned if you don't. So there's a lot of good examples. I was looking at a company just recently, Symbio. It used to be called MyNetPhone. It had a phenomenal return on equity. I'll try and bring it up. It's a telco. It's too much to sort of go into here. Anyway, I was just taking a look and, yeah, I checked out the return on equity. So back in like mid-2015, around then, they were getting 40 % return on equity. Today, that's 5%. Wow. I had not followed this for a couple of years, mate. That is precipitous.

1:01:16Yeah, yeah. So I haven't dug into it enough to, I know they had a couple of bad periods there and the rest of it. But again, it's worth pointing out these things because a diligent investor might look at this, rising earnings per share, very good growth, very high return on equity, hopefully a bunch of other things, check, check, check, check, check. And then it wasn't until it wasn't. so you've got to be aware of that and I would even say with again having done the due diligence because it just sort of came across my desk and I was looking at a specific thing, unrelated to this point and I noticed it but I also noticed they're heavily expanding geographically, I think Taiwan and Singapore and somewhere else they're moving into well guess what, that costs a lot of money and you don't get the money back until those investments are established and starting to generate cash flow.

1:02:05So sometimes a falling return on equity, particularly when these things are just looked at on a year on year on year basis. So all this money goes out the door, no return on that yet. The business is still being built, established over in those new jurisdictions, or maybe it's a new product altogether. But then next year, those come online and then the profit gushes and their ROE figure looks very different again. So you've got to look, I think it's always through the lens of what's the return on invested capital. But you're going to see natural variation there and sometimes it's not going to be a bad thing.

1:02:41I would love to say, and as a younger investor, I definitely did this. Just look for these four metrics and make sure they fit within these parameters and you'll be fine. It's a very appealing thought, but it doesn't work, doesn't it? No, it doesn't work for a couple of reasons, mate. The other thing about the symbiote numbers as I'm looking at now, The ROE's fallen actually not, well, partly, not only because the business is, it's not so much the business is less efficient than it used to be. It's the fact that profit's actually falling. So, which is almost kind of the point, right? In terms of, if you think about, you know, backward looking as you rightly highlight.

1:03:17Well, okay, back in, you know, 2015 when its ROE is 40%, it was making a certain level of profitability. And then it's, you know, grew a little bit up to 2017. and that is basically since then earnings have continued to fall it's very hard to get a a good or growing return on equity with falling earnings unless you're actually getting rid of some equity at the same time because the e on the bottom return on the top so profit divided by equity effectively if the profit falls the equity doesn't fall then your roe must go down by definition it's kind of the way these things work out um and i think that's an important consideration so think about what's looking forward rather than backwards uh very hard for a declining business to improve roe almost by definition right so which is on one hand not a surprise mathematically it also probably everyone said well of course i wouldn't buy a business that was had falling profits that be silly and yet you would have might have looked at symbio in 2015 and gone 40 roe of course i'll buy it uh let's look at the roe it's great i think that's the problem with these um fundamental based reviews when you just plug in some numbers and say roe of this whatever that and the problem with it even though people who use these formulas or ways of investing would would absolutely say in the next sentence of course you need to know what the profit's going to be you need to do the work on that and so it's kind of like they do i guess we all do we do you and i talk about pe's and price of free cash flows and other things as if they won't change either it's the same thing with pe right pe will fall uh sorry pe will rise if earnings fall so pe of 14 looks great but then a pe of 20 because the earnings fallen by half is not particularly attractive right uh so that's kind of the the way i think it's worth thinking about these roes in terms of why it doesn't get more coverage it's just complex and that's the individual investor's opportunity but it does require you to go a couple levels deep in understanding what companies do um that being said uh sorry sorry i should say so you ask about which number is too low i i don't have an roe target for two reasons one is what we just talked about before which is that the future matters not the past so you know i own companies that are loss making businesses or very modestly profitable businesses that have terrible roe because i think the future is going to be brighter for their profits so it'd be silly for me to say imagine imagine amazon or uh pick what's the other company's gone from lost a profit and done really for to skew right no it's always terrible i'm not gonna buy shares in that you go fast forward x number of years like no actually no it turns out you know that actually worked out pretty well so you've got to be very careful with that um um and that's just i said a couple of reasons that's pretty much the only reason i don't use historical roes for the sake of it i would absolutely love a high return equity business if i can find one but the other thing is moving forward and this is this is really important if you're gonna if you're gonna retain any equity so your point about the question and the examples given brett are really good ones because if a company retains any equity at all then it needs to be able to effectively utilize that equity to grow in other words it's going to to invest that money and do something with it.

