Keep an eye on the RoE


Director, Banyan Tree Advisors

December 20, 2011

The record of return on equity of a stock is a great first-cut method to weed out the laggards from the multi-baggers . Here’s how the best investors do it.
I HAVE an extremely interesting friend — call him Mr Knowledgeable. He is a fund of information and I have often benefited immensely from the depth and breadth of his knowledge. Like the time I wanted to buy a car, I simply called him up. He knew the exact power difference between a Lancer and a Honda City, the difference between the engines of the Accent and the Ikon, and the mileage of a Zen or a Santro. Nor was he the repository of wisdom on automative matters alone. You could ask him about anything – a TV or a DVD player — and he would take centrestage and talk confidently, and knowledgeably, on the pros and cons of different models. And rarely have I gone away not knowing more about the product. His ability to collect information and zero in on the key factors to look for in a product is simply wonderful.

But such a knowledgeable man becomes a completely different being when it comes to investing. I have often had the opportunity to see him in action as he makes his investment decisions. His personality undergoes a marked transformation. Gone is the suave, sophisticated man who can enliven hangers-on with his incisive analyses. First,
he looks around furtively and ensures that nobody is within earshot. He then picks up the phone and in a hushed voice asks someone in the finance field for a tip. He adopts this popular investing philosophy called ‘tips-based’ investing. And since I’ve spent a good bit of my time being a ‘tips-based investor’, I empathise with him.

I confronted him one day and asked him why he does not do the same thing he does while buying a car or a DVD player: simply find out the features of different stocks, compare them and make a decision on what stock to buy. His problem was simply that he knew that horsepower, engine capacity, mileage, maintenance cost, resale value and the like were important parameters for cars. But when it came to stocks, he could not figure out what to ask after someone told him that a company is great.

Truth to tell, Mr K is not unique in facing such a quandary. So I decided to speak with some experienced investors and ask them what they looked for when they went out to make stock investments. The following is a list of some of the key parameters that good investors look for. And surprisingly, the methodology is much the same as buying a car.

Return on equity.

The first and foremost question to ask is what is the return on equity (RoE) on the stock. RoE is the total profit divided by the net worth — or earnings per share divided by book value. Ideally, when you’ve got a company in your sights, try to find out the RoE for the past five years. It’s quite easy to ferret out this information — the interactive tool we’ve provided right here will let you do it in a jiffy. Else, you can check the annual report of the company — most companies have started giving out the financials for the last five years. Or you could simply ask your broker to provide you the information — make him earn the brokerage.

If the RoE has been below 14-15 per cent for all five years, it’s like buying a car that gives you a mileage of 5 km per litre. The company is definitely not worth investing in, especially if you want to stay invested for more than a year. On the other hand, if the RoE is more than the 15 per cent benchmark for all five years, then you can be sure it’s a good company, well worth your investment.

The reason why you should look for at least 15 per cent is that even AAA-rated company bonds give you about 12 per cent returns; some really good companies give you even 13 per cent on their bonds. When investing in equity, it is reasonable to expect an additional 2-3 percentage points in returns. If a company has been earning RoE of less than 10 per cent for five years, one is better off investing in AA bonds. Some of the best examples of stocks that have high RoE are Hero Honda or Infosys.

Is RoE increasing every year? Have you ever had the experience of going to the market, picking up a dozen mangoes and finding one so juicy it is far superior to all the others you’ve bought? The stock with the increasing RoE is like that. These are the stocks that make a 20- or 50-bagger. (For more clues on sniffing out a multi-bagger, read my earlier column: Stalking the 100-bagger.) Look at HLL’s track record. It shows that the company is not only a great company but is also improving its relative position within the industry.

The market valuation of such stocks keeps on improving as long as the RoE continues to increase.

Decreasing RoE. The market hates nothing like a stock with a ‘decreasing RoE’. It is even worse than the low RoE stock. It simply means that the company is losing its relative competitiveness within the industry. The company continuously disappoints investor expectations — there is no limit to the losses one can make in such stocks. For examples in this category, you need look no farther than Shiram Honda, Carrier Aircon, MTNL and Colgate. All these companies had extremely high RoE at some point in their history and saw their profitability drop over the next three-four years. You’d do well to avoid these stocks; as a new investor, get in only after it is firmly established that RoE has turned. There is no reason to worry that you’ll miss the run on the stock. The stock will not turn around in a hurry, as there will be several investors stuck with the stock at various levels waiting to get rid of the stock the moment it reaches their buy price.

Avoid companies that promise high RoE. Over the past few years, many companies have caught on to this emphasis on RoE. As a result, many state upfront that their targeted RoE is about 20 per cent: but they never really reach that magic figure. Beware of such companies until they actually prove their credentials. This is one of the greatest traps the market can set for you and if you can avoid this diligently, half the journey is done.

And finally, you may ask about those companies with high RoE but with stocks that have not performed. That takes us to the second criteria that investors look for: growth in sales. But more on that later.