A company’s return on equity is the key to building long-term shareholder value. But how do you know a high ROE is not just a flash in the pan, masking underlying problems with the company’s fundamentals?
Several years ago, we came to the realization that owning and managing a portfolio of carefully selected stocks offers greater long-term return potential along with the capacity to better manage risk. Thus, far we’ve been proven right. We’ve often shared our philosophy that, when we can identify and invest in genuinely great companies at great prices, they turn out to be the best investments.
We have also shared the criteria-based process we use to find and select great companies. We have established five critical criteria that, if satisfied, provide the most reliable indication that we are looking at a great company. We have often referred to these criteria – or characteristics – as the five pillars upon which we build our portfolios.
To give you an indication of how strict our criteria screening is, when it’s applied to the 30 companies in DJIA – all considered to be industry stalwarts – not a single one meets all five criteria. Fewer than 3% of the nearly 3,000 publicly traded companies in the U.S. meet all five criteria. So, we have set a high bar for what we consider a great company.
Return on Equity: The End-all and Be-All Growth Indicator
But, we have learned that, while all five characteristics are critical to the process, only one can be considered the true “pillar.” It’s the one essential characteristic a company must possess to be considered a great company – and that’s Return on Equity (ROE).
Why is ROE so important? It’s the key measure of a company’s profitability and, more importantly, how well the company’s leadership manages its shareholders’ money. The equity is what shareholders have given management to invest in the enterprise on their behalf. It is represented by the equipment, property, and inventory the company invests in to generate a profit. So, ROE is simply a fancy way of expressing how much profit the company makes with the shareholders’ money. There is no more important measurement for investors than what they get back for their investment.
ROE is also a measure of efficiency, which is the key to generating long-term value. When a company’s ROE is rising, it’s an indication of management’s efficiency in deploying shareholder capital in high-growth business areas that create long-term value. It’s also an indication of management’s ability to generate more profit as the value of underlying assets increases. The bottom line is that a high ROE is an indication that the company is making smart decisions with shareholders’ money.
ROE Stability Requires a Four-Legged Chair
So, if ROE is the end-all and be-all, where does that leave us with the four other great company characteristics? Why are they important to the equation? It’s because, for many companies, a high ROE may only be fleeting – an anomaly. A company may generate a good profit for a year or two, but what’s the likelihood it will continue in the third year and beyond? Or ten years into the future?
The problem is a period of high profits can lead to high ROE, which can deceive investors. Extremely high ROE can actually indicate a higher risk due to a shrinking equity account or increasing debt levels compared to net income. In those cases, a high ROE can mask underlying problems.
That’s why we look for the four other characteristics in addition to ROE. They act as stabilizer bars that support the central pillar and add predictive value. With those firmly in place, we have the confidence to know it’s not an anomaly and that it has the staying power to generate earnings years into the future. Having all of these elements in place gives us the conviction that, regardless of how the stock is performing today or next year, the company will grow shareholder value over time. With more than 400 data points to pull from at any time, we can assess the strengths of the characteristics and their ability to support ROE.
Assessing the Reliability of ROE
It also gives us the ability to objectively assess the companies in our portfolio to determine if there are any reasons to question the reliability of their ROE. If any of those supporting characteristics start to falter, we can look to see if it can potentially destabilize the pillar. Is it just part of a season of life, or could it devolve into a permanent condition that could weaken ROE over time?
For example, if a company generates a significant portion of its revenue from overseas sales, its profitability is directly related to the exchange rates between countries. We know that exchange rates can vary, which makes them unpredictable. But the factors affecting them tend to be cyclical, which means they can be moving in the wrong direction today, but they could move in the right direction six months from now, giving us a strong tailwind. We can conclude that it’s not a permanent condition and that its ROE won’t be impacted over the long term.
In another example, an insurance company relies on interest rates to generate revenue on the premium dollars it collects and holds in reserves. It’s a source of profits for insurance companies. Currently, interest rates are at historic lows with no expectation they will increase significantly in the foreseeable future. While it may not be a permanent condition, if low rates persist for an extended period of time, it could negatively change the company’s fundamentals in such a way that we would consider selling it.
The bottom line is we know what we want in our portfolio – companies with high and sustainable ROE. That’s what produces long-term shareholder value, which is the key to generating consistent returns. But, to have conviction in that strategy, regardless of how the stock may be performing now, we must have all five characteristics present – the ROE pillar along with its four stabilizers.
