Watch Return on Equity Closely

 | Apr 16, 2013 | 3:00 PM EDT
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Let me begin with a silly question: why invest in stocks? The trained answer is "to make money." Fair enough, making money is one thing; actually doing it is another. The way to make money in stocks is to pick businesses that deliver positive returns. Businesses deliver positive returns when they, too, invest successfully and earn attractive returns on invested capital and return on equity.

The math is glaring simple: a company has $100 of equity capital and uses that capital to earn $15 in profit. Return on equity capital is 15%. If the valuation ratios remain the same, then the stock price will deliver a 15% return. Over time continued attractive return on equity should continue to deliver an attractive return on the stock price. We know that leverage amplifies return on equity during good times.

If the company above uses $60 debt and $40 equity to earn $13, return on equity skyrockets to nearly 30%. (You should assume $2 worth of interest expense.) Yet leverage can be equally as destructive as it is helpful. For most investors, focusing on businesses that attain attractive returns on unlevered (or the use of modest leverage) equity is likely to deliver attractive results over the long run.

I've tracked down some businesses with attractive returns on equity that use little or no debt. I've also tried to focus on names with stronger growth prospects since it becomes increasingly difficult to reinvest billions of dollars. Microsoft (MSFT) earns an unlevered return on equity of over 30% but it does that with a very small portion of its capital, which is why Softy is now paying out a hefty dividend.

PetMeds Express (PETS), the online pet pharmacy company, makes the cut with a market cap of $240 million, no debt, over $40 million in cash and a return on equity of over 20%. While PetMeds continues to find ways to grow -- the stock price has been in a tight range -- the company is returning cash to shareholders a rate of nearly 5% a year via dividends. Shares trade for $12.30. An entry price of $10 to $11 would not be a bad idea.

Mattress maker Select Comfort (SCSS) shares are trading near a 52 low at $18, off from $36. Market cap is $1 billion, no debt and over $100 million in cash. Current return on equity is north of 45% but has averaged around 30% historically. SCSS has had its ups and downs -- at the height of the financial crisis, the shares traded for as low as 20 cents before heading up to $36! It may not be a steal at $17, but it's a clean business with very high returns on equity. Keep an eye on it.

Babock and Wilcox (BWC) is a specialty construction company that focuses on nuclear power and other power generation activities. The company has been around since 1867 and has a market cap of $3 billion. The company began trading in 2010. BWC has no debt and returns on equity of 20%. The power generation segment, which accounts for over 54% of revenues, is slowing but the nuclear business seems to be holding strong. BWC operates in an attractive industry given the long-term need for better, cheaper, and cleaner domestic energy uses in the US.

Return on equity can be a powerful creator of value if analyzed appropriately. To have a return on equity, a company must show profits. So that's the first step -- understanding whether a company can generate future profits, namely future growing profits. Often, the focus is on price/earnings multiples, which can be misleading when you don't pull back the layers and analyze profitability measures like return on equity.

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