Return On Assets Is The Hit By Pitch Of Investing

Summary: Despite all appearances to the contrary, this is a post 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?

Despite all appearances to the contrary, this is a post 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 blog 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 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.