Higher return ratios lead to superior returns? Think again...


Reducing an investment framework to bite-sized rules sounds interesting in meetings and webinars; their efficacy in long-term cross-cycle investment returns is sadly rather poor.

Higher return ratios lead to superior returns? Think again...
Over years of investing in equity markets, have you amassed a few sets of rules and formulae that have always turned profits for you? That ONE formula that always seems to work? How about buying companies that have the highest return ratios? Or investing in leaders of a sector? Something that just works, irrespective of market cycles!
Adam Grant, in his book, Think Again makes remarkably interesting points on the matter. This story from him will help set the context.
In 1949, a massive fire had engulfed the forest around the Missouri river, with flames stretching as high as 30 feet. After a while, it became evident to the smokejumpers that fighting was no longer an option, and they will have to run for their lives. But the fire was catching up on them fast and it was an uphill climb. That’s when Wagner Dodge did something that baffled others.
Instead of outrunning the fire, he took a matchbox and burnt the grass around him. He then dampened a towel and lay face down for fifteen minutes in the vacant space as the fire raged directly above him. Essentially, he had taken away the fuel that a fire needs to keep going. This method did not make sense to the crew, which chose to follow the textbook. Tragically, twelve smokejumpers perished. They were taught to douse a fire, not to start one.
While that was sad, what was bizarre was that the bodies of a few smokejumpers were found with their equipment still on them. A backpack, 25-pound chainsaw and other tools. While trying to outrun a fire, in an uphill climb, why would they not simply ditch the equipment? One firefighter later explained that discarding your tools doesn’t just require you to unlearn habits and disregard instincts, but it’s perceived as admitting failure and shedding part of your identity. You don’t fight fire with bodies and bare hands; you fight it with tools, which become a part of your existence.
Adam insists that we don’t just hesitate to rethink our answers, we hesitate at the very idea of rethinking. Seth Stephens-Davidowitz carries this concept further in his book Everybody lies. In 2013, a reddish-brown horse (no. 85) was among the 152 horses being auctioned in upstate New York. The horse’s current owner was an Egyptian beer magnate, Ahmed Zayat, who wanted to sell no. 85 and buy other horses. To help him, Ahmed had hired a team of experts—a small firm called EQB, headed by Jeff Seder.
After a few days of evaluating, Seder’s team told Ahmed that they were unable to recommend any horse to buy in this auction, but had a near-desperate plea—he cannot, ABSOLUTELY POSITIVELY cannot sell horse no. 85! Thankfully, Ahmed paid heed and retained the horse (later renamed American Pharoah). American Pharoah went on to become the first horse in more than three decades to win the Triple Crown! What did Seder know that apparently, no one did?
Historically, people had believed that the best way to predict horses’ success was to analyse their pedigree. Being a horse expert meant being able to rattle off about the horse’s father, mother, grandparents, siblings, etc.
However, Seder (a Harvard grad) found that pedigree wasn’t a consistent predictor of a successful racehorse. He was more interested in data and started collecting it, for years on. He measured the size of horses’ nostrils; he did EKGs to examine their hearts and cut the limbs off dead horses to measure the volume of their twitch muscle. He grabbed a shovel to determine if the size of a horse’s excrement had any correlation to its wins (had it lost a lot of weight before a race?). He then got his big first break when he decided to measure the size of their internal organs. Since technology didn’t exist back then, he created his own portable ultrasound. The results were remarkable. He found that the size of a horse’s heart, especially the left ventricle, was a massive predictor of a horse’s success—the single most important variable.
At the New York auction, of the horses on offer that day, No. 85 was 56th percentile on height, 61st percentile on weight, 70th percentile on pedigree, but a whopping 99.6th percentile on the left ventricle. The data screamed that no. 85 was one in ten thousand or even one in a million horse.
Now let’s come back to the question I had asked at the start of this letter: can you think of that one winning formula that has always helped you generate a profitable investment? Earlier this month, I had argued that boiling down an investment framework to bite-sized rules has historically not worked. Today, let us look at a similar euphemism: “Buy businesses that generate strong return ratios, and they will continue to outperform the markets forever,” they say.
Whereas it is obvious that one would not want to invest in businesses that cannot earn their cost of capital. However, I humbly submit that historical return ratios are of little help as sole predictors of investment returns. The chart below is the frequency distribution of the stock returns of 674 companies (with a market cap above Rs 5 billion and those that have a 10-year share price history). We took the average of return on capital employed (ROCE) between 2007 and 2010 (so that one year does not have an outlier effect) and compared their stock returns over the next decade (2011 to 2021). As the chart indicates, returns aren’t materially different across ROCE buckets.
Data indicate that you cannot predict future returns based on the historical return ratios of businesses. How then, you might wonder, could the high ROCE fallacy have started? I believe some experts would have looked at stocks that have done well over the last decade and studied common traits—say, all had great return ratios a decade back. He then would have concluded that buying businesses with great return ratios results in superior investment returns.
However, we miss the huge survivorship bias here. Humour me for a bit. One could look at all the successful companies, compare their traits and conclude that ‘all of them are successful because they took outsized risks.’ Fair observation. However, there are companies that took outsized risks and perished on account of an unfavourable outcome. Unfortunately, they are no longer part of the universe you are analysing (because they went bankrupt). If you think that no one does that, I can list two books that were written explicitly stating that, and they sold more than 4 million copies!
Similarly, businesses that returned superior investment returns may have a common trait—they generate superior return ratios. However: (a) all businesses that generated strong return ratios a decade ago did NOT result in superior stock returns; and (b) there is a subset of stocks that delivered superior investment returns, but were NOT generating high return ratios a decade ago.
We should be cautious in what we choose to believe in as it becomes an unshakeable part of our investment framework (like smokejumpers clinging to their equipment). Adam concludes that ‘once we accept the story as true, we rarely bother to question it.’ The more we rely on data, rather than narratives, the better off we are in the long run. Reducing an investment framework to bite-sized rules sounds interesting in meetings and webinars; their efficacy in long-term cross-cycle investment returns is sadly rather poor.
Jigar Mistry is the co-founder of Buoyant Capital. The views expressed in the article are his own
Disclaimer: Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on the Disclosure Document filed with SEBI.

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