A great way to uncover Compounders, which are companies that are able to compound their earnings over time, is to screen stocks using Return on Equity (“ROE”) as a filter. However, this filter isn’t perfect and therefore, some stocks that should hit the screen actually don’t. The reason is straight forward: ROE is impacted by the amount of cash and marketable securities held in the company and not paid out to shareholders through either dividends or share buy-backs.
Alphabet (Google) is a great example of this phenomenon. Largely due to the massive success of their internet search business, Alphabet has managed to generate vast cash reserves, $102B as of December 2017, of which $11B was cash and equivalents and $91B was invested in short-term marketable securities. Since Alphabet does not pay a dividend or have a share buy-back program, all of this vast liquidity remains included in Alphabet’s ROE denominator, which as calculated has been around 15%. Once short-term marketable securities are removed, Alphabet’s ROE effectively doubles to around 30%. This is a very important implication to understand when running ROE equity screens. You don’t want to miss out on potential opportunities due to the fact that some highly successful companies hold too much cash!