A recent article in an Australian newspaper declared Return on Equity (ROE) the ‘secret sauce’ for value investors. An astute client who read the piece asked for our assessment of the value of ROE. While we use it, we certainly don’t consider it to be a ‘secret sauce’. The reason is primarily because a single metric rarely holds the key to investing wisely. If it did, we wouldn’t have jobs.
Here’s the article:
As investors buckle down, fearing a recession and more choppy months to come, listed companies with a strong ROE are now proving their value. Just look at two outstanding examples on the ASX. First we have ANZ and its humdrum move to buy Suncorp. How does ANZ fare when it comes to ROE? Well, a good ROE is 10 per cent or more – the best stocks in the world will consistently make double digits.
ANZ is heading for an ROE in 2022 of 9.9. Last year it failed to make double digits as well. Now let’s look at the ANZ share price; does the ROE tell us anything? Why yes, ANZ is $22.5 today. Five years ago, the share price was higher at $30. In fact, 15 years ago the share price was also $30!
In contrast, lets focus on a stock where the ROE is consistently strong: The healthcare leader CSL. As the wider market drifts lower, CSL, which invariably gets a double-digit score, is gaining momentum. Just now the ROE at CSL is nearly 20 per cent. The stock might look “expensive” but where ANZ’s share price effectively goes backwards, CSL trends higher and higher.
CSL is back near $300 – and up from $250 mid-year. Better still it keeps getting upgraded: Wilsons just upgraded its price target this week to $345.
ROE is the secret sauce for value investors. Technically, it is the measure of a company’s net income divided by the shareholder’s equity (assets minus liabilities). In essence it tells us how much money a company is making for shareholders unclouded by dilutions such as equity raisings or any other variables.
Correlation and causation
The author correlates ANZ’s relatively low ROE with its 15 year share price decline. He then links CSL’s relatively high ROE with its share price increase.
There are two major problems with this.
For one, the author cites only two companies, ANZ and CSL. Two is definitely not a large enough sample size to draw any conclusions about the correlation between ROE and share price. And if it were, correlation doesn’t show causation. There is no evidence having an ROE in excess of 10% makes the share price go up, even if that appears to be what the limited data is saying.
Additionally, the author fails to understand share price and ROE are not directly related. Nevertheless, the two can be linked by:
- the price to book (P/B) ratio (share price divided by the book value of equity per share)
- the retention ratio (the % of net income retained by the company calculated as 1 minus the payout ratio)
The P/B is fairly intuitive. If a company reinvests at an ROE of 100% but its P/B halves (i.e. equity doubles and its multiple halves) then its share price remains unchanged. It doesn’t matter the company had a 100% ROE because you paid too much for it!
The retention ratio is more important though, and requires a more detailed explanation.
The retention decision
Let’s look at an example. Assume company A has equity of $100 and a market cap is $300 so its P/B is 3x. It has net income of $21 so its ROE is 21%.
If company A pays out all its earnings as dividends, shareholders will make a return of 7% (21/300). Since it retains no earnings, the equity doesn’t change. Assuming the multiple is held, the share price also remains unchanged.
If, however, the company retains its earnings rather than paying them out, shareholder equity increases by 21%. Assuming again it holds its multiple, the share price also increases resulting in an unrealised return of 21%. Furthermore, if it can reinvest retained earnings at its ROE, it will compound this growth over time.
This difference in the decision to retain vs pay out explains much of the performance difference between ANZ and CSL. ANZ typically pays out more than 70% of earnings and reinvests the rest at less than 10% return. On the other hand, CSL typically pays out less than half and reinvests the rest at around 40%. Consequently, ANZ struggles to achieve any growth while CSL grows at around 20%.
Sustainable growth rate
The following table shows the top 20 stocks mentioned in The Australian article with the 5 year average ROE and retention ratio (RR) for each. We have multiplied the two figures together to show the sustainable growth rate (SGR) which shows that a good ROE is irrelevant to future earning capacity if a company cannot reinvest earnings.
ANZ or CSL
Clearly, value investors should prefer CSL over ANZ. However, this is not simply due to its higher ROE but because it can reinvest its earnings at that high ROE, unlike ANZ.
Long term investors should focus on finding companies with large reinvestment opportunities and management with a proven track record of allocating capital to the highest returning projects. If you can buy these companies at fair multiples, they will compound earnings over time, generating far superior return to the value of a dividend paid to investors to reinvest.
The DuPont analysis breaks the ROE into three components for a deeper analysis of company performance. It is named after the DuPont Corporation, which developed the formula in 1914.
The three components, Net profit margin, asset turnover, and financial leverage (equity multiplier) provide insight into how profitable a company is, how efficiently its assets generate revenue, and how much leverage is used in financing its assets.
If we take the same 20 stocks listed above, its clear the high ROE many have is primarily due to leverage. 17 of the 20 have financial leverage greater than 2 which means more than half of their assets are funded with debt. While not necessarily a bad thing, we try to avoid companies with excessive leverage, especially those that aren’t particularly profitable. (Note these figures are for one year and the previous table showed five year averages.)
While the DuPont analysis is informative, it gives no insight into the opportunities a company has to reinvest, or the skills of the management team to identify those opportunities. Fundamentally, the ROIC is a better measure of this, but the reality is no financial ratio tells you everything you need to know. If you want to be a successful investor you must come to terms with spending the hours necessary to complete your due diligence. There is no secret sauce.
This document has been prepared without consideration of any specific clients investment objectives, financial situation or needs. While this document is based on the information from sources which are considered reliable, Swell Asset Management, its directors and employees do not represent, warrant or guarantee, expressly or impliedly, that the information contained in this document is complete or accurate. Any views expressed in this email communication are taken to be those of the individual sender, except where the sender specifically attributes those views to Swell Asset Management and is authorised to do so.
Swell Asset Management Pty Limited ABN 16 168 141 204 is a Corporate Authorised Representative (CAR No. 465285) of Hughes Funds Management Pty Limited ABN 42 167 950 236 (AFSL 460572)
About the Author
The Education of a Value Investor by Guy Spier
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