From the smallest to largest company, profitability is the great leveller when assessing management effectiveness. Quite simply it is not how much profit a company makes, but what profit represents as a return on total assets (ROA) and on shareholders' equity (ROE) that are critical.
But sweeping conclusions cannot be drawn from the tables compiled for the FM by McGregor BFA. Buying Servest for its 3 863% ROE without examining the company's fundamentals would be unwise.
It is also important to bear in mind the basis of calculations. ROE and ROA are calculated exclusive of intangible assets and goodwill, while taxed profit attributable to shareholders includes nontrading items such as abnormal losses and profits and nonrecurring costs. For example, Servest's ROE was enhanced by the exclusion of R301m of intangible assets, equal to 94% of shareholders' funds.
Investors should check ultra-high ROEs relative to those obtained using different methods. The most common is headline earnings as a percentage of total assets including intangible assets. This can make a big difference, even in multibillion-rand companies.
In Richemont's case an 84,6% ROE in financial 2001 came with a big helping hand from the exclusion of goodwill and the inclusion of exceptional items. Goodwill of à6,04bn represented 77% of unit holders' funds. Exceptional gains on the disposal of BAT preference shares and sale of an investment in Vivendi added à722m to profits.
If goodwill is included and exceptional profits excluded, Richemont's attributable profit of à968m on an adjusted basis, as reported, reflects a far lower ROE of 12,5%.
Similarly, the ultra-high ROEs of companies that followed aggressive acquisition strategies in recent years should be treated with caution. Many of these companies, particularly in the IT sector, paid big premiums for intangible assets which were subsequently written off.
Spescom, for example, boasts a 968% ROE. But if intangible assets of R72m (84% of shareholders' funds) are included, ROE in the year to September 2001 falls to 26%. Adding back R245m intangible assets written off in financial 2000 reduces ROE to a humble 7,2%.
ROA levels should be viewed as industry-specific indications of a company's achievements. Banks, which have high asset levels and work on low lending margins, will tend to have low ROAs. SA's big four banks, Standard, Absa, FirstRand and Nedcor, for example, produced an average 8,0% ROA in the review period. But at the ROE level an average 25,5% return, up from the previous period's 23,0%, was more than acceptable by global standards.
Consistency of returns is also an important reason for the popularity of leading banking shares in institutional portfolios.
Similarly, high-volume, low-margin retailers Pick 'n Pay and Massmart had ROAs of 9,2% and 6,6% respectively. But their ROEs, where profitability counts most, were 28,3% and 43,3% respectively.
Consistency of returns is often more important than absolute returns. A company that produces a phenomenal ROE one year but slumps into oblivion the next is unacceptable. Many examples were produced by the 1998-1999 boom in growth-share listings and the frenetic acquisition strategies of companies exploiting their overpriced shares.
Software developer FrontRange, formerly Ixchange, is typical of these. Previously credited with a 67,8% ROE, it now has a negative 37,3%. And SetPoint Technologies' ROE has fallen from 218,4% in 2000 to a negative 746%.
Generally, ROEs much above 40% should be examined carefully, particularly with regard to sustainability. Mining companies, for example, can achieve high ROEs during periods of rising commodity prices. Here a notable entry into the super-profitability league is Anglo American Platinum, with an ROE of 63,7%, double the previous year's level.
Sustaining this ROE level in the face of a volatile platinum price is another issue (see page 145 ). But certain industrial companies do keep up above-average profitability.
One of few companies regularly among the top ROE generators is Spur Corp. By the nature of its business, franchising of restaurants, Spur's asset base is relatively small and revenues are stable. This has enabled Spur to deliver an average ROE of 70,7% over the past five years.
Top honours for a major industrial group generating consistently above-average ROE go to electronics and electrical group Reunert, thanks to a restructuring programme initiated by CEO Bull Pretorius four years ago. Restructuring focused on eliminating low-profitability operations and enhancing overall financial efficiencies, particularly in working capital management.
The results show in Reunert's average 45,9% ROE over the past three years, with a variation from 50,6% in financial 1999 to 43,5% in 2001. In the latter year, calculated on a headline profit basis and including intangibles, ROE was still an impressive 37,1%.
Altech, which targeted Reunert in an unsuccessful takeover bid three years ago, has not achieved similar returns. But a 26,4% three-year average and the 35,8% it achieved in 2001 are admirable.
High returns with consistency from companies such as Spur, Reunert and Altech are particularly attractive during periods of uncertainty. But such companies are scarce. One that demands inclusion in their ranks is Pick 'n Pay, with a five-year average 28,5% ROE achieved with negligible variation from year to year.
Similarly low ROE variation levels over five years were achieved by packaging group Bowler Metcalf (25,3% ROE), Delta Electrical (29,5%) and Chemical Services (32,3%).
Another trend to watch for is a steadily rising ROE. Bidvest is an example, with ROE rising steadily from 14,5% to 30,6% over five years. Others are Sasol (from 10,1% to 24,8%), New Clicks (19,3% to 24,6%), Afrox (18,2% to 22,4%), Ceramic Industries (15,7% to 29,2%) and PPC (16,0% to 21,8%).
In establishing an ROE benchmark, it's helpful to look at well-managed companies that generate consistent levels of profitability and have low levels of intangible assets and insignificant nonrecurring profit and cost items.
Over five years, this approach indicates that an ROE of 20%-25% can be regarded as a fair benchmark. Using the 20% level shows 61% of listed companies performing below standard and some market favourites being unexpectedly weak.
Interesting examples include Imperial Group, with an uninspiring 18,9% ROE and poor 14,2% five-year average. Packaging group Nampak has battled to maintain the 20% level and its five-year average now stands at 18,9%. Aggressive restructuring by Nampak's management appears to be aimed at rectifying this situation. In the same sector and with an even bigger challenge ahead is Malbak, with a 12,7% five-year average ROE.
Most retailers dependent on discretionary consumer spending have lost profitability sharply over the past five years. Edcon's ROE is down from 18,1% to 7,9%, Ellerine's down from 19,8% to 17,3%, Woolies' from 19,9% to 11,2% and JD Group's from 17,4% to 10,5%.
At Netcare, Afrox Health and Medi-Clinic, average ROEs have risen from 13,5% to 19,7% over three years. Just how sustainable this is, remains to be seen. Private health care is coming under the spot light in medical aid's battle to fight medical inflation.