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Monday, July 27, 2015

Predictability of long range stock return using ROE kcchongnz

This comment below appears in my post: http://klse.i3investor.com/blogs/kcchongnz/80238.jsp
Posted by Icon8888 > Jul 22, 2015 10:32 PM | Report Abuse http://cdn1.i3investor.com/cm/icon/trans16.gif
kc, stock market not easy. Not easy. If I can border line pass, I contented already

Hey, why is it not easy? Isn’t someone out there offering to teach you how to be a super investor?
In a paper titled “The Super Investors of Graham and Doddsville”, Warren Buffet showed the track records of each of nine disciples of Benjamin Graham that they all generated annual compounded returns (CAGR) of between 18% and 29% over track records lasting between 14 to 30 years.
So to me a super investor is one who can generate the kind of return in his investment in the stock market consistently over a long period of time as mentioned above.
But I agree with you. It is not easy to make money in the stock market, especially in the short term. Otherwise Bursa and everywhere will be filled with super rich people without having to work for it.

In awarding the 2013 Nobel Prize for economics, the Royal Swedish Academy of Sciences noted the following in itspress release:
There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analysed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.”
So even Nobel Prize winners for economics also mention that trying to predict the stock price in the short term is very hard work, but calling it long term may not be that difficult.

Investing is about process and probability. There is no sure thing in investing. The key to success is to develop a process that attempts to increase your probability of being right more often than wrong; and when you make, make it big but when you lose, lose it small.
Heads I win (big); Tails I don’t lose much” The Dhandho Investors
There are many ways investors can make extra-ordinary return from the stock market. For example, Buffett invests in awesome companies at reasonable prices. Walter Schloss, one of the super investors mentioned by Warren Buffett above, invested in cheap companies with little debts, etc. Those different strategies employed by different super investors above all have one common characteristic, a plausible reason. For example buy good companies by Warren Buffett, buy cheap by Walter Schloss.
Yes, whatever investing method used, it must be plausible, and predictble. If not, what is the logic that your investment can provide you with extra-ordinary return? Unless you are a syndicate, institutional investor or heavyweight who has the clout to manipulate and move stock prices, but that is only for the short term.
So give me a plausible story. Let me give you one first.

Return on Capital or Growth in Earnings
In his book, “the Warren Buffett Way”, Robert Hagstrom wrote this:
Customarily, most investors measure annual company performance by looking at earnings per share (EPS). Did they increase over last year? Are they high enough to brag about? For his part, Buffett considers EPS a smokescreen. Most companies retain a portion of their previous year's earnings as a way of increasing their equity base, so he sees no reason to get excited about record EPS. There is nothing spectacular about a company that increases EPS by 10%, if at the same time, it is growing its equity base by 10%. That's no different, he explains, from putting money in a savings account and letting the interest accumulate and compound. Worse still, there are many companies borrow huge amount of money to improve EPS, but the marginal return is way below its borrowing costs.

The test of economic performance, he believes, is whether a company achieves a high earnings rate on equity capital ("without undue leverage, accounting gimmickry, etc."), not whether it has consistent gains in EPS. To measure a company's annual performance, Buffett prefers return on equity or ROE. -- The ratio of operating earnings to shareholders' equity
.”
Let us examine the above with some numerical examples. Assuming you want to invest RM1000 and your required return is 10%. You have the option to invest in two different Islamic banks below which distribute interest according to their financial performance. Bank A is able to give you an interest rate of 10% through the 5 years you invest with them, and Bank B a declining interest rate from 10% initially to 8% in year 5. It is obvious that if you are a rational investor, you would want to invest in Bank A, as after 5 years your initial equity, or capital would have built up to 1611, but for Bank B, your capital will only build up to RM1538 in 5 years, or 4.7% more for Bank A than Bank B as shown in Table 1 below.
Table 1:
 
Bank A
     
Bank B
   
Year
Beg Capital
Interest
End Capital
Interest
 
Year
Beg Capital
Interest
End Capital
Interest
1
1000
100
1100
10%
 
1
1000
100
1100
10.0%
2
1100
110
1210
10%
 
2
1100
105
1205
9.5%
3
1210
121
1331
10%
 
3
1205
108
1313
9.0%
4
1331
133
1464
10%
 
4
1313
112
1425
8.5%
5
1464
146
1611
10%
 
5
1425
114
1538
8.0%

The return of your capital, or equity (ROE) from Bank A is 10% every year, whereas ROE for Bank B is obviously less than 10%, the cost of your equity. Similarly, the compounded annual growth rate (CAGR) of your interest is 10% for Bank A, and less than 10% for Bank B. Obviously there is a plausible reason that investing in Bank A with a higher ROE is better than Bank B, isn’t there?
It is a simple decision which bank to put your money for the above example. Let us make life a little more complicated in the next example.
Table 2: Additional capital for Bank B
Year
Beg Capital
Interest
Capital Inject
Add Interest
Total interest
End capital
Interest
Growth
1
1000
100
  
100
1100
10.0%

2
1100
105
100
10
114
1314
9.5%
14%
3
1314
118
200
18
136
1650
9.0%
20%
4
1650
140
300
26
166
2116
8.5%
22%
5
2116
169
500
40
209
2825
8.0%
26%

