Carrett, Graham, Frank & Buffett - A Reprise (2)

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The four gentlemen also felt that a company's return on equity ("ROE") was an important measure of its financial strength.  The higher the ROE number, the better the job the company's management is doing for the shareholders.  To understand what ROE is and what it means to an investor, I'm afraid we will have to look at some accounting principles, but I'll try to keep it as short and simple as possible.

There are a few accounting terms we need to address in order to fully understand the term ROE.  Obviously, the most important one is the word, equity.  Book Value of the securities issued by a company is the price it received when it sold them to investors in a public offering - not the current market price of those securities.  A company's capitalization is the book value of all securities issued by a company: its common stock, any preferred stock and any bonds or other long term debt.  Typically, the term capital refers to the book value of a company's issued common stock.  Equity means the capital (the common stock book value) plus the company's retained earnings.  You may remember that retained earnings are the earnings of a company not paid out in dividends after all expenses have been paid.

Therefore, the Equity of a company is usually smaller than that company's Capitalization, but if the company has operated at a profit in the past, its Equity should be larger than the Capital of the company.  ROE is the ratio of the annual earnings of a company divided by its equity, the book value of its common stock plus retained earnings.  An individual investor might also compare the ratio of the earnings to the current market price of a stock.  Al Frank suggested that a 15% ROE or a 15% return measured against the current price of shares were measures of a potentially good investment.  

However, there is one trap in this metric.  An individual investor should look for a company with a high ROE whose debt is not excessive.  If the equity percentage of the total capitalization of a company is only 10% and the remaining 90% is debt, it would not be hard to have a high ROE.  The equity percentage is very small and the company could be viewed as overleveraged.  A company worth considering as an investment should have a high ROE (15%-20% or better) based on a significant equity base with moderate debt.  One sign of good business management is a high ROE on large equity.

The gentlemen recommended that the individual investor also look for companies with a history of dividend payments (even better if the dividends have been regularly increased) and a history of increasing earnings.  By history, they meant at least the last 5 years.  As mentioned above, another sign of a well managed company was one with a moderate amount of debt when compared to the company's total capitalization.  This means that the earnings of the company can be directed towards increasing the business and paying dividends; not paying interest to lenders.  A certain amount of debt is to be expected; but if the company is heavily indebted (significantly more debt than equity), this could presage financial problems for the company during difficult economic times.  Given traditional economic cycles, the individual investor must expect some periods of economic stress during his or her investment career.  It is during a down economy or recession when truly strong business managers excel and keep their companies on track.

We have now devoted approximately 10 blogs to learning about fundamental analysis from four highly regarded value investors.  If what they have to say makes sense to you as an individual investor, I recommend you read at least one of the books from Carret, Graham or Frank to learn more.  Regardless of which one you choose (I suggest reading all of them) you should also read, in any event, either the first or the second edition of Lawrence A. Cunningham's collection of Buffett's shareholder letters, The Essays of Warren Buffett: Lessons for Corporate America.

There are two subsets of fundamental value investing:  growth investing and contrary investing.  We will address those next.

Comments are always welcome.