Financial research suggests that so-called “quality” companies, i.e. those with high return on equity (or “ROE”), tend to be able to produce market-beating shareholder returns. But as this note demonstrates, it’s not enough to simply rank companies based on their current ROE – rather consideration must also be given to the likely sustainability of their ROE over time.
Why ROE sustainability is the key to quality share price performance
It stands to reason that companies with a high ROE should be able to produce relatively good shareholder returns over time. After all, if a company can generate high profits relative to its invested equity, it will be well positioned to provide either attractive dividends and/or high earnings growth through the re-investment of retained profits.
That said, as seen in the chart below, it is not enough to simply identify companies with a high ROE over the past year. Indeed, what has mattered historically for market-beating share price performance is a company’s ability to sustain a high ROE over time. Indeed, the chart demonstrates that for companies with a relatively high ROE in any given year, the strongest subsequent share price performance was attributed to those that sustained a high ROE in the following two financial years.
So far so good. But once we’ve identified companies with a higher-than-average ROE, how can we judge the likely sustainability of their ROE over time?
It turns out there are several tell-tale signs.
Firstly, companies should not have achieved their higher-than-average ROE by being overly reliant on leverage. After all, companies with low leverage (i.e. debts relative to equity) are less likely to be affected by changing market conditions and so are more likely to maintain their high ROE over time.
Another useful indicator is a company’s ability to generate strong operating cash flows – perhaps a better underlying measure of sustainable earnings – relative to their assets over time.
Finally, companies with a track record of earnings consistency (or low variability in earnings) are likely to sustain consistent growth and achieve a higher ROE.
These considerations happen to be in keeping with one of doyen investor Warren Buffett’s key strategies in picking stocks, namely, to look for companies able to sustain a high and reasonably stable ROE over time without undue reliance on debt.
The BetaShares Global Quality Leaders ETF (ASX Code: QLTY)
Given the benefits of this investment approach, the BetaShares Global Quality Leaders ETF (ASX Code: QLTY) has been specifically designed to provide investors exposure to a diversified portfolio of global companies (ex-Australia) that demonstrate “quality” characteristics with the potential to deliver a relatively high and sustainable ROE over time.
From a universe of 1800 stocks across global markets, the Index which QLTY aims to track first selects the top 50% of stocks when ranked by ROE. Broadly, the Index then narrows this set of stocks down to the top 150 that score best on three additional ROE sustainability indicators covering leverage, earnings stability and cash-flow generation capacity.
This approach leads to a portfolio of premium companies, many of whom are household names. For example, as at October 2018, some of the largest index holdings included: AIA Group, The Walt Disney Company, Intel, Johnson & Johnson and Unilever.
As seen in the chart and table below, the Index which QLTY aims to track has delivered impressive historical total return performance. As at the end of October 2018, the Index QLTY aims to track delivered a 10-year return of 13.3% p.a., compared with 8.8% p.a. for the MSCI World Index (of course, past performance is not indicative of future performance and investment value can go down as well as up). In this period, the Index has also benefitted from significantly lower drawdowns, with a maximum drawdown approximately half of that experienced by the MSCI World Index.
All up, QLTY provides an easy, transparent and cost-effective way for Australian investors to gain exposure to a diversified portfolio of quality global companies that have the potential to sustain high returns on equity – and hence potential to outperform benchmark global equities indices over time.