A Weak Link Between ROE and High Returns
Thursday, January 17, 2013
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

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Three factors determine how effectively profits are generated.

Using ROE to Analyze Stocks
What you use to calculate ROE matters.

AAII Discussion Boards
What profitability measures do you use?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 43.9%, down 2.5 points
  Neutral: 28.7%, up 2.1 points
  Bearish: 27.3%, up 0.4 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

A popular measure of profitability, return on equity (ROE), does not hold up well as a primary screening criterion for identifying stocks with potential upside.

The ratio divides net income by shareholder equity. It reveals how much profit a company is earning of off its net assets. The more effectively management uses the company’s resources, the higher ROE will be. It is said to be a favored indicator of Warren Buffett.

Given this, it would seem logical that ROE would be a useful ratio for identifying stocks likely to outperform in the future. Yet, ROE may work better as an indicator of risk than of potential return. This is the finding of two books: “What Works on Wall Street, Fourth Edition” by James O’Shaughnessy (McGraw-Hill, 2012) and “Quantitative Strategies for Achieving Alpha” by Richard Tortoriello (McGraw-Hill, 2008). Both authors say only stocks with ROE ratios ranking in the top 20% enjoyed clear outperformance.

What was more significant was the performance of the stocks with ROE ratios ranking in the bottom 20% of all companies. These companies lagged significantly. The margin of their underperformance was far greater than the margin by which companies ranking in the top quintile for ROE ratios outperformed. The average excess returns were -9.6% and 6.2%, respectively, according to Tortoriello. Using a different database and longer time period, O’Shaughnessy calculated average annual excess compound returns of -3.9% and 1.0% respectively.

In between, there was not much advantage to relying on ROE as a primary screening criterion. Companies whose ROE ratios put them in third-highest decile didn’t deliver returns that were significantly better than those that ranked in the sixth-highest decile. Rather, according to O’Shaughnessy, backtesting results seemed to suggest no notable advantage to using ROE as a primary indicator for finding companies likely to outperform.

These findings coincide with the comparative performance of the AAII stock screens. The screens with the highest long-term risk-adjusted returns don’t use ROE as a criterion. The Piotroski: High F-Score comes close, using return on assets (ROA). However, it looks for a year-over-year improvement in ROA instead of a specific number or level.

So why doesn’t ROE work well as a primary screening indicator? A big problem is that ROE is not comparable from one industry to another. ROE is impacted by how quickly assets are turned over, the level of debt and profit margins. A company with comparatively low incremental costs for selling additional products that have short lifespans will typically have higher ROE ratios than a company with comparatively high incremental costs for selling additional products that have longer lifespans. For example, I buy Intuit’s TurboTax every year, but my Honda Accord is more than 12 years old. The two companies have ROE ratios of 36.2% and 7.6%, respectively. Neither ROE is necessarily better; Intuit and Honda operate in very different industries.

Richard Tortoriello also observed that ROE does not work well as a primary indicator within all industries. He observed that higher levels of ROE work as a screening criterion for technology and consumer discretionary stocks, but not well for financial and utility stocks. Tortoriello and O’Shaughnessy also noted a higher level of volatility when ROE is used as the sole indicator for finding stocks that will outperform. This could be a reflection of industries coming into and falling of out favor as well as the fact that high profit margins attract competitors.

What does seem to be consistent, however, is that low levels of ROE lead to lousy performance. This makes sense because high debt levels, poor margins and slow rates of asset turnover are all signs of higher risk. So, requiring a minimum level of ROE can eliminate potentially poor stocks from consideration, without restricting the pool of potential candidates too much.

ROE also works effectively when combined with other indicators. Since it is a quantitative measure of management’s effectiveness at generating profits from a company’s net assets, it serves as a great complement to valuation criteria, such as price to book and price to earnings. It can also complement growth criteria, especially revenue growth. In both cases, including ROE in a list of screening criteria can help narrow down the list of potential investment candidates.

