In my last post, I discussed how Return on Shareholder’s Equity can be a useful metric in predicting the long term, sustainable rate of earnings and dividend growth.

I pointed out several companies in our portfolio which have ROE’s in the high teens to low twenty percent range, (or higher) which after adjusting for a 40-50% dividend payout ratio, should equate to a EPS growth rate of approximately 10-12% – higher than the market’s 8-9% estimated growth.

 But the analysis can and must go deeper at Berkshire:

 Any rationale investor seeking to own a business should start the process with 2 major questions in mind:

1)    “HOW does this company generate its profitability?

2)    “Is this profitability CONSISTENT AND SUSTAINABLE?”  (i.e. what are the threats to the cash flow?)

 Utilizing the DuPont formula, ROE can be broken down into its component parts and help answer those questions. 

 ROE = Operating Margins x Asset Intensity x Financial Leverage x Management of Taxes 

 The breakdown provides a road map for analysis for virtually any company in any industry:

 Operating Margins:

• How profitable is the core business?
  • What type of pricing strategy is the company following?
  • What kind of pricing power exists?
  • How does the company differentiate its products?
  • Can they charge more for this differentiation?
  • How economically sensitive is the company’s revenue?
• Asset Turnover:
  • How capital intensive is the business?
  • How much shareholder capital needs to be reinvested to maintain growth?
  • What level of fixed costs need to be covered to maintain break even status?
• Financial Leverage:
  • How does the use of debt magnify returns (or losses)?
  • What does management do with excess capital?
    • Buy back stock
    • Pay dividends
    • Reinvest back into the business
    • Make acquisitions
• Taxes Efficiency
  • How well does the company manage its tax obligations?

 Applying the Formula:

There is no “right” number for ROE or its components. It’s all business and industry dependent.  A company with stable revenue can handle more leverage (think consumer products, pharmaceuticals, or subscription based services) than a company with volatile earnings – (think energy, commodities or materials).

For example, operating margins for many steel companies at the peak of the cycle in 2008 rivaled that of many high margin consumer products companies. But a longer term look at DuPont analysis shows low to negative operating margins during many normal part of the cycle. Now our research indicates more steel capacity has come on line, demand has dropped, and margins are likely to fall – showing that ROE’s (and earnings growth) recently enjoyed by this sector are not sustainable.

In my next post, I’ll show specific examples of how we’ve used this type of analysis to make portfolio decisions.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.

The Berkshire equity strategy seeks companies with high and sustainable return on shareholder’s equity (ROE). ROE measures how much profit for shareholders is generated for every dollar of equity capital that is invested in the business. Four levers drive the ratio: profit margins, asset utilization, management of taxes, and the amount of debt used.  Decomposing ROE into these components can provide an accurate and comprehensive attribution of a corporate manager’s skill at deploying shareholder capital.

 Earnings growth should equal its ROE MINUS what the company pays out in dividends over time. If a company generates a 20% ROE and pays out 50% as dividends, earnings should compound at 10%. Importantly, dividends should also grow at the same rate as long as management keeps the payout ratio constant. This demonstrates why a high, expanding or at least stable ROE is desirable for growth of dividends. Analyzing the four levers helps an investor determine dividend safety and sustainability of earnings.

US stocks are on pace to post about a 14% ROE and estimated to pay out about 47% of earnings (as estimated by Thompson Baseline). So the long term sustainable growth rate of earnings and dividends should approximate 7%.

Our portfolio is packed with companies that we believe can grow earnings and dividends at above average rates based on ROE evaluation.

• 16% of our model portfolio has an estimated ROE above 20%
• 38% of our model portfolio has an estimated ROE of over 16%
• 65% of our model portfolio has an estimated ROE at least equal to or greater than the average US stock.

Approximately 15-20% of our portfolio has an estimated ROE that is temporarily below average, but we believe their businesses are rebounding. ROE’s should once again outpace the average stock in the market. These include a few large cap financials, and consumer discretionary stocks.

This is why we are of the opinion our portfolio can generate growth in dividends and/or cash flow at rates in the low teens.

Disclosure:

Berkshire equity portfolios and Berkshire employee accounts have long positions in the stocks and sectors mentioned in this post. 

The views expressed in this commentary reflect those of Berkshire Asset Management, LLC (Berkshire) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Berkshire disclaims any responsibility to update such views. These views are not intended to be a forecast of future events, a guarantee of future results or investment advice. Because investment decisions are based on numerous factors, these views may not be relied upon as an indication of trading intent on behalf of any portfolio. The information contained herein has been prepared from sources believed to be reliable, but is not guaranteed by Berkshire as to its accuracy or completeness.

References to particular securities are intended only to explain the rationale for the portfolio manager’s action with respect to such securities. Such references do not include all material information about such securities, including risks, and are not intended to be recommendations to take any action with respect to such securities.

Investment Risk: All investments are subject to risk, including possible loss of principal. Because Berkshire Asset Management, LLC’s investment style expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the portfolio’s overall value to decline to a greater degree than a less concentrated portfolio. Our equity investment style may focus its investments in certain sectors or industries, thereby increasing the potential vulnerability to market volatility.