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Powerful Evidence: Companies with High Returns on Equity Outperform the Market

Over the weekend, I read a book entitled Buffett and Beyond by Dr. J.B. Farwell, who is both an investor and professor of finance. The book presents compelling evidence that stocks of companies with high returns on equity materially outperform the market.

Buffett has been a longtime proponent of investing in these types of companies, which make up the bulk of Berkshire’s portfolio. Also, Joel Greenblatt has presented research which shows that cheap stocks (as measured by the ratio of EBIT/Enterprise Value) with a high return on invested capital outperform the market by a large margin over the long-term. Greenblatt’s approach has been popularized as the “magic formula”.

Buffett and Beyond chronicles Dr. Farwell’s journey as an investor and how he came to focus on stocks of companies that earn a consistently high return on equity.

In order to compare different companies, Farwell normalizes earnings in his calculations by omitting non-recurring items in the income statement and certain non-cash items that would affect a company’s equity, such as a large write-off of a future pension liability. He calls these adjustments the Clean Surplus Accounting Return on Equity. (See the book for exact details.)

The Test

Dr. Farwell tested his ideas by comparing the performance of the eight stocks in the Dow 30 with the performance of the entire DOW 30 and the S&P 500.

Here is his methodology.

“The Portfolio of 8 Dow stocks for any one year was selected by taking the 8 Dow stocks with the highest ROEs for the previous year. Fourth quarter of the previous year was comprised of estimated earnings and dividends, as these numbers are not known with absolute certainty on January 1st.

The 1987 portfolio consisted of the eight stocks out of the Dow 30 with the highest ROEs of 1986.

The calculations were performed on the first day of the year. Thus on January 1st of 1987, the 1986 ROEs were calculated. The eight stocks with the highest ROEs became the 1987 portfolio.

All eight stocks were held for the entire year.”

The Results from 1987 to 2002 – Average Returns

Dow 30 – 13.50% ($100,000 becomes $658,012)

S&P500 – 12.35% ($100,000 becomes $522,651)

DOW TOP 8 18.74% ($100,000 becomes $1,286,085)

Did Farwell Find a Correlation Between the ROE’s and Returns of Stocks?

Dows 30 (average ROE from 1987-2002)

ROE – 14.00%

Total Returns – 13.50%

Dow 8 Stock Portfolio (average ROE from 1987-2002)

ROE – 22.00%

Total Returns – 18.74%

Farwell’s data show a high correlation between a stock’s return on equity and its total return. Keep in mind that the ROE calculations were done using Farwell’s Clean Accounting method.

These are the types of stocks that are included in my watch list. I will add to the watch list each week. The watch list will continue to focus on stocks that have averaged a return on equity of 18-20% over the past 10 years.

Overtime, we can expect Mr. Market to offer shares of some of these companies at compelling bargains. One key to exploit these opportunities is to keep regular tabs on your watch list so you’re not sleeping when opportunity knocks. You will also need to do your own valuation homework so you have the conviction to pull the trigger when the time comes.