Correction to Last Week’s Commentary

A few members asked for clarification on what I wrote about IRA distributions and the new tax law last week. In hindsight, I should have phrased the explanation more clearly. The American Taxpayer Relief Act of 2012 extends a provision that allows those age 70-1/2 or older to distribute up to $100,000 from their traditional individual retirement account (IRA) tax-free to qualified charities for both the 2012 and 2013 tax years. (You have until January 31, 2012, to make a charitable distribution from your IRA for the 2012 tax year.)

To be clear, regular distributions from a traditional IRA, such as those for your living expenses, are taxable. My apologies for any confusion this may have caused.

More on AAII.com

AAII Model Portfolios Update

There were no changes in either of the model portfolios during the month of December. However, one of the holdings in the Model Shadow Stock Portfolio implemented a name and ticker change. Effective January 1, 2013, the company originally known was PC Mall Inc. (MALL) changed its name to PCM Inc. with a ticker symbol of PCMI.

For December, the Model Shadow Stock Portfolio gained 3.8%, closing out a very strong year. The Model Shadow Stock Portfolio outperformed the Vanguard Small Cap Index fund (NAESX), which gained 3.1%, and performed the same as the DFA US Micro Cap Index fund (DFSCX) in December. For the year, the Model Shadow Stock Portfolio finished up 33.3%, outpacing the 18.0% gain achieved by the Vanguard Small Cap Index fund and the 18.2% gain for the DFA US Micro Cap Index fund.

The Model Fund Portfolio was up 2.9% for December. This compares to a 1.2% gain for the Vanguard Total Stock Market Index fund (VTSMX). For the year, the Model Fund Portfolio was up 15.5%, while the Vanguard Total Stock Market Index fund was up 16.2%.

The Week Ahead

The U.S. financial markets will be closed on Monday in observance of Martin Luther King Jr. Day.

Next week will be the first busy week of fourth-quarter earnings season with approximately 80 S&P 500 member companies scheduled to report. Included in this group are Dow components E.I. DuPont (DD), International Business Machines (IBM), Johnson & Johnson (JNJ), Travelers (TRV) and Verizon (VZ) on Tuesday; McDonald’s (MCD) and United Technologies (UTX) on Wednesday; 3M (MMM), AT&T (T) and Microsoft (MSFT) on Thursday; and Procter & Gamble (PG) on Friday.

The week’s first economic report will be December existing homes, which will be published on Tuesday. Thursday will feature the Conference Board’s December leading indicators index. December new homes sales will be released on Friday.

The Treasury Department will auction $15 billion of 10-year inflation-protected securities (TIPS) on Thursday.

AAII Sentiment Survey

Even with a small decline in optimism, more than 40% of individual investors describe themselves as bullish in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 2.5 percentage points to 43.9%. This is the seventh time in eight weeks that optimism has been above 40%. The historical average is 39%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.1 percentage points to 28.7%. This is a four-week high. Even with the improvement, neutral sentiment remained below its historical average of 30.5% for the 14th consecutive week and the 16th time in 18 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, edged up 0.4 percentage points to 27.3%. This is the first time since August 2012 that pessimism is below 30% on consecutive weeks. This is also the fifth time in six weeks week that bearish sentiment is below its historical average of 30.5%.

Sentiment about the short-term direction of stock prices shifted last November and we continue to see many individual investors express optimism. There is not one single event which caused this shift, but rather a combination of higher stock prices, monetary stimulus, continued economic growth and seasonality. It is important to note, however, that bullish and bearish sentiment remain well within their typical historical ranges. Thus, while individual investors are comparatively more optimistic, it would be a mistake to describe them as exuberant.

This week’s special question asked AAII members how the revised capital gains and dividend tax rates are impacting their short-term outlook. The overwhelming majority of respondents said the new legislation had no impact. Many respondents said they were below the top tax bracket, held their investments mostly in tax-deferred accounts or were long-term investors.

Here is a sampling of the responses:

  • “There was little change, so it doesn't matter to me.”
  • “Very little to not at all. I am not in the highest income bracket that will be affected the most.”
  • “Not at all. We have ROTH IRAs.”
  • “Not as much as I thought. I took some capital gains last year, but it was not necessary.”
  • “At least we know what to expect, so it is a net positive.”

» Take the sentiment survey