Go for the ROE

 | Dec 10, 2012 | 4:00 PM EST
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We are in full pre-Holiday mode at Chez Melvin. This primarily consists of my wife running around decorating everything that moves, so I move around a lot lest I become light-adorned. Meanwhile, I caught up with friends around the country and had one conversation with a reader who mentioned one of my favorite undiscovered growth stocks, C&J Energy Services (CJES). It is not often, he pointed out, that you find a stock with a return on equity north of 40% trading at a single-digit earnings multiple.

I took that as a challenge. Return on equity has been shown by many investors form Phil Fischer to Aswath Damodaran to be one of the more important metrics of corporate valuation. If we can buy high ROEs on sale, we should have a good chance to earn outsized profits. I sat down this morning and ran a simple high ROE, low price-to-earnings ratio screen to see what I could find.

The first thing I noticed is that this can be a dangerous model to use blindly. Many of the not-for-profit education stocks are on the list and, at first glance, qualify for a purchase. But a little additional research shows that the ROE for most of the companies has been dropping steadily. The ROE for Apollo Group (APOL), for example, peaked in 2006 and has been lower every year since. I really do not want to buy into a company where returns are declining. When looking at these types of companies, take the time to determine the trend of the return on equity. Stable works well and rising is best, but declining is to be avoided at all costs.

Back to C&J Energy Services, 80% of this company's revenues are derived from its fracking-services business, and that has kept a lid on the stock price. All of the chatter about the dangers of fracking and political posturing about green energy leads many to avoid the stock. Here is the simple truth: We may see some politicking around fracking and the environmentalists may make noise, but fracking is here to stay. It is simply too important to the economy. Cheap natural gas is now critical to the U.S. economy. Drilling in natural gas fields will begin to increase once again and C&J will see more than its share of the resulting business. This has the potential to be one of the great growth stocks of the next five years.

Another intriguing company on the list of high-earning cheap stocks is Coleman Cable (CCIX). This company doesn't make any sexy or exciting products, but its products are used every day by industry, consumers and just about every person in the country. Coleman makes cables for industrial uses, extension cords, holiday displays, light timers, and a host of other wire and cable products. The company is highly levered but generates more than enough cash flow to cover interest payments and to meet capex and production needs. It has made several smart acquisitions over the past fewer years that has expanded its product lines and offered entry into new markets. With a debt-to-equity ratio above 7, this is basically a stub stock with the potential to act like a highly profitable leveraged buyout with huge returns over the next decade.

ACCO Brands (ACCO) is another company whose product offerings are not particularly exciting but they are necessary. The company makes basic office supplies likes staplers, document shredders, accounting tools, planners and computer accessories. The company recently completed the purchase of the office products division of MeadWestvaco (MWV) and this has strengthened its market presence. The company is using cash flow to pay down debt, and it recently released expectations above analyst estimates. The basic business may not be exciting but the combination of low valuations and high returns on equity capital could lead to stunning long-term returns for patient investors.

This is a simple but potentially effective screen for growth and value investors alike. Be careful to do the homework after you run the screen and avoid those companies with declining returns. Focus on those where sustained high returns can lead to a return of multiples, not percentages.

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