In the world of investing discussions often revolve around high return on equity (ROE) as a key indicator of a company’s profitability and efficiency. High ROEs are typically seen as a sign of a strong business with superior management and market position. However, as David Einhorn articulated in his speech at the Value Investing Congress in 2006, there is substantial value in focusing on companies with low ROEs and the potential for significant improvement. This perspective challenges conventional wisdom and highlights the transformative power of improving ROEs through strategic measures.
Investing is a highly competitive activity. There are tons of intelligent individuals dedicating significant time and effort to investment selection. High ROE companies represent firms that conduct operations at an above-average rate, leading to market recognition and higher valuation. Companies that exhibit high returns also face tougher competition due to the most advantageous participants actively trying to take market share in highly profitable industries.
One of the most important principles of investing is to find situations in which there is a competitive advantage. This does not always translate to finding the best companies on the market with their own competitive advantage but instead involves looking for companies with the potential to improve operations. Improving operations is about seeing a company for what it could be with a few proper capital allocation decisions. This means that it is not something that can be easily screened for using quantitative measures; one must look beyond historical financial data to find avenues where returns could rise moving forward.
Understanding ROE in Different Business Models
To appreciate the value of low ROEs, it’s essential to differentiate between capital-intensive and non-capital-intensive businesses. Capital-intensive businesses, such as traditional manufacturing companies, distribution companies, financial institutions, and retailers, require substantial investment in fixed assets and working capital to grow. In contrast, non-capital-intensive businesses, like pharmaceutical companies, software firms, and service providers, rely more on intellectual capital or human resources.
For capital-intensive businesses, ROE can be a crucial metric. However, in non-capital-intensive businesses, the relevance of ROE diminishes because their growth is not constrained by physical or financial capital. Instead, these companies’ success hinges on their intellectual property, human resources, or brand equity, none of which are accurately reflected on the balance sheet. Therefore, Einhorn emphasizes the importance of analyzing ROE specifically within capital-intensive sectors.
ROE is more significant in capital-intensive businesses because these companies rely heavily on their physical assets to generate returns. For non-capital-intensive businesses, where success may depend more on intellectual capital and less on physical assets, other financial metrics might be more insightful for assessing company performance.
One of the issues with non-capital-intensive businesses is that traditional accounting measures do not always accurately reflect the value on the balance sheet. This is because assets such as human capital, intellectual property, and software are not always precisely represented in the book value. This discrepancy can skew the ROE calculation, resulting in a higher ROE due to a lower denominator (equity).
For capital-intensive businesses that invest heavily in tangible assets, the book value has substantially more meaning and provides a clearer gauge of the productivity level of the assets held on the balance sheet.
Let’s consider a scenario comparing a capital-intensive manufacturing company with a non-capital-intensive software company to illustrate how ROE can increase significantly in businesses with heavy asset investments due to the potential for noticeable improvements.
The manufacturing company starts with an equity of $100 million and an initial net income of $5 million, giving it an ROE of 5%. This company invests heavily in machinery and equipment, typical of capital-intensive industries. On the other hand, the software company, relying mainly on intellectual property and skilled employees, has an equity of $30 million and a net income of $9 million, resulting in an ROE of 30%.
Now, suppose both companies implement efficiency improvements. The manufacturing company adopts a new production process that enhances output and reduces waste, boosting its net income by $10 million. Meanwhile, the software company makes some optimizations in its software, leading to a minor increase in revenue that raises its net income by $1 million.
After these changes, the manufacturing company’s net income rises to $15 million, increasing its ROE to 15%—a 200% increase from its original ROE. In contrast, the software company’s net income reaches $10 million, pushing its ROE to 33.3%, an 11% increase. This stark difference illustrates that capital-intensive businesses, like our manufacturing example, have more significant potential to leverage existing assets to boost ROE substantially compared to non-capital-intensive businesses, where improvements are less reliant on physical assets and thus may yield less dramatic increases in ROE. This example clearly shows why efficiency gains in capital-intensive sectors can profoundly impact financial ratios, highlighting the scale of opportunities for improvement in these industries.
