Return on equity (ROE) measures how efficiently a company uses Shareholders’ Equity to generate profits. For any readers unfamiliar with ROE, it is calculated by dividing net income by book value of equity.
It’s no coincidence that Warren Buffett is a fan of the measure - companies with high ROEs tend to exhibit the high-quality, moat-like business traits that he is so fond of gaining exposure to.
Under Buffet's investing philosophy, if you can find a company that consistently allocates its capital profitably (indicated by a high ROE), the chances are you are onto a long-term winner.
Unfortunately, CEOs at firms are not generally promoted based on their ability to allocate capital – even though this is what they then go on to spend time doing.
As Mauboussin writes in one of his research papers:
“Capital allocation is one of management’s prime responsibilities. Yet few senior executives are versed or trained in methods to allocate capital most effectively. Further, incentive programs frequently encourage behaviors that are not in the best interests of long-term shareholders.”
So, if as an investor you’re only looking at sales and earnings growth, you are missing an important question: how is that growth being funded?
Finding companies that allocate capital well
As investors, we want to find high ROE stocks whose fantastic business models are being rewarded by the market. One way to do this might be to screen for shares with both positive one-year relative strength and upgraded current year broker forecasts. The former ensures these shares have been outperforming the market, and the latter suggests the outperformance can continue.
One stock that currently qualifies for this screen is Trulieve Cannabis (CNSX:TRUL). The group has:
A trailing twelve month return on equity of 85.3%
An average current year EPS forecast upgrade of 10.5% from brokers, and
A one-year relative strength of 10.6%
Studies indicate that combining factors such as Value, Quality and Momentum is a more effective way of outperforming the market over longer time frames. That's why we have constructed our StockReports to give an instant impression of how well exposed Trulieve Cannabis (CNSX:TRUL) is to these three factors. We go into greater detail on factor investing in this video.
Stockopedia helps you to identify return-enhancing factors such as Quality, Value and Momentum by analysing thousands of data points every day. To find out more about you find investment opportunities and analyse your portfolios then take one of our two-week free trials and have a look around.