Assuming you invest in Bank B with an initial capital of RM1000, but you put in additional capital each year; RM100, RM200, RM300 and RM500 respectively for year 2, 3, 4 and 5. Now compared with Bank A, your interest will grow faster from RM100 in year 1 to RM209 in year 5 compared to just RM146 for Bank A as shown in Table 1. The growth rate of interest for Bank B is consistently higher at 14%, 20%, 22% and 26% for year 2, 3, 4 and 5 respectively compared to just 10% of Bank A throughout the years. So which option would you take?
The above example is synonymous to investing in a company. The amount of money you put in the bank is your equity. The interest is the profit you get with the interest rate as return on equity (ROE), and the additional money you put in the “Rights issues”, private placement, bond issues, additional bank borrowings or whatever you call it. The growth in your interest is the equivalent profit growth. Yes, the profit growth for Bank B is phenomenon, more than double that for Bank A. But that growth is a result of additional capital put in, not generated from the “business”, and earns a return lower than your required return of 10%. Again, great profit growth but declining ROE, lower than the cost of capital. Is it still better than Bank A?
What did Buffett say above?
What if instead of putting your extra capital in Bank A earning a return of 10% instead of Bank B at a declining interest rate? Table 3 below shows that your interest in Bank A will grow to RM267 in year 5 compared to RM209 for Bank B as shown in Table 2 above, or 27.5% more. Your equity will increase RM2936 as compared to RM2825 for Bank B as shown in Table 2, or 4% more.
Table 3: Additional capital for Bank A
Year
Beg Capital
Interest
Capital Inject
Add Interest
Total interest
End capital
Interest
Growth
1
1000
100
  
100
1100
10.0%

2
1100
110
100
10
120
1320
10.0%
20%
3
1320
132
200
20
152
1672
10.0%
27%
4
1672
167
300
30
197
2169
10.0%
30%
5
2169
217
500
50
267
2936
10.0%
35%

So what is more important in investing, profit growth or higher ROE? Isn’t that obvious?
But there is this argument that investing is for the future, accounting number ROE is obtained from the past, i.e. audited account, no use. Is this reasoning plausible?
Let’s say Tan Sri Datuk Liew Kee Sin (LKS) of EcoWorld and Bill Ch’ng Chong Poh are starting a property SPAC and you intend to invest in one. You check LKS and found that based on the past record in SP Setia, he has built tremendous shareholder value for investors. Then you check the record of Bill Ch’ng in MPCorp, and he has made thousands of investors lost their pants, but he tells you the past is immaterial, it is the future that is important. He expects you will make tons of money in my SPAC in the future based on this and that projection of his.
So which property SPAC will you chose to invest in? Which SPAC has a more plausible reason to invest?
Plausibility is also often required in academic research in economics and other fields. Otherwise the result of the research can be considered as spurious.
What about predictability? Which metric is more predictive, high ROE or high profit growth? I haven’t read any research saying that high profit growth expectation has earned extra-ordinary return yet, but I give you one on the predictability of high ROE.

Predictability of ROE: Academic research
Dr. Joseph Belmonte's in his research using the S&P 500 stocks for the years 1990 through 2002 shows that portfolios of stocks with high, average ROE adjusted for non-operating earnings and equity of a four-year holding period outperformed the market average consistently. In fact every portfolio with high ROE which was predicted to outperform the S&P index did indeed do so whether the holding period was a one year or a four year holding period. The charts below shows the result of the research. The red bar shows the average ROE of S&P, and the green ones are portfolios of above-average ROEs.

 
Do you have academic research showing that an investing strategy basing just on profit growth for the next one or two quarters work? We would like to see that.
So there are evidences that high ROE stocks do outperform. But critics will say that is in US. In Bursa, it won’t work. Bursa is different, no good and lasting companies.
Well I don’t know if there is any academic research showing that but I do have a little recorded experience investing since about three years ago as published in i3investor. Of course I have much longer records but those were not published before, and talk is of no use.

My personal experience using return on capital
I have published two stock portfolios in i3investor since January 2013. Sorry I have to use these portfolios again to illustrate, otherwise what else can I base on?
Almost all my stocks in the two portfolios were selected basing on high return on capital. I actually use a different parameter for the return on capital, i.e. return on invested capital. But basically the principle is the same, invest in companies with high return on capitals, whether it is ROIC for the firm, or ROE for just the equity shareholder.
The results of my investment in two separate portfolios are shown in the link below:
The result of the portfolio of 10 stocks in the first portfolio shows an average return of 120.2% and median return of 74.5% compared to the broad market return of just 12% during the same period. All stocks in that portfolio made positive returns and there were no loser, absolutely none. Only 2 out of 10 stocks under-performed the broad market, and just marginally.
The result of the portfolio of 11 stocks in the second portfolio shows an average return of 86% and median return of 45% compared to the broad market return of just 3.3% during the same period. All stocks in that portfolio made positive returns except two but at average of small single digit losses.
Those stocks with high ROIC of more than 30% such as Pintaras, SKPResources, Jobstreet, Prestariang, Homeritz and Datasonic all returned more than 300% as at to date in less than two and a half years. Nothing was mentioned about growth in profit when the stocks were selected. But of course there were growth in profit as a result of the high ROE, a growth from the internally generated funds, a reinvestment of its earnings and cash flow to yield equally high ROIC.
My portfolio selection actually incorporate another parameter that is the valuations in term earnings yield for the firm, i.e. Earnings before interest and tax over the enterprise value.
Why the valuation metric?
The price you pay determines your rate of return” Warren Buffett
It should be me who should ask why your stock selection never consider what the price is but just profit growth.
A good company is not necessary a good investment, a bad company can also be a good investment. It all depends on the price you pay”.

Conclusion
What is more plausible and has a better predictive power in investing, based on backward looking return on capitals from audited account, proven record, and buy when they are selling cheap, or a forecast based on a quarter or two of profit growth, without even have to look at the financial statements, and even not bothering about the price you pay for the stock?
Your call now.
This article is for sharing of investment philosophy and strategy. All constructive criticisms are welcomed. After all, sharing is caring.

K C Chong.

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