The example comparing the capital-intensive manufacturing company with the non-capital-intensive software company not only demonstrates a significant percentage increase in ROE for the manufacturing firm but also highlights why such an increase is more sustainable and realistically beneficial over the long term.
When the manufacturing company improves its ROE from 5% to 15%, this threefold increase is not only notable in percentage terms but also sustainable in a business context. An ROE of 15% is generally regarded as slightly above average in many industries, indicating efficient use of equity while still leaving room for further improvement without reaching impractical levels. This level of ROE improvement is substantial because it represents a realistic and achievable target that significantly enhances the company’s financial health and attractiveness to investors.
On the other hand, while the software company’s ROE increase from 30% to 33.3% is positive, it is less impactful. High ROE levels, such as 30% or more, are often challenging to improve significantly due to diminishing returns as the base becomes larger. Pushing beyond certain thresholds—like aiming for 50% or higher ROE—can become unrealistic without extraordinary business achievements or unusual market conditions. Thus, any improvements at this high level are less likely to be dramatic or sustainable.
Furthermore, the increase from 5% to 15% in a capital-intensive business is not just higher in magnitude than the incremental increase seen in a high-ROE business, but it also brings more substantial and durable benefits. For capital-intensive businesses, leveraging existing assets more efficiently to achieve a mid-range ROE can result in a stable path to higher valuations, reflecting a steady improvement in profitability and asset utilization.
Therefore, the goal is not only to increase ROE but to do so in a way that leads to higher and more sustainable business valuations. For capital-intensive businesses, achieving a moderate but robust ROE like 15% provides a reliable indicator of good financial health and operational efficiency, making the business more attractive to investors and enhancing its market valuation over time. This approach helps ensure that the benefits of increased ROE are not only realized but maintained in the longer term.
The Potential in Low ROEs
The allure of low ROEs lies in their potential for significant improvement. Unlike high ROE businesses that attract competition and face difficulties in sustaining their returns, low ROE businesses offer a fertile ground for transformation. There are three primary ways to enhance ROE:
Improving Asset Turns: Increasing the efficiency with which a company uses its assets to generate revenue. This involves optimizing the use of existing assets and minimizing idle resources.
Enhancing Margins: Increasing profitability by either raising prices, reducing costs, or a combination of both. This might involve streamlining operations, renegotiating supplier contracts, or investing in technology to improve productivity.
Adding Financial Leverage: Using debt to finance growth, thereby increasing returns on equity. While this approach involves higher risk, it can be highly effective if managed prudently.
One effective method to analyze and potentially improve ROE is by employing a DuPont analysis. This technique decomposes ROE into its components: asset turnover, profit margins, and financial leverage. By breaking down ROE in this manner, it becomes easier to identify specific areas where improvements can be made.
For capital-intensive businesses, the DuPont analysis offers a valuable perspective. Rather than dismissing a company with low ROE as a poor investment, this analysis allows investors and managers to pinpoint specific areas where enhancements can lead to increased ROE. For instance, improving asset utilization (asset turnover), increasing operational efficiency (profit margins), or optimizing the use of debt (leverage) could all contribute to a higher ROE.
This approach can lead to a potential revaluation of the company in the market at a higher price, as improvements in these areas signal to investors that the company is managing its resources more effectively, thus warranting a higher valuation. By using the DuPont analysis, stakeholders can derive a more nuanced understanding of a company’s financial health and identify actionable strategies to enhance performance.
Conclusion
Einhorn’s insights highlight a compelling investment strategy: identifying capital-intensive businesses with low ROEs and substantial potential for improvement. By focusing on companies that can enhance their asset turns, margins, and leverage, investors can uncover opportunities for significant returns. This approach not only challenges the conventional emphasis on high ROEs but also underscores the transformative power of strategic financial management in unlocking value in overlooked sectors.
Investors should consider the long-term potential of low ROE businesses and the myriad ways in which these companies can enhance their profitability. By doing so, they can position themselves to benefit from the substantial gains that come from turning around underperforming enterprises.
The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation. Past performance is no guarantee of future performance.