1:06:19Now, imagine a business that is, imagine a software business, right? Almost the entire investment, almost the entire cost base is people. You know, there's a couple of servers, but you probably rent those anyway. So what equity does a fast-growing software company need to deploy? And so it's almost, there's a couple of versions of this. I think on one level, you want to keep it if you can use it, which Buffett has done by investing in more and more things. The other thing is, even if you've got a higher OE, if you can't get a high return on the incremental, the next lot of equity you keep, you still should pay it all out.

1:06:54Yeah. Does that make sense? I'm trying to explain. I was going to go there, actually. Yeah. So there's a concept called return on incremental capital. Oh, sorry. Gosh, that's another rabbit hole. A return on incremental equity. It's a different metric measures. Capital just looks at debt as well. So it's just like, what's the return on all the capital at my disposal? One just looks at net assets. Anyway, it's a whole other rabbit hole to go down. But return on incremental equity is saying, what is the return on the money that I retained, the equity that I retained, what return did I get on that?

1:07:32So I strip out the profit from last year. I strip out the equity that I already had from last year of the new equity that I gained by retaining earnings. So equity is net assets. I retain cash, so my net assets go up. So I've retained this much equity and I've generated a return above last year. So again, you can already imagine with what I'm talking about, there could be all sorts of exceptions to the rules and things that change that. But it is a useful way of looking at it because companies may have had historically very high return on equity, but the retained earnings is actually getting a very poor return, which suggests very bad reinvestment, which suggests just pay out a bloody dividend.

1:08:11no reinvestment mate like you might you might be able the software company you keep the cash you put it in the bank you never actually need it because you don't use it for anything so what happens your cash pile grows your roe drops because you can't like you're going you're going and the other one by the way the bit in between is where it gets hidden yeah it looks like high roe because the business is just growing yeah we're actually not even using that equity even even in a growing roe business it can still be a bad idea to retain that cash and not pay it as a dividend which sounds really strange if i'm growing why not why not you know keep all the money and use it to grow and i would completely agree but once you get to the point as a business where you are cash flow positive you don't need that the retained money doesn't do anything for you there is literally no use for that cash you're keeping you might have bolster the balance sheet pay us some debt i mean there's there's you know individual bits and pieces but once you get past that tipping point the money you're keeping you don't you don't use unless you invest unless you literally invested in something you don't need you should pay it out so i i would i think there are i would actually absolutely say there are businesses out there that are giving worse returns to their shareholders than that should be the case because they are air quotes growth businesses growing their balance sheets apple was a great example for years actually mate they've changed now because they're doing these big share buybacks but for a long time apple had this growing balance sheet people say that was a wonderful thing they didn't need the money because they were generating so much bloody cash that they couldn't they didn't need to use it to grow because they could they could grow out of the current year's cash flows so why build the war chest for the sake of it there was absolutely no and i'm not an apple you know i'm not an apple fanboy i'm not an apple critic either berkshire owns a lot of it i own shares in berkshire so i'm happy for it to do well but for a long time there even though the returns equity were growing they were growing because the profits were growing faster than the retained equity but they didn't retain the equity at all they really they literally hurt like swimming buying back shares or paying out a dividend much much much earlier than they did but they chose not to because i think at some point it was just like i've got more more coins in the in the corporate swimming pool to dive into and that's probably a good thing and i don't blame i'd rather have that than you know risking too much debt and risking insolvency but yes you want to what you want to ask yourself is how much equity are they retaining how much is actually used to generate and retain equity in the form of assets because they've bought a factory or built a machine or invested in r &d then great that's that's fantastic but if that return on equity and the equity itself is largely cash equity or something else then they're just they're again no harm putting nuts away for winter but you just want to be really, really careful.

