Boring Portfolio

Return on Equity
...the good, the OK and the ugly
by Mark Weaver (MWEAV)

SPRINGFIELD, IL. (June 25, 1998) -- The market couldn't hold early gains and instead fell today. The S&P 500 lost 0.32% and the Nasdaq 0.77%. The Borefolio was also down, but a more modest 0.29%, as six of our eight stocks declined. Nothing in the portfolio moved more than a point. All in all, it was a day that will go unnoticed.

In a similar vein there was no news of significance on any of our stocks.

Perhaps this is a good day to point out that it is very possible to be a highly successful investor without watching for news and quotes on a daily basis. Even though we write a daily update on our stocks, the reality is that watching the daily action in stock prices and paying close attention to each and every press release is, in large part, a wasted effort.

So, rather than dig up some drivel to discuss I thought I would spend time on a subject that is of more significance to an investor -- namely, return on equity.

Here in the Borefolio we often talk about such arcane subjects as Return On Equity (ROE) and stock valuation. While subscriber numbers (AOL) and estimates of the numbers of impotent males (Pfizer) can fuel the rise of stock prices, ultimately an investor is concerned with, "How much can I expect to make for every buck I invest?" Ultimately that boils down to ROE. The simplified equation for ROE is Earnings/Equity. The ROE measures how much money the company makes for every dollar of equity. However, there is an awful lot of interpretation that goes into properly understanding that simple equation. This is because the equation is actually a composite of three factors:

Earnings/Sales x Sales/Assets x Assets/Equity = ROE

Another way to look at the equation is:

Net Margin x Inventory Turnover x Leverage = ROE

Hmmm, maybe all ROE is not created equal. Is a firm with a high ROE based on high net margins the same as one that is based on leverage?

One Borefolio holding with an exceptional ROE is Cisco Systems (Nasdaq: CSCO). Sporting an ROE of over 24%, the company is a market leader in the ROE department. Lets look at the components of Cisco's ROE. The majority of its impressive performance comes from an outstanding net margin of 16.3%. The company turns over inventory at a modest clip and has almost no leverage (debt). A company selling niche products has an opportunity to charge more for its products and its return on equity is based on a superior product. The highest "quality" ROE is that which comes from a high margin business.

Contrast Cisco to Safeway (NYSE: SWY), a company that also sports an impressive ROE of over 25%. Run a stock screen for ROE and this stock comes out well up the list. When looking at the components some interesting comparisons come to light. Net margins are only 2.5%, a far cry from Cisco's but not at all surprising given the different businesses. The way Safeway can pump up ROE is to sell more groceries. The more heads of lettuce Safeway sells, the better its ROE. Volume is the key in the grocery biz and Safeway is no exception. Safeway turns over its assets at a 260% clip compared to Cisco's 120%. Smaller margins but more units sold is still a decent way to make a buck. There are some very decent businesses that run on thin margins but have a volume business. A business built on volume can also represent good "quality" in the ROE department.

However, Safeway pumps up ROE through leverage as well. Safeway is leveraged to a much greater extent than Cisco with a ratio of Assets to Equity of 4.0 versus 1.2 for Cisco. While in good times the use of leverage can enhance returns, it ultimately increases the costs of doing business and adds some risk in times of economic trouble. When equity is not the dominant part of the corporation's capital structure the ROE can look good from afar but can be far from good.

All in all, looking at the two companies in detail, the quality of Cisco's ROE outshines Safeway's by a large margin... literally.

FoolWatch -- It's what's going on at the Fool today.

06/25/98 Close

Stock  Change    Bid 
 ANDW  -  1/4   18.75 
 CGO   +  1/8   33.00 
 BGP   +  1/2   37.31 
 CSL   -  7/8   43.06 
 CSCO  -  13/16 86.94 
 FCH   -  1/16  31.50 
 PNR   -  1/4   40.13 
 TBY   -  1/16  8.38 
                   Day   Month    Year  History 
         BORING   -0.29%   1.22%   2.44%  28.90% 
         S&P:     -0.32%   3.53%  16.37%  81.67% 
         NASDAQ:  -0.77%   4.74%  18.65%  78.99% 
     Rec'd   #  Security     In At       Now    Change 
   2/28/96  400 Borders Gr    11.26     37.31   231.48% 
   6/26/96  150 Cisco Syst    35.93     86.94   141.94% 
   8/13/96  200 Carlisle C    26.32     43.06    63.58% 
    3/5/97  150 Atlas Air     23.06     33.00    43.12% 
   4/14/98  100 Pentair       43.74     40.13    -8.27% 
   11/6/97  200 FelCor Sui    37.59     31.50   -16.20% 
   5/20/98  400 TCBY Enter    10.05      8.38   -16.63% 
   1/21/98  200 Andrew Cor    26.09     18.75   -28.13% 
     Rec'd   #  Security     In At     Value    Change 
   2/28/96  400 Borders Gr  4502.49  14925.00 $10422.51 
   6/26/96  150 Cisco Syst  5389.99  13040.63  $7650.64 
   8/13/96  200 Carlisle C  5264.99   8612.50  $3347.51 
    3/5/97  150 Atlas Air   3458.74   4950.00  $1491.26 
   4/14/98  100 Pentair     4374.25   4012.50  -$361.75 
   5/20/98  400 TCBY Enter  4018.00   3350.00  -$668.00 
   11/6/97  200 FelCor Sui  7518.00   6300.00 -$1218.00 
   1/21/98  200 Andrew Cor  5218.00   3750.00 -$1468.00 
                              CASH   $5511.82 
                             TOTAL  $64452.45