Originally published by BetaShares
Financial research suggests that so-called "high-quality" companies, i.e. companies with a high return on equity (or "ROE"), are able to produce market share-declining shareholder returns. But as this note shows, it is not enough simply to rank companies on the basis of their current ROE – a lot of attention must also be paid to the likely sustainability of their ROE over time.
Why ROE sustainability is the key to high-quality share price performance
It goes without saying that companies with a high ROE in the course of time should be able to produce relatively good shareholder returns. After all, if a company can generate high profits against its invested capital, it will be well-positioned to offer either attractive dividends and / or high earnings growth through the reinvestment of retained earnings.
That said, in the graph below it is not enough to simply identify companies with a high ROE in the past year. What has been historically important for defeating the performance of stock prices is the ability of a company to maintain a high ROE over time. The graph indeed shows that for companies with a relatively high ROE in a given year, the strongest performance of the share price was attributed to those who had a high ROE in the next two financial years.
Companies that had a consistently high ROE
So far good. But if we have identified companies with a higher than average ROE, how can we assess the likely durability of their ROE over time?
It appears that there are various informers.
First, companies would not have achieved their higher than average ROE by being too dependent on leverage. After all, companies with low leverage (ie debt related to equity) will be less likely to be affected by changing market conditions and will therefore probably retain their high ROE over time.
Another useful indicator is a company's ability to generate strong operational cash flows – perhaps a better underlying measure of sustainable income – over their assets over time
Finally, companies with a track record of consistent earnings (or low variability in revenue) are likely to undergo consistent growth and achieve higher ROE.
These considerations fit one of the main strategies of doyen investor Warren Buffett in stock picking, namely to search for companies that are able to maintain a high and reasonably stable ROE over time without undue reliance on debt.
