Check Out These 7 High-ROE, Low-Debt Companies

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Includes: AGX, ATRI, CLCT, PAYX, PLOW, USPH, WSM
by: Wayne Hylarides

Summary

Businesses with high ROE and low debt are often superior businesses that provide stellar returns.

I provide 7 examples of high ROE companies to study further.

Caution: Don't overpay.

Thesis

By far one of the most fundamental performance indicators of a business is its return on equity (ROE). ROE is an indicator of how well management allocates its capital and is of primary concern to the CEO and the shareholder. Businesses with high ROE and low debt are often superior businesses that provide stellar returns.

Let's break down the formula

ROE: Net earnings/Equity

Where:

Equity = Assets - Liabilities

For a company that has zero liabilities, the ROE is equal to the return on assets (ROA).

Let's assess an easy example. Consider a real estate rental property where you put 20% down and have a line of credit (interest only payment). For simplicity, I'll substitute net earnings for free cash flow (NYSE:FCF) to avoid depreciation calculations.

Levered FCF = FCF/Equity

Also assume you self-managed the property:

Purchase price: $300,000

Down Payment: $60,000

Rent: $1,500/month x 12 = $18,000

Costs (3% interest + 1% taxes + CapEx/maint) = $11,400

FCF: $6,600

Levered FCF: $6,600/60,000 = 11%

If we change the capital structure to a 50% down payment:

Purchase price: $300,000

Down Payment: $150,000

Rent: $1,500/month x 12 = $18,000

Costs (3% interest + 1% taxes + CapEx/maint) = $8,700

FCF: $9,300

Levered FCF: $9,300/150,000 = 6.2%

By changing the capital structure, management has reduced the return on equity and changed the risk profile of the business. If you use the cash flow to reduce debt, equity will increase (through retained earnings). The ROE decreases unless the cash flow proportionally increases (rent increases or cost of debt decrease). If you pay out 100% of the cash flow as profit, the ROE stays the same (assuming 0% principal repayment and constant rent). Therefore, ROE is an important measure of how management reallocates profits into business projects. Since debt magnifies return, it's clear why real estate investors use it. Without debt, the ROE would be under 5% and have a small growth rate, which is not a superior investment.

As a business owner, you want management to maintain a high ROE throughout the life of the business and reinvest profits into new high return projects. If management can't find attractive projects, they should extract the earnings via dividends so owners can invest them into other businesses with high returns. This is what Buffett does. He finds businesses that need very little retained earnings to grow and uses the dividends to reallocate earnings into other businesses. ROE grows in those businesses since equity stays the same. In some businesses he has even been able to extract existing equity (cash holdings) and increase ROE (see Buffett's 1994 letter).

A complementary attribute of a superior business is low debt. This means that the business is producing excellent earnings without having to use leverage to magnify the earnings or to grow. Compare the previous cases of renting a property to using Airbnb (AIRB)(assume you self-manage):

Purchase price: $300,000

Down Payment: $60,000

Rent: $130/day x 25 x 12 = $39,000

Costs (3% interest + 1% taxes + CapEx/maint + utilities) = $13,800

FCF: $25,200

Levered FCF: $25,200/60,000 = 42%

100% down payment (zero debt) Levered FCF: 10.8%

It should be obvious that (in this example) the Airbnb rental is a superior business than the regular rental property. An astute capital allocator would move more capital into Airbnb rentals rather than regular rental properties (risks being equal).

Note: Although this was purely for illustrative purposes, you should include management costs (management workload) and other risks in both business models.

Price

Can we buy businesses on the stock market with these returns? The answer is probably not. Businesses with high ROE and low debt are usually expensive. If you buy and setup your own Airbnb property, you can buy directly into a very high ROE. But consider rental properties grow through reinvesting your earnings into new rental properties. They are capital intensive and debt intensive.

Warren Buffett highlighted the importance of ROE in his 1987 shareholder letter and the importance of the price you pay:

Of course, the returns that Berkshire earns from these [businesses] are not as high as their underlying returns because, in aggregate, we bought the businesses at a substantial premium to underlying equity capital.

In Security Analysis, Graham and Dodd also highlighted the importance of stock price, (paraphrasing): Any businesses, no matter how bad the underlying fundamentals, can become an attractive investment if the price is low enough. Whereas, no matter how great the business is, there are prices that would turn it into a poor investment.

Consider the above real estate cases with elevated purchase prices (i.e. $600k, $900k). Even now we see elevated prices in some real estate markets resulting in smaller ROEs. In the stock market, selecting stocks with high ROE at reasonable prices is the capital allocation problem. How much should we pay for the ROE and its growth?

