Every investor wants to buy stock in companies with good management. But while billionaire shareholders can get face time with corporate managers and tours of plants and facilities, individual investors are unlikely to have such opportunities. So how can you tell if management is doing a good job? In a recent piece for Forbes.com, Validea CEO John P. Reese says that Warren Buffett’s investment strategy provides a clue.
In their book Buffettology, Mary Buffett and David Clark say one key metric that Warren Buffett uses to assess the effectiveness of a company’s management is “return on retained earnings.” These are the earnings that a company does not use to replenish needed capital equipment or pay dividends, Reese writes. Retained earnings are used instead to grow a firm’s business, and what management does with these retained earnings is crucial.
“Whether or not the management of the company can utilize its retained earnings is probably the single most important question you must ask yourself as a long-term investor in businesses,” Mary Buffett and Clark write, according to Reese. “Warren discovered that simply being able to retain earnings free of the burden of having to spend them on maintaining current operations was not enough. The management of the business must have the ability to allocate retained earnings to new moneymaking ventures that also give high rates of return on invested capital. If no new ventures are available, these excellent businesses engage in stock buybacks.”
Reese’s Warren Buffett-inspired Guru Strategy uses return on retained earnings as one of its key criteria. He looks at a handful of stocks that have high returns on retained earnings and which also get strong marks overall from his Buffett-based approach. Among them: IT firm Wipro.