A value investor will analyze a company's financial statements before buying its stock. Part of the process of unearthing an undervalued stock is to calculate its past years' financial ratios. The value investor can then grasp a rough picture of how the company has performed in the past and determine if the history will repeat itself in the future.

Of course, there are many ratios which I will personally calculate. You may discover them in my book which can be purchased here at only US$ 9.99 (50% discount).

 

In my opinion, the most crucial financial ratio for the value growth investors is Return on Equity.

 

 

As shown above, return on equity (ROE) is how much a company earns for its shareholders out of a dollar of shareholders' equity. The higher the ROE, the more efficient the company is in generating profits for its shareholders.

 

Hence, if you are a value growth investor who will only buy and hold a company for years, you ought to check out a company's 5-year return on equity. This is because if the company could maintain its above-average ROE for many years (10%), it will be able to compound its earnings and share price higher over the period without you performing further work.

 

However, investing is not that simple. An investor still needs to ponder over a few things upon finding a company that has a consistently higher than 10% ROE for the past 3-5 years:

 

 

#1. Is the ROE sustainable?

 

The formula tells us that ROE is affected by two elements - net income attributable to shareholders and shareholders' equity. You might wish to avoid companies in cyclical industry such as oil and gas, construction etc. By looking at the past 5 to 10 years net profit figures, it can somehow reflect if the company is stable in nature. However, this alone is not enough.

 

Shareholders' equity will also be affected by the amount of profits a company pays out as dividends. The higher the dividends payout, the lower the shareholders' equity and therefore, the higher the ROE. A good management team will always increase dividend payouts if they think the business can't generate acceptable returns on equity in the years ahead.

 

 

#2. Is the debt level manageable?

 

Some companies used high debts to boost its earnings which results in high ROE. While I am a believer of using debts to do business but it has to be manageable. In short, it is advisable to use the bank's money to create more wealth for the shareholders, with the condition that the company must be able to repay its interest expenses easily.

 

While I do not wish to pinpoint any oil and gas company, some of them used very high debts to achieve better ROEs. However, when the tide turns (oil price fell), their profitability was greatly affected with some went into default cases.

 

 

#3. DuPont Analysis

 

ROE is the multiplication of Asset Turnover, Net Profit Margin and Equity Multiplier.

 

Based on DuPont analysis, you can find out which of them caused the change in ROE. Asset turnover is the amount of sales made per dollar of total assets. Higher asset turnover means higher sales made per dollar of asset. Despite constant ROEs, higher asset turnover and lower net profit margin, accompanied by the same equity multiplier shows that the company is implementing a different business strategy by sacrificing profit margin for higher sales volume.

 

 

Gadang Holdings Bhd

 

Gadang is principally engaged in civil engineering and construction, property development, water supply, mechanical and electrical engineering services and oil palm plantation. Construction segment made up of 71% of total sales in 2016. By this, one should know that Gadang is very cyclical in nature due to its construction business.

 

However, if you examine its revenues and profits for the past 5 years, you would notice that they were increasing consistently. You might ask why did I say Gadang is cyclical?

 

 

 

Take a look at Gadang's performance in the latest 1Q2017:

 

 

 

Source: Bursa Malaysia

 

First quarter's construction sales fell 60% q-o-q! I was surprised that it was able to maintain its first quarter's construction profit before tax. The company said it was due to higher margin projects but I think it was due to the nature of accounting reporting manner.

 

Despite selling at a PE of below 10, the share price fell 30% in a month's time because it could not meet the investors' expectation of making higher profits. This is a typical case of the cheap gets cheaper. 

 

So what's the lesson, despite increasing sales and profits for the past 5 years, these are not valid reasons to believe that Gadang is not cyclical in nature. The more important factor is the underlying business model, the qualitative factors. Good operating history does not repeat itself in this case.

 

 

 

 

 

Besides, the increasing ROE was due to higher debts and higher profit margins. Based on its financial reports, I think interest expenses are manageable for Gadang. However, due to its involvement in construction and property, I avoid investing in this business because the profitability can be very volatile.

 

At VGrowth Capital, this is exactly why I always avoid investing in cyclical companies and we are not the shareholder of Gadang despite its low PE and good past 5 years performance. Its cyclical business nature is the main reason why we avoided investing. I am neutral and under-researched on other sides of Gadang.

 

Conclusion

 

Low PE of below 10 and good 5 years ROE should not be treated as a conclusion to buy a company. Many investors bought Gadang when it was selling at a PE of 8.88 when the share price was RM1.30. Besides, they noticed the ROE was improving. Thus, many rushed in to buy with the expectation that the past performance will repeat itself.

 

Again, I am not saying that Gadang is a bad company. I just think it is involved in construction business which is very cyclical in nature and investors, especially value growth ones, need to think twice before putting your money in.