Yesterday I covered the KKR (KKR) report that gave the company's outlook for 2016. In it the strategists mentioned that rising return-on-equity (ROE) stories were one of their few favored spots in the public equity markets right now.
I set up some screens to look for companies that had rising returns on equity and the results were pretty interesting. I looked for companies that had sequential increases and year-over-year increases in return on equity and came up with a decent list of stocks. When looking at some of the companies, it became obvious that the qualitative factors were as important as the quantitative, and you really needed to dig deep to figure out the reason behind the ROE increase. There were more than a few instances where the ROE went up because of declining equity value and rising debt levels. That is not exactly what I want to see in stocks I own.
There were some useful observations that we can employ to make money. For example, the most widely represented group was small regional and community banks. As they have moved through the credit cycle and conditions have improved, so have returns. They are still a long way from pre-crisis highs, but they are getting better for the small banks pretty much every quarter.
Those that are not taken over should see two more bumps in ROE over the next few years. Those little banks that reach $1 billion or so in assets will see an increase as they achieve the type of scale needed to spread regulatory and technology costs over a sufficient asset base. There will be another bump when they get above $3 billion or so in assets and have the asset base to allow them to expand their offerings and compete more efficiently in the marketplace. They then have a long runway to continue growing until they run into the $10 billion level and face the fee reductions imposed by the Durbin Amendment and increased regulatory scrutiny and costs.
Another group that is well represented is equity REITs. Conditions in many markets around the country are improving and occupancy rates and rents are rising for many of these property-owning REITs. Some of my favorite buys right now are Stratus Properties (STRS), Silver Bay Realty (SBY), BRT Realty (BRT) and Wheeler REIT (WHLR). I will mention that based on the pro-forma numbers, Colony Starwood Homes (SFR) should also make the cut.
Aerospace and defense are well represented on the list, and two of my current favorites are showing ROE improvement. Kratos Defense & Security (KTOS) is one of my favorite long-term picks and it should see huge benefits from the changing face of warfare and the work on things like drones, cyberwarfare and critical infrastructure defense. CPI Aerostructures (CVU) makes structural aircraft parts for fixed-wing aircraft and helicopters in the commercial and defense aerospace markets. They do a lot of business with the military and also have been focusing on growing the commercial side of the business. Both pretty much have to be considered as possible takeover candidates in the years ahead as consolidation of the industry continues.
There are not may publicly traded water utility companies, but most of them are showing ROE improvements. Water is one of my favorite long-term trends (as well as one of the themes recently mentioned by Michael Burry of The Big Short fame) and water utilities are well represented not only here but on my "buy a bunch in a crash" list.
Being me, I had to try to invert the criteria and look for areas where ROE is shrinking sequentially as well as year over year to see which sectors might struggle in 2016. It will come as no surprise that oil- and gas-related companies dominate the list. Mining companies are also well represented on the list of industries struggling for profits this year. Commodity prices have collapsed and it's hard to improve returns when the price of your core product is collapsing.
High-end and organic grocers Whole Foods (WFM), Sprouts (SFM) and United Natural Foods (UNFI) made the list of companies with falling ROEs as well. I am not one to speak about high-end grocers, as I am more likely to be caught dining on Campbell Soup (CPB) and a peanut butter sandwich on Wonder bread than an organic, free-range, wireless chicken sandwich with sprouts and hand-raised baby lettuce sprinkles served on some type of bread I have never heard of, but consumers do not seem to be as willing to pay up for foodstuffs as they were a few years ago.
Looking for rising and falling ROEs has some limitations as a stock-picking tool, but searching by sector to spot pockets of opportunity and potential danger seems to be a useful exercise.