The Search for Superior Businesses

I performed a stock screen looking for small to mid cap companies with reasonable debt, high ROE, and that pay a dividend. I came up with the following businesses:

Douglas Dynamics Inc (NYSE:PLOW)

"Douglas Dynamics, Inc. is a manufacturer of vehicle attachments and equipment. The Company's portfolio includes snow and ice management attachments sold under the BLIZZARD, FISHER, SNOWEX and WESTERN brands; turf care equipment under the TURFEX brand, and industrial maintenance equipment under the SWEEPEX brand. The Company also provides ice control equipment, snow plows, dump bodies, muni-bodies, and replacement parts. The Company offers a range of sand and salt spreaders for light trucks. The Company also provides a range of related parts and accessories. The Company also provides customized turnkey solutions to governmental agencies, such as Departments of Transportation ((DOTs)) and municipalities. The Company has manufacturing facilities in Milwaukee, Wisconsin; Rockland, Maine, and Madison Heights, Michigan. It also has a production facility in Manchester, Iowa. It sells its products through a distributor network primarily to professional snow plowers." (Google Finance)

ROE: 17.7% (2016)

Market Cap: 685.7M

Equity: 220.46M

Market Cap to Equity: 3.1

Shareholder ROE: 5.7%

Div Yield: 3.15%

Payout Ratio: 35.7%

Long term debt to assets: 45.6%

Paychex Inc. (NASDAQ:PAYX)

"Paychex, Inc. is a provider of integrated human capital management (NASDAQ:HCM) solutions for payroll, human resource (NYSE:HR), retirement and insurance services for small- to medium-sized businesses in the United States. The Company also has operations in Germany. The Company offers services, including Payroll processing, Human Resource Services, and Accounting and Financial Services. As of May 31, 2016, the Company serviced approximately 605,000 payroll clients. It offers a portfolio of HCM services and products that allows its clients to meet their payroll and HR needs. Its payroll-related ancillary services and human resource service offerings often leverage the information gathered in the base payroll processing service, allowing it to provide outsourcing services covering the HCM spectrum. The Company, through its HCM software-as-a-service platform, Paychex Flex, provides an integrated product suite that covers the employee lifecycle from recruiting and hiring to retirement." (Google Finance)

ROE: 39.6% (2016)

Market Cap: 20.81B

Equity: 1.912B

Market Cap to Equity: 10.88

Shareholder ROE: 3.63%

Div Yield: 3.16%

Payout Ratio: 65.9%

Long term debt to assets: 0%

Williams-Sonoma Inc. (NYSE:WSM)

"Williams-Sonoma, Inc. is a multi-channel specialty retailer of products for the home. The Company operates retail stores in the United States, Canada, Puerto Rico, Australia and the United Kingdom. It operates through two segments: e-commerce and retail. The e-commerce segment has various merchandising strategies, such as Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm, PBteen, Williams-Sonoma Home, Rejuvenation and Mark and Graham, which sell its products through the Company's e-commerce Websites and direct-mail catalogs. The retail segment has various merchandising strategies, such as Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Rejuvenation, which sell its products through the Company's retail stores. The Company franchises its brands to third parties in a number of countries in the Middle East, the Philippines and Mexico. The Company's products are also available to customers through its catalogs and online across the world."(Google Finance)

ROE: 24.4% (2016)

Market Cap: 4.781B

Equity: 1.248B

Market Cap to Equity: 3.83

Shareholder ROE: 6.37%

Div Yield: 2.9%

Payout Ratio: 40.8%

Long term debt to assets: 0%

Collectors Universe Inc. (NASDAQ:CLCT)

"Collectors Universe, Inc. provides authentication and grading services to dealers and collectors of coins, trading cards, event tickets, autographs and historical and sports memorabilia (collectibles). The Company operates through three segments: coins, trading cards and autographs, and other collectibles. The Company is engaged in the authentication, grading, publication and Web-based advertising, subscription-based business and product sales. The other collectibles segment includes the Certified Coin Exchange (NYSE:CCE) subscription business, the Coinflation.com business and its collectibles conventions business. The Company is also engaged in selling of printed publications and collectibles price guides and advertising in such publications; selling of membership subscriptions in its Collectors Club; selling of subscriptions to its CCE dealer-to-dealer Internet bid-ask market for certified coins and to its CoinFacts Website, and conducting collectibles trade shows and conventions." (Google Finance)

ROE: 51% (2016)

