Stock picking is an art and a science. The art of stock picking relies on the skill to choose the right stock at the right time. It’s possible to do this in a more consistent manner through the technical analysis of a stock chart. The science in stock picking is in analyzing the fundamental picture of a company in an effort to forecast future performance. The good balance between art and science breeds the most successful investments.
One easy-to-use and underutilized metric for making wise investment decisions is return on equity (ROE). This metric can tell investors whether a company is a cash creator or a cash destroyer relative to its competitors. The ROE measures a company’s profitability by determining how much profit is being generated from the money invested by shareholders. So knowing this figure enables investors to compare multiple stocks and isolate the most profitable companies of an industry.
#-ad_banner-#In its most simple form, the ROE is determined by dividing a company’s annual earnings by the average shareholder equity, also known as book value (ROE = annual earnings/shareholder equity). There are several financial websites where you can easily find these figures.
And when investors can find companies that have a high ROE and low debt, then they’ve got a great investment opportunity awaiting.
Here are two stocks with a high ROE and low debt that are strong candidates as profitable portfolio holdings.
1. Telecom Argentina (NYSE: TEO)
An ROE close to 33% and a very small debt load (133 million Argentinian pesos in debt vs. 2 billion Argentinian pesos in cash) make this stock very appealing. In fact, the debt-to-equity ratio has been dropping this year and is now at 0.02, compared to industry stalwarts such as AT&T (NYSE: T) and Verizon (NYSE: V), which sport debt-to-equity ratios of 0.63 and 0.57 respectively. The fact that this leading Argentinean telecom offers a 9% dividend yield and has registered a 37% earnings growth in the past five years, makes this a true income-generating machine.
Despite these good figures, shares were hammered down by nearly 24% between August and November. The problem wasn’t really the stock, but the country — Argentina. Investors are fearful the company will be nationalized by the Argentinean government, which is teetering on a debt default.
As you can see from the chart below, the share price has bounced from the November lows, hitting resistance at $11. This price action sets up a classic breakout trade. Buy the stock on the first daily close above $11, with this number becoming the initial stop level. My target price on this stock is $24 sometime during the next 18 months, barring any aggressive government intervention.
2. Ross Stores (Nasdaq: ROST)
This discount retailer’s ROE of nearly 47% makes it better than 92% of its competitors in the apparel industry. The company reported better-than-expected same-store sales in November, with a 2% gain compared with the previous month. Total sales ramped up 6% for the month of November 2012 to $813 million compared to $765 million in November 2011.
With the holiday season upon us, management has projected monthly same-store sales to increase 2-3% in December and 1-2% in January. Ross Stores has boosted steady gross profits by 27% and operating income by 11% since 2009. In addition, its price-to-earnings-ratio (P/E) of 16.7 compared with the sector average of 18 paints a compelling picture for additional growth. In 2011, revenue pushed above $8 billion, making this discount retailer a true player in the sector.
After posting a strong uptrend in 2012, shares have been selling off since August. Plunging nearly 20 points to just above $50 has set up a technical value “buy” opportunity. Buying in the channel between $51 and $55 with a stop at $49 makes sense right now. I would not be surprised to see this stock return to near $70 within the next 12 months.
Risks to Consider: While the ROE can be a powerful stock-screening tool, it shouldn’t be used by itself. There are factors such as share buybacks and increasing corporate debt that can result in a high ROE, yet poor stock performance. So don’t invest based solely on a strong ROE number without taking the entire company’s picture into consideration.
Action to Take –> I like the technical and fundamental picture of both companies right now. I think Argentina will work out its debt issues without additional meddling in Telecom Argentina, although anything can happen. Ross Stores’ improving metrics should only get better as consumers feel more confident to spend this holiday season. If you apply the science of stock picking and the art of chart reading, then Telecom Argentina as a breakout trade and Ross Stores as a pullback value investment make sense.
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