1:10:32An incremental bit is absolutely what it's all about in my mind. This might be a good example. You might know the business better than me. It's a little telco called Telstra. And Telstra actually, its return on equity has been on the wane for a decade or more. So back in 2013, they had a return on equity of 30%. Today, it's sort of closer to 15%. But it's not a terrible figure, right? Like it's awesome. In 2021, it was 20%. but at the same time, they pay out the vast majority of their earnings. Now, I would put it to you. Now, if you go over the last 10 years, the share price is actually down a bit, but on a dividend-adjusted basis, I wouldn't have blown the lights out, but it'd be okay.

1:11:15Store of wealth, bit of an income, not a terrible, not a great, but not a terrible investment. And I would put it to you that shareholders would have done much worse had they retained the earnings and invested it back into the business. Because just there wasn't the opportunity that was there. They would have torched it. They just would have got a very bad return on that. And it's sort of like it's been – and this is why dividends can be – there's a lot of reasons why dividends be good. But one of the reasons I think dividends are particularly good is it gets rid of that money that's burning a hole in your pocket when you're in the boardroom.

1:11:50It means that when you do need to make some CapEx, some capital expenditure, some investments, you've got to be, there's much less cash that's around. You've got to be much more certain of it. Yeah, yeah. So, again, I don't want to sort of throw shade at Telstra. Having to navigate through some very difficult structural challenges and all the rest of it. But I think that's a good case in point of a company that still has a reasonable return on equity but has absolutely made the right decision to transfer the vast bulk of that profit back to shareholders. they shouldn't have returned it but someone could have made the argument oh look at our return on equity we should retain that like no no in fact the reason that return on equity has been on the wane suggests very strongly i think that yeah right that any any return any any reinvested money would have done even worse that that decline would have been far worse had they not paid out most of their money yeah yeah i think it's fine so i think like my my bottom line for me is ROE is really important.

1:12:51I absolutely do look at it. It's absolutely a measure of quality for me for businesses that are mature or maturing, where you can reasonably assess their ability to handle the profitability. You're obviously going to be profitable to have an ROE. So they can handle that profitability. They don't have meaningful needs for reinvestment. If they do, you understand, again, that return. Basically, you divide, let's go to the algebra for half a second. Look at the growth in profit year on year. Look at the growth in equity year on year. Divide those two. That's the return on incremental equity. And that's the number I think you need to be careful of.

1:13:24If you think you're going to have a reasonable stab at how well it's growing, look at that number and see what's going on. But at some point, yeah. So what number do I use? I don't know. I'd love more than 15 given the choice if I found a strong, solid business with good fundamentals, reasonably sustainable levels of profitability, understandable business, forecastable or not even forecastable, roughly guessable, future growth prospects and a high ROE. That's a pretty good thing. More often than not, you'll do really, really well doing it. More often than not, by the way, those businesses are highly priced for exactly that reason as well.

1:14:00So again, you're looking for the variant perception. It's a very good tell on the quality of a business. The one that, no guarantee, but a business that has consistently generated a high return on equity, it's got something going for it, right? Like it's clear, the future may change. We've made that point, but it's certainly been doing something right. And when you see a company with a long history of very ordinary return on equity, I mean, mathematically, it sets the upper limit of earnings growth for you. Like it's very, I think in fact, it's mathematically impossible for me to get a better earnings per share growth than what the rate of return of equity is over a long enough period of time.

