• ROEs Run Year One
  • Implications for One-Year Stock Selection & Core SMID Model
  • ROE Reversion Matters for Long Horizon Investors
  • Volatility: The Setup for Stock-Picking, Spreads for the Patient
  • Low Volatility & Core SMID: Risk-Aversion, Sharpe Ratios and Small Spreads
  • High Volatility & Core SMID: Spreads, Returns and Stock Picking

Introduction: ROEs Run Year One

In Part I of The Quality Conundrum, published in August, we wrote extensively about the tendency of companies with high current returns on equity (ROEs) to suffer significant economic mean reversion over the subsequent five years as measured by margins, asset turnover, leverage and cumulatively, ROEs. While these findings would seem consistent with both generally accepted economic theory and our experience as fundamental investors, we did not spend time examining the implications of these findings for stock selection based on various investor time horizons. For the purposes of this paper, we have chosen to primarily focus on analyzing how to optimize this information around the one and three year holding periods.

Generically speaking, we find that investors with one-year time horizons would be well served to avoid companies with lower ROEs no matter what universe of data we have used. The findings show that the bottom two quintiles generate moderate negative excess returns with the rest generating negligible to moderate rising excess returns in a fairly monotonic fashion for both our All But Micro (ABM)2 and Large3 universes.

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