After all, if a company can generate high profits relative to its invested equity, it is likely to be well positioned to provide attractive investor returns over a sustained period – be it either through high dividends and/or high earnings growth from the reinvestment of profits.
Importantly, however, research has shown that as important as high ROE is, what is perhaps even more important as a predictor of return performance is a company’s ability to sustain that high ROE.
Companies with sustained high ROE have historically strongly outperformed those companies that are unable to sustain this. Therefore, truly “Quality” companies are those with both high current ROEs but also those with the likelihood of sustaining this high ROE over time.
Whilst this is relatively intuitive for investors to understand, what is perhaps more interesting is how these quality stocks have performed during market drawdown events. Historical numbers show that quality stocks have held up better than the wider market in drawdown events, whilst also holding their own in bull markets – with less volatility.
Investing in quality stocks over a sustained period of time has helped to shelter investors from the full effects of wide market drawdowns such as the GFC. This is worth considering, given concerns over current market valuations, and the ongoing macroeconomic uncertainty regarding the trade war between China and the U.S and lingering Brexit concerns, for example.
In this point in the market cycle, it would be reasonable for investors to be looking for quality companies that may provide sustained returns, and lower volatility.
Quality companies, therefore, have the potential for lower drawdowns during market falls, given their strong fundamentals.
In the research we have done on Quality companies, it appears as though some of the key indicators of sustained high ROE are low leverage (i.e low debts relative to equity) and high profitability (i.e. strong cash-flow generation ability).
Blair Modica is a Business Development Manager at BetaShares