Return on Assets is the Hit by Pitch of Investing
Despite all appearances to the contrary, this is an article
about investing - not baseball. So, to those of you who love
reading about investing but hate reading about baseball: don't
be deterred. It's worth reading all the way through.
Return on assets is the hit by pitch of investing. Common sense
suggests it isn't a very important measure. Why would any
investor care about return on assets when return on equity and
return on capital tell you so much more?
You don't have to know a lot about baseball to know that the
number of times a batter is hit by a pitch shouldn't tell you
much about his value to the team. After all, getting hit by a
pitch is a fairly rare occurrence. Even if some players are
truly talented when it comes to getting plunked, they still
won't get hit enough to make a huge difference, right?
That's true. In and of itself, the act of getting hit by a pitch
is not particularly productive. But (and here's where things get
interesting), as a general rule, a simple screen for the batters
who get hit most often will yield a list of good, underrated
players.
Why? The most likely explanation is that a HBP screen returns a
list of players who are similar in other, more important ways.
Perhaps batters who get hit more often also tend to walk,
double, homer, and fly out more often - while grounding into
double plays less often. Even a casual baseball fan might
suspect this.
Since this article is about investing rather than baseball,
there's no reason for me to discuss whether such a correlation
really does exist. I'll just provide a list of the top ten
active leaders for HBP: Craig Biggio, Jason Kendall, Fernando
Vina, Carlos Delgado, Larry Walker, Jeff Bagwell, Gary
Sheffield, Damion Easley, Jason Giambi, and Jeff Kent.
After the top ten, the list is no less impressive. #11 - 15 are:
Derek Jeter, Luis Gonzalez, Alex Rodriguez, Matt Lawton, and
Barry Bonds. Since this list is based on career totals for
active players, it's biased towards players who remain in the
majors and who get a lot of plate appearances.
That fact alone means the guys on this list are likely going to
be above average players. However, even if you look at the
single season HBP list, which includes a few young players
(e.g., Jonny Gomes), the guys with high HBP totals still tend to
be extraordinarily productive offensively. Simply put, screening
for HBP tends to return a much higher number of "bargain"
batters than you'd expect.
One explanation for this is that the good things players with
high HBP totals do tend to be less conspicuous than the good
things other players tend to do.
Might there be a parallel in the world of investing? You bet.
So, again I say -
Return on assets is the hit by pitch of investing.
Return on assets is a good screen for high - quality, low -
profile businesses. A high return on equity does not go
unnoticed for long. Sometimes, a high return on assets does.
Jakks Pacific (JAKK) is one good example of a high ROA stock.
Its returns have basically been what you'd expect from a toy
company. That may not sound like great news to owners of Jakks;
but, it is.
Jakks sells at a price - to - earnings ratio of about 12 and a
price - to - sales ratio of about 1. The company has grown
quickly. Over the past five years, revenue has grown at an
annual rate of about 25%. Shareholders haven't enjoyed the full
benefits of that growth, because of share dilution - but, that's
something best left to a longer discussion of Jakks. The point
here is simple.
Jakks may not be anything special as a toy company, but it is a
toy company. Jakks' past return on assets proves that simply
being a toy company is something special. Jakks' "normal" ROA of
around 5 - 12% may be nothing extraordinary in the toy business;
but, it is far more than what most businesses earn. If there
will be any future growth at Jakks, the current P/E of 12 will
be shown to have been utterly ridiculous.
If you screen for high returns on equity, you might have missed
Jakks. But, if you screen for high returns on assets, you'd have
caught this apparent bargain. By the way, I believe Joel
Greenblatt's magic formula would have lead you to Jakks as well.
Village Supermarket (VLGEA) is another stock I've that has often
earned a good return on assets, but has failed to ever earn a
high enough return on equity to get much attention. This
business is not as cheap as it once was; but, it isn't exactly
expensive at these prices either. For at least five years now,
Village has looked quite clearly like it should be valued as a
mediocre business. That's saying something, because the market
has continually valued VLGEA as a sub - par business; which it
isn't.
In 2000, you could have bought VLGEA at a 50% discount to book
value. In 2001, the average buyer still obtained shares at a
greater than 25% discount to book value. By then, anyone who had
been monitoring Village's return on assets for the previous five
years would have known the stock was cheap.
For the last ten years, Village's return on equity has been
nothing more than average; however, the performance of the stock
has been anything but average. An investor with one eye on
Village's price - to - book ratio and the other eye on Village's
return on assets would have enjoyed the decade long climb
without breaking a sweat.
Another one of my favorite high ROA stocks is CEC Entertainment
(CEC) - better known as Chuck E. Cheese. Recently, the stock has
earned a good return on equity. However, a simple screen based
on ROE would have brought a lot of less than wonderful
businesses to your attention along with Chuck E. Cheese.
Return on assets told a different story. Chuck E. Cheese has
consistently earned an extraordinary return on assets for the
last decade.
Now, it's true that Chuck E. Cheese has earned a very nice
return on equity as well. But, if you're an investor who knows
what normal ROA numbers look like, one look at CEC's return on
assets will blow you away.
Debt can play the role of the fairy godmother. So, an investor
needs to look beyond the veil of current performance. Return on
assets can often provide a glimpse of what the stroke of
midnight will bring. ROA is just one piece of the puzzle. But,
it's an important piece nonetheless.
A high return on assets doesn't guarantee quality. However, I've
found that Mr. Market has usually offered many more small,
growing companies with extraordinary returns on assets than he
has offered small, growing companies with extraordinary returns
on equity.
Therefore, just as a general manager might want to run a quick
screen for a high HBP number, you may want to run a quick screen
for a high ROA number. I know it's not supposed to be the best
indicator of a bargain. But, in my experience, it tends to turn
up a lot of neat ideas.
Obviously, a high return on equity is important. I'm not saying
it isn't. I'm just saying a high return on assets is more
important than you think.