Saturday, May 15, 2010

BAGAKOAA May 13, 2010 ROE ROE ROE your boat.


Due to technical reason this could not post till this morning.  Sorry.

May 13, 2010 ROE ROE ROE your boat.

I had to stop listening to the noise today in the market and continue honing my investment skills or discovering my lack there of. You have heard me harp on Shareholder’s Yield based upon Free Cash Flow usage. So I won’t bore you with more info on that, though it is becoming more and more critical everyday as U.S. companies have more cash on their balance sheets since World War Two, adjusted for inflation.

So if you do your cash flow studies and like what you see there is one more quatitiave exercise you might want to execute. Look at the ROE, Return on Equity. Here is a brief primer, mostly in my own words, but based upon a series of articles by Ben McClure who is director of McClure & Co.

Simply put ROE is a way of determining how efficient a company’s management is at generating profit from the assets available to that management. It can indicate whether a company is fat and lazy or lean and mean. It is an important relationship between an organizations profit and it’s investors return.

Now the only value of an ROE is a relative metric used to compare one company to another or a company to an overall industry or sector. Typically you want to look at the company’s 5 year trend in ROE and then compare it with that of another company or the industry it is in.

The metric is easily determined by dividing net income by shareholder’s equity. These figures are readily available on almost all publically held company’s financials. And you do not have to calculate it since that metric is very common and found on most financial websites. Now a couple of things can artificially inflate ROE and you need to look out for them. Any one time or unusual write off reduces shareholder’s equity which by definition increases ROE. Also, a stock buy back (an important element in the use of free cash flow) will have a positive impact on ROE.

Here are a couple of examples:

ABC company has a shareholder equity of 100 million dollars. In 2009 the earned 10 million in net income. Their ROE, Return On Equity would be 10%. 10ml/100ml. Now if ABC makes 10 million in 2010 and has cash to buy back 10 million worth of share, the ROE becomes 11.1%. 10mil/90mil. Or if an unexpected or one time capital expense reduces shareholder’s equity, the same effect is true.

Now if Shareholder’s equity stays the same or similar, ONLY a change in net income can impact the ROE.

ABC company has a shareholder equity of 100 million dollars. In 2009 the earned 10 million in net income. Their ROE, Return On Equity would be 10%. 10ml/100ml. Now if ABC makes 15 million in 2010, the ROE becomes 15%.

So what is a good number? Many analysts look for 15% as a minimum. I like 25% or more but admittedly those are hard to find. You can’t take ROE in isolation as you really need to look at the overall fundamentals, but ROE is a strong metric to look at.

In the category of “Only In America”, I read one of my favorite columns in the WSJ today and could not help but laugh. I enjoy “Overheard” on the Heard on The Street” page in the journal. Todays “Overheard” was priceless. Apparently congressman Mike Pence (R) is drafting a bill for house consideration to limit Federal Funds to the IMF (International Monetary Fund) to only countries with a debt to gross domestic product of below 60%. Makes good fiscal sense. We should be lending money to countries whose debt is a large proportion of their total production. I would support that, wouldn’t you? Ironically The US’s current debt as a percentage is 60.3% and is expected to conservative expand to 66.7% over the next 5 years. Some analysts (Barclay’s) see our debt to GDP going to 95% by 2019. So we would not loan money to ourselves under Congressman Pence’s Bill. Only in America!

In listening to all the after close banter, there is no clear direction for the market.  It seems to be downward and some technicals support that direction.  So I am in no hurry to declare a new rally.  It interesting to listent to all the talking heads banter about the US Dollar, the Euro, Gold, Oil, and inflation.  It sounds as though the volatitly is coming from the belieg (I think it is a mistaken belief) that the Euro might collapse.  But since this thinking exisits and it has enough influence to overcome some good retail sales number as well as great industrial production numbers, you got to play it as you see it.  I added to AAPL, SBUX, GLD, SLV and took a huge position in VXX today.  I did not get in early enough to enjoy the 8% pop today but feel these concerns are going to linger a while.  I have a very narrow stop on the position at 3% and I am looking for it to hit 35-37 in the next couple of weeks then settle down again.  There is NO concern about inflation in any of these markets so the creeep in Gold and other commodities seems to be a strong dollar play and maybe a subtle underlying demand pressure.

Salve Lucrum


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