Here's why blindly chasing companies with high ROE can get you in trouble
Efficiency is important. You have put your money into a business, so it is natural that you want the most out of it. Hence, going after companies with a high ROE is one of the core tenets of long-term equity investing.
But here's something many investors miss. High ROE by itself is not enough. Without significant earnings and revenue growth, a high ROE is akin to garnish.
Without growth, a company can, at best, just maintain its ROE but rarely grow it. In addition, companies that maintain a high ROE while simultaneously growing their earnings and revenue will outperform companies with high ROE but poor growth.
You don't have to take our word for it. To prove our point, we conducted a simple exercise.
We took companies with a market cap of over Rs 500 crore that maintained an ROE equal to or above 15 per cent each year between FY13 and FY17.
We then divided these companies into two groups. Group 1 contained companies with an annual revenue and earnings growth of 10 per cent between FY13 and FY17. Group 2 had companies with an annual revenue and earnings growth of less than 10 per cent in the same period.
Next, we determined the past five years' average return of these two groups if one had invested in 2018 and held the shares to date.
Here's what we found.
As expected, Group 1 outperformed Group 2; Group 1 gave a median five-year return of 5.1 per cent per annum between 2018 and 2023, while the latter gave a measly return of 0.8 per cent per annum. Also, a further testament to our claim is that 44 per cent of the companies in Group 1 reported higher ROE in FY17 as compared to FY13, meaning that these companies grew their ROE on the back of their earnings. In contrast, only 18 per cent did so in Group 2 and consequently offered lower returns.
What you should do
As stated above, blindly chasing companies with high ROE can be disastrous for your portfolio. Hence, ROE should be viewed in conjunction with the overall financial growth of a company.
Suggested read: What is return on equity?