The Persistence of Profits – The Quality Conundrum, Part I

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The Persistence of Profits – The Quality Conundrum, Part I
  • Relentless ROEs?
  • Economic Gravity Reigns Supreme
  • ROEs Reconsidered
  • High and Low ROE Companies Experience Meaningful Reversion

 

Introduction: Relentless ROEs?

As avid consumers of a wide variety of investment material, we have to admit that certain firms have demonstrated such proficiency at lucid commentary they have become in-house favorites. In some cases, the writing has such a profound impact that we find ourselves entangled in visceral debates post publication, vexing our wonderful programmers with follow-up questions seeking further clarification or insight. In our opinion, Grantham Mayo (GMO) is one of these firms, kindly offering some of the most erudite market commentary in the industry. Their recent white paper, Profits for the Long Run: Affirming the Case for Quality by Chuck Joyce and Kimball Mayer, proved to be no exception.

The authors offer readers a wonderful roadmap that helps explain how fundamental constructs can effectively be brought to bear on the highly topical item of “low-risk investing.” We strongly recommend the white paper as the work is loaded with exceptional insights into the intersection of volatility, fundamentals and returns. What created a collective brain stall in our group however, was the powerful analysis on the persistence of high and low ROE companies. Effectively GMO manages to show that companies with the highest (lowest) ROEs five years ago displayed persistently higher (lower) ROEs on a current basis.

GMO took its universe of stocks, broke it into quartiles based on ROEs and then plotted the five-year forward ROEs of the highest and lowest quartiles over time. Although our methodology differs slightly, we ran a similar exercise on our all but micro (ABM) universe of stocks2 and found results that confirmed what GMO showed: those companies that were more (less) profitable five years ago based on ROE seem to remain in their respective economic stations into the future as shown in Fig. 1. Coming from avid believers in mean reversion, this chart carried an unsettling message (to us anyway) by questioning what we see as the laws of economic gravity.

Disclaimer

Knight Capital Americas LLC (“Knight”) and Kailash Capital, LLC (“Kailash”) terminated their consulting arrangement effective May 31, 2013. Knight and Kailash are not affiliated in any way. However, Knight has given Kailash permission to reprint and redistribute certain material created during the term of the consulting arrangement. The content of this report, including those materials referenced in the report, are provided without warranty of any kind, express or implied, and Kailash and Knight bear no responsibility for the accuracy or completeness of the information contained therein or for the use of any such information by the recipient.