The companies that investors choose for their portfolios should have a ROE that is high and consistent over time. The problem is that practically all investors calculate ROE in a way that is both inefficient and unreliable. Traditional ROE is not a useful ratio for comparing the operating efficiency of one company to that of another because, for most companies, it is inconsistent from year to year. Worse, there is almost no correlation between book value (equity) and stock returns.
Traditional ROE uses earnings to calculate the return portion of ROE. But earnings include both non-recurring items, which are not predictable, and future liabilities. As Belmonte argues, “[i]n no way do these events show how efficiently you’ve been running your operation. And we’re concerned with operating efficiency in our ROE ratio and not branches falling out of the sky because of a hurricane passing by.” (p. 59) So, for the return portion of the ROE ratio one should use net income, not earnings.
What about the equity portion of ROE? Owners’ equity (or book value) equals the common stock issuance plus all retained earnings, where these retained earnings can come only from net income minus dividends.
Based on his research, indicating that stocks with a history of high Clean Surplus ROEs outperformed the S&P 500, Belmonte came up with six simple rules for structuring a portfolio.
- 1. Choose stocks with Clean Surplus ROEs above 20%.
- 2. Choose stocks that have a good history of operation, either a solid ten years or a shorter history but with high and rising ROEs.
- 3. Choose stocks with low or no dividends.
- 4. Choose stocks with little debt.
- 5. Stocks with rising ROEs are attractive even if their ROEs are below 20%.
- 6. Sell a stock when the Clean Surplus ROE drops below 20%.
The top stocks in Belmonte’s 2014 screen were Gilead, Priceline, Lorillard, Apple, and BlackRock. Panera was a stock that came out of his portfolio when the forecasted ROE for 2014 fell below 20 percent. Monster Beverage, by contrast, held to a steady ROE around 23% over the last three years. “In the two years since we made that change, Panera has no gain, while the S&P 500 index has risen 35 percent and Monster Beverage has risen 70 percent.” (p. 128)
Belmonte ran numerous backtests, but they are not models of rigorous quantitative research. Investors might want to crunch their own numbers before committing hard-earned money to his system.