1:14:36So that's why it's interesting. I mean, I look at big, big, dominant, top 20 companies. I'll pick a different whipping boy from AMP, Origin Energy, right? Yeah. Yes, for example. They are on 5%. I think maybe 7 % they got last year return. It's a very ordinary business. Of all the money that they have got, the billions and billions and billions of dollars, they're getting a 7 % return. It's okay. It's half of what you've just said that you look for, and I agree. I think that sort of 15 % level is sort of a nice level to look at. But I look at that and just think, what are the odds that they're going to be able to materially deliver far higher profitability in the future when for a long time they've not managed to do much at all?

1:15:17I'm going to flick across to the share price part, but I think it's kind of like I can't see how this isn't anything but ordinary. Right, right, right. And, yeah, sure enough. So even over a 10-year period, it's gone down 20 % or something. Yeah. you know it's just a poor business so I will say the flip side of this mate is I will actively avoid a mature maturing business with an ROE under 10 yeah that oh well with the exception of certain business types I think if you're at bank the ROEs don't really count there's other things where you've got to be a little bit careful so again I shouldn't be absolute with my blanket statements but if you've got a terrible ROE you just you can't as you said mate over a long enough period of time get a good result as an investor honestly though you have to believe those businesses are going to suddenly improve their ROEs for one reason or another um the only thing i'm going to add very quickly we have to start mate but is you can boost ROE by borrowing a truckload of money i was gonna go down that hole yeah yeah yeah and because it because like anything you know you could let's say you got a business with a hundred dollars worth of equity and you're making ten dollars worth of profit a year right so you know attempts in ROE it's reasonable.

1:16:27What you do though, is you say, actually, I'm going to borrow$95. And I'm going to use those proceeds to pay back the shareholders. So now I've only got equity of$5 and I've got my $10 profit. Look at that. I've now got a 200 % ROE. I'm a genius. Except that you've got a$95 debt, which if you're paying interest around, what, five odd percent, let's call that$4.50 in interest, all of a sudden you've halved your potential long-term profitability and you've made the business far, far, far more risky as an entity. Now, some business is going to handle more debt. Telstra is one of those, by the way.

1:17:01It's part of the ROE. It would be much, much worse than it was if they didn't have a truckload of debt. So be careful. That's just the other thing to just keep an eye on. Yeah. Yeah. No, well said. I mean, I always try to bring it back to just, it gets very complex and mathematical and all of this kind of stuff, but it just, you know give me a million dollars and if i can if i can make a profit of 200k on that within a year i mean i'm just demonstrably a better business than if we gave a million bucks to you and you made ten thousand dollars that year i just it just is right right exactly yes well what do you want higher please but but it needs to be legitimate and it needs to be consistent and it needs to be replicable and that's that it just that's all it is we sort of couch it in this this sort of fancy language and mathematics.

1:17:47But I just want to be able to generate as an entity, as an economic machine, as much money as I can from the net assets I have available. That's it. Full stop. That's what we're trying to look at here. But understand the business itself. Don't just look at the numbers and say ROE is X, therefore it's a good or bad business, so therefore I should buy it or not. Understand the business's future. Understand what it does. Understand how it makes its money um we've said a million times both on friday and today you know if it was if if it was easy enough to just plug it into a machine then it would already be done and we'd be you know that's all you need to do yeah it is and it doesn't it can't be at least not yet until i becomes properly sentient then we're all in trouble um but you know the it's it's it's a nice it's a really good starting point if you if you were to look for businesses with roes over 15 for example on the asx i think most broker tools have like they've got some really simple roe screening tools do that as a starting point they go right off that list and then go from there and now it's not the only way because you'll miss the the turnarounds you'll miss the business that don't necessarily fit that you'll miss the small business that are going to grow and keep growing um so you don't want to only do that but if you want to do it as a starting point you'd get a very very good list of quality businesses from which to start then thinking about their futures and prices and and build your portfolio that way 100 % mate 100 % i mean look and look at it just from a comparative basis as well.

