Super stock returns: ROE/PTB vs ROE vs PTB (Part 1)

The following article is a good read for all Fundamental Analysts out there!

By TEH HOOI LING SENIOR CORRESPONDENT (Source: Business Times)

LAST week's article - In Search Of Super Returns In Stocks - struck a chord with readers and investors out there, judging by the number of emails I received.
For those who missed it, basically I screened all the stocks listed on the Singapore Exchange from 1990 until 2006 based on their return on equity and price-to-book ratio.
I then grouped the stocks into 10 portfolios with equal numbers of stocks, starting from those with the highest ratio when we divided ROE by price-to-book, to the lowest. This screening process can help us identify some mispriced stocks.

A company that is able to generate a high return on equity - one that exceeds its cost of equity - should trade at a higher price than the book value of its equity. And vice versa. But if a company generates a relatively high ROE, yet is trading at a relatively low price-to-book ratio (PTB), careful analysis is warranted.

There could be legitimate reasons for the low valuation. For example, the earnings were due to exceptional items. If not, the stock may be under-priced.
But without any detailed analysis other than simply grouping stocks based on ROE/PTB, I found that investors can actually generate super returns.

By investing in the 10 per cent of stocks with the highest ROE/PTB every year between 1990 and 2006, and holding each portfolio for a year, one could have turned $100 into $34,000 over the past 17 years. That's a compounded return of 41 per cent a year. All the calculations exclude transaction costs.

If we assume that the investor had lost 10 per cent of the portfolio value to transaction costs every year, the return is still a respectable 27 per cent a year. But in absolute terms the portfolio value today, at $5,678, is significantly less than the $34,000 which excludes transaction costs.

From the above, we can see that ROE/PTB is a good screening tool.