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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Berney who wrote (1019)	11/23/1998 8:47:00 PM
From: Freedom Fighter	Read Replies (1) \| Respond to of 1722

Berney, Return on Equity >>I've enjoyed your macro perspective of whether current levels of ROE can be maintained in the future. I profess no knowledge on this subject. Nevertheless, I would put forth the hypothesis that the ROE factor is why so many large-cap stocks, outperform their smaller brethren.<< I agree with you. There is a demonstrable reason why high ROE companies are worth more all else being equal. Here's two examples: First let's say company A and B both earn $1 per share and have the opportunity to reinvest it all. One gets a 20% ROE and the other a 10% ROE. One will increase its earnings 20% and the other 10%. Now let's say the same two companies both have an opportunity to expand their sales by 5%. The 20% ROE company will require 1/2 the amount of additional capital to do so as the 10% ROE company. That leaves more money available for dividends, stock repurchases, or the purchase of additional businesses. Either way 20% ROE is more valuable. As to the sustainability of the high aggregate return on equity we now have, these are my thoughts: The historical record is very clear that margins and ROE advance as a business cycle matures. This is a very advanced state of the business cycle. Margin levels are at historic highs by every measurement I am aware of. One would have to think that the current level of economic activity is now the norm to consider these ROE levels as sustainable. I can think of many industries where I am certain that this is not the case or norm. Second, as margins and returns advance, there should be a tendency for business to invest much more of their earnings chasing those returns. Especially if the cost of capital is falling. This should also lead to lower margins and ROE as a result of more capacity. Third, there is a tendency for companies to compete for market share. When margins are high it is more difficult to hold those margins because of aggressive competition. Fourth, higher margins imply productivity gains. There has been a tendency for employee income gains to match productivity gains over the long haul. This would come from profits. So while none of these things is etched in cement, the probabilities suggest a shrinkage of margins over let's say the next few years or whatever. In general, the only companies that have sustained higher than average margins over the long haul have been companies that have some competitive advantage either in costs, quality, reputation, etc... over their competition. (Above average companies) It seems unlikely that suddenly after 125 years almost everyone in the S&P500 is above average. In fact by definition everyone CAN'T be above average. The S&P500 is too large a percentage of the pie for me to think they are that much better than the rest. I can make too big a list of companies that are not. Keep in mind that there are disputes about what the actual returns on equity are. GM is a good example case as the article stated. But I have made adjustments to the figures for all the recent accounting changes (for the DOW) and the ROE is still higher than average for many companies. And the margins as a % of sales etc.. also suggest we are operating above average. Wayne Crimi Value Investor Workshop members.aol.com