On the Virtues of Return on Equity

On the Virtues of Return on Equity

Regular readers will know that we are keen observers of business quality, and feel that one of the more helpful markers of business quality is the ability of a business to sustain a high return on equity (ROE).

With this in mind, we thought it might be helpful to look at some of the evidence.  If high ROE is a valid marker for investment merit, then we should be able to see that expressed in the returns produced over time by high-ROE businesses.  We put together a simple analysis to test whether the facts are with us.

Using companies from the ASX300 Index, we assembled a data set, comparing ROE with subsequent investment performance.  For our ROE metric we took a simple average of reported ROE for the previous three years, and trimmed the data to remove any extreme high or low values.

For investment returns, we looked at relative outperformance, which we adjusted to remove the effects of beta (for example a low beta company that does well in a falling market isn’t necessarily performing well – it might just be doing better because of the low beta).

When we looked at this data set over the most recent 12 years of ASX300 history, here is what we found:

• A portfolio made up of companies in the top 10 per cent by historical ROE would have outperformed the market by a risk-adjusted 5.1 per cent p.a. That number is before expenses, but this is quite a low turnover strategy, so it’s a strong result.

• We tracked the strategy in 3 month intervals, and found that it outperformed in about 60 per cent of those intervals, which is also a solid result. Most investment styles experience periods when they are out of favour, and 60 per cent is quite a respectable success rate.  Unsurprisingly, the first quarter of 2016 was one period in which the strategy did not perform well.  Our observation has been that in this last quarter a lot of low-quality businesses have done very well, and the numbers gel with that observation.

• Where the strategy really shone was in avoiding the disasters. Companies in the bottom 10 per cent by ROE did especially poorly.  Being able to short sell some of these weaker names would have been very profitable.

All in all, the data seems to point to ROE being a good starting point in looking for quality businesses.  It’s by no means the whole story – a complete company analysis should also take account of the likelihood that ROE will be higher or lower in future periods, any use of gearing to enhance reported ROE, and the opportunity for the company to reinvest in future while sustaining a high ROE. Nonetheless, starting with a strong ROE seems to tilt the odds in your favour.

The numbers also highlight that a strategy that invests in loss-making or low-profit businesses in the hope that their fortunes will improve in future has its work cut out for it.

Call us lazy, but we prefer a strategy where the odds are in our favour, and we don’t need to produce heroic investment insights to get good results.

Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To invest with Montgomery domestically and globally, find out more.

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Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.