A popular measure of profitability, return on equity, also referred to as 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 screen comes close, using return on assets, also referred to as ROA. However, the screen 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 (NASDAQ:INTU) TurboTax every year, but my Honda (NYSE:HMC) 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.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.