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ROE Champions

Recs

8

April 04, 2014 – Comments (1)

Board: Berkshire Hathaway

Author: JohnCLeven

Greeting Fools, and welcome to my big post of the year!

My post last year got pretty good reviews, so I decided to do it again.

The inspiration for this original screen list can be found in the 1987 Berkshire Hathaway Letter, see excerpt below:

"Here's a benchmark: In its 1988 Investor's Guide issue, Fortune reported that among the 500 largest industrial companies and 500 largest service companies, only six had averaged a return on equity of over 30% during the previous decade. The best performer among the 1000 was Commerce Clearing House at 40.2%.

Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago. That is no argument for managerial complacency. Businesses always have opportunities to improve service, product lines, manufacturing techniques, and the like, and obviously these opportunities should be seized. But a business that constantly encounters major change also encounters many chances for major error. Furthermore, economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise. Such a franchise is usually the key to sustained high returns.

The Fortune study I mentioned earlier supports our view. Only 25 of the 1,000 companies met two tests of economic excellence - an average return on equity of over 20% in the ten years, 1977 through 1986, and no year worse than 15%. These business superstars were also stock market superstars: During the decade, 24 of the 25 outperformed the S&P 500. The Fortune champs may surprise you in two respects. First, most use very little leverage compared to their interest-paying capacity. Really good businesses usually don't need to borrow. Second, except for one company that is "high-tech" and several others that manufacture ethical drugs, the companies are in businesses that, on balance, seem rather mundane. Most sell non- sexy products or services in much the same manner as they did ten years ago (though in larger quantities now, or at higher prices, or both). The record of these 25 companies confirms that making the most of an already strong business franchise, or concentrating on a single winning business theme, is what usually produces exceptional economics." - (1987 Berkshire Hathaway Letter)

Inspired by that excerpt, every year, I conduct a modern day re-creation of that same study, by going page-by-page, through all the companies that Value Line covers. I screened by hand for companies with: 1) a 10 year average ROE over 20%, AND 2) Zero years in the past decade with a ROE below 15%.

Just 145 out of 1705 companies (or 8.5%) passed both of these two hurdles from 2004-2013.

Those 145 companies on this year’s list are:

***drumroll***

AAP, ACN, ADP, AMX, AMGN, APH, APOL, ATK, BAX, BCR, BDX, BF.B, BLL, BOH, BTI, CAT, CEB, CHRW, CI, CL, COH, COKE, COL, CPA, CPB, CPSI, CSCO, CTSH, DCI, DD, DE, DECK, DLTR, DRI, DST, DVA, EAT, EFX, EL, EMN, EMR, ENR, ESI, EV, FAST, FDO, FDS, FII, FMC, GGG, GILD, GIS, GPS, GRMN, GSK, HD, HIBB, HRB, HSY, IBM, IDXX, IFF, IGT, IMO, INFY, INTU, IT, JBHT, JCOM, JNJ, JOY, JWN, K, KMB, KMP, KO, KR, LDR, LH, LXK, LLTC, LLY, LMT, MA, MAT, MCD, MDT, MHFI, MIDD, MKC, MLHR, MMM, MMP, MNST, MRK, MSFT, MTD, NDSN, NKE, NSR, NUS, NVO, OMC, ORCL, PAYX, PBI, PEP, PETM, PETS, PII, POOL, PX, PZZA, ROK, ROL, ROST, SAP, SBUX, SCCO, SEIC, SHW, SLGN, STJ, STRA, SYK, SYY, TECH, TEN, THI, TJX, TROW, TSCO, TSM, TTC, TUP, UL, UPS, UTX, VAR, WAT, WDC, WMT, WEX, WU, YUM

92.8% of last year’s ROE Champions were Champions again this year. Here are the 7.2% that either failed to pass one of our two tests of economic strength, or were de-listed in 2013: ABT, AVP, AZN, FRX, JW.A, UNH, QSII all failed to pass at least one of our two tests of economic strength. CEC was acquired, and taken private.

Miscellaneous adjustment : McGraw Hill’s (old ticker MHP) successor company is now listed under the ticker MHFI after selling its education unit, and remains on the Champion list.

Last year, I promised you that there would be errors/omissions in my research – and I kept my word.

I completely missed at least 8 companies that should have been on last year’s list.

Lastly, just for fun – Here are the companies’ that will reach the 10th consecutive year of 15%+ ROE/10 yr AVG >20%, if they perform well in 2014, and would likely qualify for next year’s list:AAPL, NILE, BA, BKE, CE, CBRL, FTI, GWW, GES, HLF, HON, OI, RAI, TEF, TXN

If you’ve made it this far, thanks for reading.

For those interested in my research, I have something new to add this year.

Though, I am not really a big fan of mechanical investing, I try to keep an open mind. I’ve always considered Greenblatt’s Magic Formula interesting, but somewhat inadequate. As a result, I have created my own experiment that follows a similar line of thinking, but is hopefully a slight improvement. There are two significant weaknesses in Greenblatt’s Formula, in my view. (The formula calls for a mechanical portfolio of businesses with high ROIC, and low EV/EBIT multiple.)

Weakness #1 is that only the most recent years ROIC is used. I truly believe that consistency of quality is key. By that I mean 40% ROTC last year is great, but if your 5 or 10 year average ROIC is below 10%, than I don’t want to invest there. My solution is to substitute Greenblatt’s trailing ROIC number with my ROE Champion list, which demands very consistent, high profitability, over the long-term.

Weakness #2 is that instead of a plain vanilla valuation multiple, which does not take future growth into account, I will I will replace Greenblatt’s EV/EBIT multiple with Value Line’s projected 3-5 yr total annualized return. Though this is certainly NOT a perfect metric, which I think is a better indicator of future returns than a blind PE or EV/EBIT multiple. For extra conservatism, I will rank stocks by the lower bound (for those familiar) of Value Line’s 3-5 total annualized return projection.

To test my hypothesis, I have created a brand new, Motley Fool CAPs player with the username MagicROEchamps. http://caps.fool.com/player/magicroechamps.aspx

This portfolio will consist of the top 20 stocks on my ROE Champion list, that have the highest lower-bound Value Line 3-5 year total annualized projection. (Again, for those not familiar with Value Line, this number can be thought of as Value Line’s minimum 3-5 year projected forward rate of total return.)

I will rebalance the portfolio on the first trading day of each month.

Should be a very interesting experiment!

Thanks so much for reading, and please add some feedback to these ideas, as well as point out any errors or mistakes I made.

Happy Investing,

-John 

1 Comments – Post Your Own

#1) On April 04, 2014 at 2:25 PM, Mega (99.95) wrote:

John, a response to your comment on the financial arms at GE and DE. Crossposted because the TMF boards are apparently incapable of text formatting. 

 

Financial companies generally earn lower ROA than non-financial companies, but they are able to use more leverage which makes up for it in ROE. (In the current low interest rate environment, financial companies have lower ROE compared to their historical average, and compared to more profitable industries.)

Please correct me if any of these numbers are wrong.

                      ROTA      ROTE

GE Industrial     8.1%       N/A (they don't need any tangible equity)
GE Capital       1.4%       12.1%
GE                  2.4%       25.9%

DE Industrial    12.9%      43.8%
DE Financial     2.2%      17.9%
DE                   5.9%       33.9%

So you can see their industrial arms are very good businesses. The financial arms aren't quite as good but they still compare favorably to many banks and non-bank lenders. Also note that there are strong synergies between industrial and industrial lending. (Less so at GE where some parts of GE Capital like consumer finance and real estate are not really core to their business.)

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