Persistence of Profits & Quality Investing 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.

Get our White Papers direct to your inbox: SUBSCRIBE

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. With elevated valuations having soared higher through 2022, these concepts are critical to understand prior to investing in a bear market that many believe is looming.

Subscribe now to unlock the full content

Already a member? Click here to log in

SERVICES

As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

ADDITIONAL READING

The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra for anyone seeking out more information related to the topics above.

SOURCES

Reprinted with permission of Knight Capital. Kailash is not affiliated with Knight Capital. See Infra.
All but micro (ABM) stocks include companies with a market cap greater than ~$500 million in today’s dollars, also any companies with a share price less than $3 per share and a market cap that is lesss than ~$5 billion in today’s dollars are excluded as well.
While our data results differ from those found in the authors’ work, the analysis in this paper is similar to that found in “The Level and Persistence of Growth Rates” by Chan, Karceski and Lakonishok”.
Applying historic probabilities to today’s universe
We recognize that some of this, particularly in the Low ROE sample, may be due to the survivorship issue which is discussed later in this paper
In addition to bankruptcies and take-outs, a portion of the “Exited ABM Universe” is due to insufficient data available to calculate the companies’ ROEs which could be due to a multitude of additional factors

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.