Most people, especially those on Wall Street, like to mystify the factors that have brought success to investors like Warren Buffett and Ray Dalio. They can make you feel that only 'professionals' can show you the way to riches. They may also charge you obscene fees, eating into your total return.
The truth is that success in the financial markets comes down to one thing. And it's so apparent that even professionals in other faraway fields recognize its power. I'm talking about compounding. In fact, Albert Einstein is attributed with saying that Compounding your money, or compound interest, is the eighth wonder of the world!
Today, you will see why stocks like Ross Stores (NASDAQ: ROST) and The Buckle (NYSE: BKE) can be one of these stocks that can supercharge your future wealth. Follow along to discover how investors like yourself can replicate profitable stock picking in a way that would make Warren Buffett proud.
You can't miss it
So, what is the driver behind these stocks? What is it that people like Buffett look for when they sit down to find their next long-term purchase? And, by the way, stocks that will carry lower tax burdens due to long-term capital gains.
Using MarketBeat's stock screener, you can filter through stocks with superior profitability, namely their ROE (return on equity) rates. Return on equity implies how much money a business generates on the cash you invest (equity).
However, all businesses also carry some debt, which is still counted as capital that has been invested in the company. So, if the business carries too much debt, a high ROE can be misleading since your high returns come from the leverage of the balance sheet. That's not a safe approach.
You can bypass this issue by looking at the ROIC (return on invested capital) instead. ROIC calculates your return rate on equity and debt invested in the business. The beauty of ROIC is that, over the long term, annual stock price performance will begin to reflect the average ROIC rate of the company.
To achieve the double-digit compounding returns required for wealth accumulation, you need to find stable enough businesses that can offer you double-digit ROIC rates for the foreseeable future. And you guessed it, the financials seen in Ross Stores and The Buckle have passed with flying colors.
"Show me the money!"
Taking the whole of consumer discretionary stocks, measured by the Consumer Discretionary Select Sector SPDR Fund (NYSEARCA: XLY), Ross Stores seems to beat competitors like TJX Companies (NYSE: TJX), just like The Buckle has beaten names like Abercrombie & Fitch (NYSE: ANF) on more than just ROIC.
The apparel sector is trading at a forward price-to-earnings average of 14.6x. In contrast, Ross brings on a premium of 46.9% from its significantly higher 21.4x valuation.
Why would the market be willing to overpay for a name that can 'easily' be replaced with a similar company in the sector? ROIC may be the answer here. Ross Stores has an average ROIC of 12.5% over the past four years; how would you like to compound your money at this rate?
The Buckle seems to be a bit of an underdog in this comparison. It is valued at a forward P/E of 7.6x, nearly 50% off the sector average. However, it is offering perhaps one of the best ROIC rates in the space, with its 30% average!
Comparing it to other retail names like Abercrombie & Fitch can give you a better idea of why this is the stock to pick. Abercrombie generated an average ROIC of only 5.4% during the past four years. That's nothing to write home about.
Now, Abercrombie is valued nearly at the industry average with its 15.2x multiple, which is still 100% above The Buckle's valuation, and analysts have noticed this gap. This stock currently has a $38 share price target, implying a net 14.5% upside from today's prices.
Knowing the importance of profitability when valuing stocks, analysts have placed a much lower upside to Abercrombie, with a $49.10 price target, which reflects a net downside of 26.6%... Ouch.
Now that you understand why these stocks are being favored in their own space, it is up to you to decide whether they deserve your hard-earned money. Double-digit rates of return are hard to come by, but they can mean everything during times of high inflation, like today.
