Posted by: donmihaihai | July 18, 2007

In search of super returns in stocks?

Teh Hooi Ling, Senior correspondent of BT wrote in Saturday BT with title as above but without the question mark. So what is the method she comes out with? Purchase stocks that have Low price to book (PTB) and high return on equity (ROE). She wrote a long article(will it get publish if the article is short?) with all sort of back testing and whatsoever but the key point is cheap and good. Cheap in term of PTB(Singaporean love anything that is cheap in term of BV?) and good in term of ROE.

Interestingly, I think she might have read the book written by Joel Greenblatt “The little book the beats the market” (The start of all kind of little books)

http://www.amazon.com/Little-Book-That-Beats-Market/dp/0471733067/ref=pd_bxgy_b_text_b/105-3026778-9721254

In this book, a similar idea is being explore, cheap and good. Cheap in term of high earnings yield(the inverse of P/E ratio) and good in term of return on Assets (ROA).

ROA is not ROE but it work on a same principle. High earnings yield and low PTB usually go hand in hand as they are the function of price. The lower the price of a stock, the higher earnings yield and the lower the PTB. So when someone found a high ROE stock that trade at a low PTB, the earnings yield is usually high. The key word here is usually because sometime things are unusual

Usually: The interlink between high earnings yield, low PTB and high ROE

Say Company A earns a ROE of 20% and the stock is trading at book value and equity/BV is $10. With this information, we know that the earnings yield is 20%, ROE is 20%, PTB is 1 and the stock is trading at $10.

Say Company B earns a ROE of 20% and the stock is trading at $20, equity/BV is $10. With this information, we know that the earnings yield is 10%, ROE is 20%, and PTB is 2.

The example of Company A and B shown the interlink which is the case of usually.

Unusual

Say Company C earns a ROE of 50% and the stock is trading at $25, equity/BV is $10. With this information, we know that the earnings yield is 20%, ROE is 50%, and PTB is 2.5.

Say Company D earns a ROE of 50% and the stock is trading at $50, equity/BV is $10. With this information, we know that the earnings yield is 10%, ROE is 50%, and PTB is 5.

Looking at Company A, B, C and D, using high earnings yield and high ROE, the companies are trading at same cheapness. But using PTB and high ROE, even thou the ROE is higher, PTB goes from 1X to 2X to 2.5X to 5X. So in term of PTB, it is moving from cheap to fair and even to expensive.

Which is better? Are we going to use one instead of the other just because we like it or uncomfortable about the other? The method pointed out by superinvestor Joel Greenblatt is much better of course. He can’t be a superinvestor just because of luck and what he pointed out is not something new as well, as buying securities that are cheap and good is already widely known by many investors.

Capital required and free cash flow.

A strategy of buying stock with high ROE and low PTB miss out 2 things. 1) High ROE in this case usually leave out those super income generating companies with super high ROE. 2) Capital required for generating these income. High initial capital requirement and further high rate of capital reinvestment requirement mean lower level of free cashflow.

Say Company F earns a ROE of 20% and the stock is trading at $10, equity/BV is $10. With this information, we know that the earnings yield is 20%, ROE is 20%, and PTB is 1. But reinvestment in Capital is $0.50 yearly.

Say Company G earns a ROE of 20% and the stock is trading at $10, equity/BV is $10. With this information, we know that the earnings yield is 20%, ROE is 20%, and PTB is 1. But reinvestment in Capital is $1.00 yearly.

The free cashflow of company F is $1.50 yearly while company G is $1.00 yearly. That mean Company F is generating 50% more free cashflow which also mean the intrinsic value of company F is 50% more than company G. Both have a PTB of 1 and earnings yield of 20%. As time goes, the book value of Company G wills growth 100% faster than the book value of Company F(assuming both able to earn 20% of the increase capital yearly).

Using low PTB simply exclude all super profitable companies that require little or no capital reinvestment. The best kind of business that investor should invested in unless the securities is selling at super depressed P/E of 3 or below in which able to fish out by low PTB method(Unlikely to happen).

Teh Hooi Ling, CPA, Senior correspondent of BT. Years of education and investor wasted? This is the basic of stock investment.

Written by donmihaihai, BBS(big bull shit), owner of I’ll do it myself blog.

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Responses

  1. Hey ur blog really open my eyes big big.

    Appreciate if u can elaborate more on one of the sentence “As time goes, the book value of Company G wills growth 100% faster than the book value of Company F(assuming both able to earn 20% of the increase capital yearly).”

    Many many thanks. 🙂

  2. Hi dustin,

    Retained earnings just add on to the book value so Company G book value increase by 100% more since Company G retained earnings is $1.00 while company F retained earnings is $0.50.

    But you need to twist the example abit as there are some errors in my example. In my example F and G, company F ROE must increase every year while company G ROE must remain the same for that 100% to stand.

    How u find my blog?

  3. Hi donmihaihai,

    So does that means that it should be:

    “As time goes, the book value of Company F wills growth 100% faster than the book value of Company G(assuming both able to earn 20% of the increase capital yearly).” due to the retained earnings more from company F which spent half less on reinvestment in Capital.

    Pls correct me if im wrong…haha…

    By the way, ur blog now is under my favourite folder…i used to concentrate only earnings and book value…

    Ur blog not only open my eyes, open my mind also…already start looking from another perspective.

    Thanks man.


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