1:19:02So if you made me the, I don't know, the chairman, CEO, majority shareholder of Origin Energy, I reckon I could create more value for shareholders by selling every asset that I have, paying off my debts and paying all my liabilities and putting the rest into Berkshire Hathaway. Now, people would be like, what are you doing? That's not what you do. I didn't know. It's like, well, do you want more money or do you want to say that you're in this particular game? I'm very confident that I could do that because I know the returns that are likely under that scenario versus, again, everything through investing is opportunity cost.

1:19:40There is however many billions of dollars tied up in Origin Energy and it's getting a 7 % return at best, 5 % to 7 % return. And you've got to wonder as a shareholder, it's like, well, guys, could we just invest in something else? We don't have to invest in our own business, right? I would. I would. And I think shareholders would be pretty grumpy. But 10 years later, they'd probably be pretty happy with that move. We've flung this horse. We're going to keep going just for half a second because we skipped over stuff because we assume we know the answer. We assume people know the answer. We just don't think of it.

1:20:13What is equity? Equity is the difference between all the stuff a company owns and everything it owes. What's left is the equity. The equity in your house is the value of your house minus the mortgage. That's the equity that's left over. Equity, mate. company equity so the company equity is exactly that if you took all the assets sold them all then you paid off the debts what's left is equity now mathematically that's true even if you don't do it but think about it that way now uh origin by the way you mentioned that you're very generous return equity about seven percent last year over the last 10 years the return equity was negative in two years because they had lost money in three other of those years it was less than six percent so five of the last 10 years you had roe of six percent or less and twice it was negative i know what the average would net out to over that period of time.

1:20:57It's never been more than about eight and a half or nine from what I can see here. So if you literally, and so Andrew, this is literally what you could do. You could literally sell every asset of Origin Energy, sell it to AGL, sell it to someone else, pay off the deals, take the money and go and take that money and buy a bloody term deposit, let alone invest it in something else. Yeah, right. And so you would get, I could get a four and a half percent return now. And by the way, frankly, risk-free with the equity. If I earn this outright, the equity I earn in Origin, like the equity in my house, would be what's left.

1:21:28I'd say, great, I've got this much equity in Origin Energy. What should I do with all that money? I'm going to leave it in this business returning something less than 8 % for the last nine or the last 10 years and hope that maybe the future will be profitable rather than loss-making and maybe things will get better rather than worse. by the way uh again earnings not looking real flash it's the sixth lowest uh earnings last year in the last 10 years so it's kind of all you know if you roll that all together and say if i had if i had this equity if i own this business personally privately would i keep running it or would i say i can take that money and by the way james packard did this with the media business yes he said i own i own consolidated press holdings i own the share of pbl publishing and broadcasting this is a rubbish business i'm gonna know it may or may not have been but he said this is right i'm gonna take my money and invest in casinos so i think that's a better business now in hindsight it might not have been great but the idea was he owned this thing out right on most of it said well where should that cash be yeah and we are the same as investors where should my cash be where's the likely highest return would you hold a business that's going to give you moderate mediocre returns no and yet the companies themselves are exactly that that's the operations they're in berkshire hathaway i can i i'll finish on this ram uh you know berkshire hathaway used to be it wasn't an investment company run by warren buffett it was a textile mill a failing textile it has well that's the thing it has no textile business anymore because what did it do it took it out took the equity from those sales and said let's use that money for something else i mean your point about investing origin in berkshire shares berkshire itself did that to itself internally and said this is rubbish why why are we in textiles we can make more money taking our profits let's not reinvest it in textile mills now origin energy be gutsy but maybe they should be saying actually why don't we go and invest become something else i don't love conglomerates i don't love diversification for its own sake but geez if you had all this money i think the coal company should be doing exactly this by the way around right now yeah they're getting sky high prices oh may not be stranded assets they should be going so we're making all this money we could buy more coal mines or we could do or we could take that money and become something else yeah i don't care if it's the energy business or not i don't care about you've got climate change i'm just saying as a as an idea if you have this massive influx of money you should be using that do anything other than reinvesting in what could be a lower return, potentially stranded asset business.