Market Cap: 236.66M

Equity: 13.77M

Market Cap to Equity: 17.2

Shareholder ROE: 3%

Div Yield: 5.39%

Payout Ratio: 178%

Long term debt to assets: 0%

Atrion Corporation (NASDAQ:ATRI)

"Atrion Corporation (Atrion) is engaged in developing and manufacturing products, primarily for medical applications. The Company's medical products range from fluid delivery devices to ophthalmic and cardiovascular products. Its fluid delivery products include valves that promote infection control and needle safety. It has developed a range of valves designed to fill, hold and release controlled amounts of fluids or gasses on demand for use in various intubation, intravenous, catheter and other applications in areas, such as anesthesia and oncology. Its cardiovascular product, MPS2 Myocardial Protection System ((MPS2)), is the system used in open-heart surgery that delivers fluids and medications, mixes critical drugs and controls temperature, pressure and other variables. Atrion is a manufacturer of specialized medical devices that disinfect contact lenses. Its other medical and non-medical product lines consist of instrumentation and associated disposables."(Google Finance)

ROE: 17% (2016)

Market Cap: 865.05M

Equity: 162.99B

Market Cap to Equity: 5.3

Shareholder ROE: 3.2%

Div Yield: 0.89%

Payout Ratio: 25%

Long term debt to assets: 0%

Argan Inc. (NYSEMKT:AGX)

"Argan, Inc. is a holding company. The Company conducts operations through its subsidiaries, Gemma Power Systems, LLC and affiliates (NYSE:GPS), Atlantic Projects Company Limited (NYSE:APC), Southern Maryland Cable, Inc. (SMC) and The Roberts Company (Roberts). Through GPS and APC, the Company's power industry services segment provides engineering, procurement, construction, commissioning, operations management, maintenance, development, technical and consulting services to the power generation and renewable energy markets. Through SMC, the telecommunications infrastructure services segment of the Company provides project management, construction, installation and maintenance services to commercial, local government and federal government customers. Through Roberts, the Company's industrial fabrication and field services segment produces, delivers and installs fabricated steel components specializing in pressure vessels and heat exchangers for industrial plants." (Google Finance)

ROE: 16.6% (2016)

Market Cap: 1.00B

Equity: 265.8M

Market Cap to Equity: 3.76

Shareholder ROE: 4.4%

Div Yield: 1.07%

Payout Ratio: 11% (2015)

Long term debt to assets: 0%

U.S. Physical Therapy Inc. (NASDAQ:USPH)

"U.S. Physical Therapy, Inc., through its subsidiaries, operates outpatient physical therapy clinics that provide pre-and post-operative care, and treatment for orthopedic-related disorders, sports-related injuries, preventative care, rehabilitation of injured workers and neurological-related injuries. The Company's segment is made up of various clinics within partnerships. The Company primarily operates through subsidiary clinic partnerships, in which it owns a general partnership interest and a limited partnership interest, and the managing therapists of the clinics owns the remaining limited partnership interest in the clinics. The Company operates approximately 510 clinics in over 40 states. There are approximately 380 clinics operated under Clinic Partnerships and over 100 operated as Company-owned Facilities. In addition to its owned clinics, it also manages physical therapy facilities for third parties, primarily physicians, with over 20 third-party facilities under management." (Google Finance)

ROE: 13.5% (2015)

Market Cap: 808.33M

Equity: 178.77B

Market Cap to Equity: 4.5

Shareholder ROE: 3%

Div Yield: 1.05%

Payout Ratio: 21.3%

Long term debt to assets: 13%

Discussion

Notice that all of these businesses have growing dividends and stock prices. Some even make excess cash that can't be reinvested, resulting in special dividends. Also, due to the fundamentals of the business and their industries, their high ROE has allowed them to grow with no debt. Another thing to notice is that they are all priced differently against their book values (anywhere from 3 to 17 times book value). This makes sense since each of them have different return on equities. Given the market cap to equity, the resulting shareholder ROE at the current prices is anywhere from 3% to just under 7%. These rates are similar to unlevered rental properties. The key difference between American business and real estate is that real estate revenue grows very slowly whereas certain American businesses can grow revenues faster.

Next Step

Now that we have found some potentially good businesses, the next step is to determine if they will stand the test of time and continue to grow. For that, a detailed review of the annual reports, the industry outlook, and the business' moat must be done to determine if the book price multiple is reasonable or not. The shareholder ROE is what the investor initially sees. The question is how long will it take for the business to grow to a reasonable ROE for the investor and is there a reasonable margin of safety that justifies the price. In my next article, I'll look at further sifting through these businesses.

Cheers,

Wayne

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.