Return on equity is at the centre of Under the Radar’s valuation philosophy
Under the Radar is hunting for value in both philosophies and we are always looking for cheap stocks. A key difference, however, is that because small caps have a much thinner capital base, we are looking first and foremost for companies that can reinvest their earnings. We’re not so concerned about this factor at the big end of the spectrum. In fact, it’s more of a concern if they don’t give back money!
Earnings per share still remains the focus for investors through the course of the economic cycle. This is the case because EPS produces DPS: earnings produce dividends. Dividends are the payoff an equity investor requires to compensate for the risk taken.
EPS is the product of return on equity (ROE) and book value per share.
Think of book value per share as being the size of the pie that a company has at its disposal. Book value per share is simply the net asset base divided by the shares on issue.
ROE is the company’s profitability: the return that it achieves on that pie. How much it grows the pie each year.
A company can grow EPS one of two ways.
- It can either increase its ROE, which means the size of the pie remains the same, but the company gets better becoming more productive at managing its asset base.
Say your asset base is $1 and your ROE is 10%. You will be making a profit or EPS of 10 cents in a year. If your ROE goes up to 20%, other things being equal, you’re producing an EPS of 20 cents.
- The other way is that the company increases its asset base, other things being equal, without increasing the efficiency of its business.
The ROE doesn’t change but the asset base increases from say $1 to $2. Today you’re aching an ROE of 10%, your eps is going to be 10 cents. Next year your asset base is $2. Now your EPS is going to be 20 cents.
We prefer the first channel, ie those companies that are increasing their ROE, not necessarily increasing their asset base. This is because we like management to be running as tight a ship as possible.
The key decision variables a company therefore has to make are, on the asset side:
- What size of asset base does the company have to work with;
- How can it achieve its highest level of profitability, ie ROE.
Then on corporate payout side, the company needs to decide:
- How much of its profits does it retain to be reinvested;
- How much of its profits does pay out?
WHY WE HAVE A VALUE PHILOSOPHY
What you are paying for a company also matters.
A company like the biotechnology giant CSL (CSL) might grow ROE year on year, but the key to a company being successful in the Blue Chip Value model is that you are not paying too much for its all important net assets, or book value per share.
Historically, the evidence shows that investors overpay for growth. This is why value strategies over the sweep of history, outperform across most assets and most companies.
There are exceptions such as CSL and Amazon, but in general investors get caught in the narrative and pay too much. Consequently they may surf the momentum but in times of sell-offs, they get hit overly hard.
Summing this up, below are the three attributes Blue Chip Value looks for in a company:
THREE ATTRIBUTES BLUE CHIP VALUE LOOKS FOR IN A COMPANY
The company is not expensive on a Price to Book ratio. You are simply looking at the share price divided by the net assets per share. This methodology comes up with the same result as the simple PE or price earnings ratio, but is preferred because it is more easily comparable across industries. This involves some work because you are stripping out a lot of accounting related non-cash profits and expenses.
Strong operating profitability. Under the Radar focuses on cash flow return on assets because it’s similar to Return on Assets but is more focussed on cash flow. Once again we are stripping out the non-cash accounting related effects to get back to what a company is really getting as a return from its past investments.
At the big end of town Under the Radar avoids companies that are heavily reinvesting excess cash flow or free cash flow back into the business. We don’t like big “capex humps” coming up where a company is set to spend huge amounts on assets.