1:23:40Yeah. It just makes, it would make logic. They won't because, you know, if it walks like a duck, quacks like a duck, it's a duck, every man with a hammer, every metaphor you can think of. Woolies will never do anything else other than be a grocer because that's what it does. That's fine. But if grocery ever, Cornice. Cornice should have done anything other than being an airline over the last 40 years. Should have got into anything else, anything else. But that's where we find ourselves. Oh man. How's that dead horse, mate? Is it flogged? I think we can flog it a bit more. One point I would just make.

1:24:06This sticks in my craw a little bit because people, especially when you're sort of talking about small cap investment, you go, oh, it's risky and the rest of it. It's like this. I can point to a lot of ASX top 50 companies that are absolute rubbish and they're blue chip, quote unquote, because they're big, not because they're great business. Origin, AMP, great examples. There's dozens of others, just mediocre. And then they say, oh, but at least they're not as volatile. Origin Energy, a top 20 company, was like 15 bucks a few years ago. I mean, the space of a year, it dropped down to$5 at one point in time.

1:24:42Like these are very volatile, very ordinary businesses, but they're big and therefore they're safe. And therefore that's where you should invest. And it just drives me a little bit crazy because to me, I've got companies that no one would ever would have heard of. an absolute little like, you know, a gnat on the back of a flea on the back of an elephant relative to these companies. But yeah, volatile. Yeah, the liquidity is not there. But I'd say they are far, far, far superior businesses than a lot of these so-called safe haven blue chips. News Corp, last 10 years, return on equity just for the fun of it.

1:25:158%, 2.2%, 3.5%, 1.8%, minus 12%, 3.8%, 7.1%, 5.9, 7.5. in only two of those years has return on equity been more than six percent only in three of those years has been more than four percent now again think about all the assets of news corp i'm far bit familiar to tell ripper murdoch what he should do with his money but you know and again i just picked that because you're talking about asx 20 i thought i'll look at all the banks yeah uh a mp's a bit of let's have a look at something else um you know those are those are woeful woeful woeful woeful metrics in fact by the way the return on capital is even worse because they've used He's borrowed money a lot of the time.

1:25:54So the actual money they've put in the business in total got an even worse return. The ROE has been saved slightly by debt. Even then, it's still woefully, woefully terrible. I recently, so I won't, look, I went to an event recently and there was one of the directors of AMP was on the stage. Oh no. And Rob Milner from Saltpats. Fantastic company, right? And they were sort of asking about, you know, view on the markets. I thought, can we just listen to Rob only here? Because here's a gentleman with incredible track record and pedigree, and here's someone who's sort of been at least partly responsible for overseeing one of the biggest corporate disasters.

1:26:37Well, no, that's harsh. That's overly harsh. But just a terrible outfit. It's a fair question, though, right? Who are you going to ask for advice? You're going to ask the person who's been doing it for years and doing it really, really well, or is the person who just happens to be at the top of any company who's just either parachuted in or done reasonably ordinarily, it's like, yeah, maybe. I don't think so. You know, I'm not going to get investment advice if someone has been overseeing that garbage fire of a company. Sorry, AMP shareholders. Maybe I should release a short report on AMP and see if I can really shake things up.

1:27:13I think these days you've got to find someone that actually doesn't agree with you. That's the trouble. That's the trouble. I was going to start in short reports. I'm not going to. Mate, we have done a wonderful job of going. I'm not even sure it's over time anymore. There is no time limit anymore. There is no time limit. It's all over. Thank you for a fun chat, mate. As always, I hope our listeners are found and informed. And if you're still here, thank you very much for being here. Do send us your questions, comments, and suggestions as always. And until next Friday. Fool on. Cheers. The Motley Fool and people appearing in this program may have positions in the companies mentioned.

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