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Why High ROE Screens Are Not the Perfect Way to Find Warren Buffett-Style Investments

November 06, 2012 | About:
Some caveats with using high ROE screens to search for Warren Buffett-style investments

- Debt-Loaded High ROEs

ROE is calculated as the product of net income margin, asset turnover and leverage. High leverage will artificially boost ROE. High ROE stocks with huge amounts of leverage need to be viewed with caution, as leverage is masking an inferior operating efficiency and competitive position.

- Cash-Rich High-Quality Firms

Firms with a lot of cash on their balance sheet will results in low ROE, since the interest earned on cash pales in comparison with the operating margin of the firm's core business. One way to remedy is to calculate ROE on an ex-cash basis.

- One-Offs Obscure True Profitability of Firms

The key to ROE is the net income figure, which itself is full of distortions by one-offs and accounting rules. Non-cash write-downs and charges may hit the P&L of a firm and result in low ROE for that year. Similarly, firms may boost ROE in any single year through accounting sleight of hand or divestment of assets.

- Temporary High ROEs for Commodity-Like Business

Firms in commodity-like business may show up on the high ROE screen because of industry consolidation or mergers and acquisition activities. However, the effects on ROE are likely to be temporary as the law of zero economic profits for commodity-like markets comes into play.

Remedy

Recast the financials of the firm you are looking at or "start with the As" as Buffett suggests.

About the author:

Mark Lin
Mark is a private value investor and runs the Cheapskate Investing website which borrows from the wisdom of value investing giants, using a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders. He is also a regular contributor to various value investing communities.

Visit Mark Lin's Website


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