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Stock Screen: High Returns Earned on Equity - February 22, 2012
One quick way to cut through the large number of investments available is to review returns on equity. Value Line calculates this number, which appears in the Statistical Array on every research report, by dividing net profits by shareholders’ equity (equity, or net worth, itself, is equal to the difference between total assets and total liabilities). The general idea of the measure is to see how much a company earns on the money it has been given by equity (including preferred equity) investors.
Return on equity is best used as a starting point and a comparison tool. Some industries will never show up on a screen of this nature, others will have many representatives. Thus, comparisons between companies in the same industry will provide more insight than comparisons between companies in different industries.
To create our list, we computed the average percentage earned on shareholders’ equity by each company over the last year for which we have actual data, and set a floor for the measure at 30%. We narrowed the list down further by including only those stocks with above average (60%) projected long-term price appreciation potential. Out of this list, we highlighted two stocks that we believe may be of particular interest to investors.
Crown Holdings, Inc.
Crown Holdings, Inc. (CCK) designs, manufactures, and sells packaging products for consumer goods. The company supplies the beverage industry with cans for beer and soda. It produces packaging products for other industries, as well. For example, CCK manufactures three-piece aerosol cans for personal care, household, and industrial products. Furthermore, the company manufactures and sells can-making equipment. As of 12/31/11, Crown Holdings operated 135 plants in 41 countries.
Long-term growth prospects for Crown Holdings appear favorable. The company recently completed 2011 with a full-year earnings advance in the 25% range. Although the company has faced some soft business conditions of late, it has held up considerably well and is likely to continue doing so. In fact, the company has several growth platforms which should fuel investor enthusiasm.
Shareholders ought to especially benefit from the company’s intensified investments in emerging markets. In particular, capital projects in countries such as Brazil and China, will likely bear fruit further down the road. We anticipate that heightened investments in these high-growth regions will help mitigate ongoing weakness in traditional channels, such as North America. Also, the company is investing to expand the product portfolio. At year end, it had added six new beverage-can lines and two new beverage-can plants.
CCK appears to be in a position to record solid returns on equity and good 3- to 5-year appreciation potential, and, hence, may be of interest to patient investors.
Avon Products Inc.
Avon Products (AVP) is the largest direct seller of beauty and related products in the world. The company manufactures and markets a host of cosmetics including make-up, fragrances, and skin care. In addition, it sells jewelry, apparel, footwear, lingerie, and home-decorative items. Its products are available in over 100 countries and are sold to customers directly by a vast 6.5 million independent sales representative team. In 2010, foreign operations accounted for 80% of sales and 90% of earnings.
Avon has certainly encountered its share of challenges over the past few years. In Brazil, AVP’s largest market, supply chain constraints have inhibited representatives’ ability to sell, which has hurt morale and caused representative churn. The company said the situation has stabilized, and we expect a focus on improved representative penetration of underserved regions to help the turnaround.
In the United States, Avon has recalibrated its product assortment which has stymied the average order decline. Focus on value-oriented beauty products is helping Avon regain market share. Still, a massive reorganization of the sales force into fewer, more targeted districts may cause lumpy sales going forward. On the other hand, it should lead to better-served client populations, like Hispanic and African-American, for example.
Late last year the company announced that it was splitting the role of chairman and CEO. Thirteen-year CEO Andrea Jung is relinquishing her role and moving to the chairman position. She assured investors that the yet-to-be determined CEO will have free reign to make sweeping changes to the organizational structure in order to improve cash generation and sales momentum.
Meanwhile, a new CFO, Kimberly Ross, is attacking problems that do not require the leadership of a new CEO. A head count reduction and less administrative spending should benefit near-term results; better forecasting and time to market are long-term goals. However, the negative impact of higher raw materials cost, foreign exchange losses, wage inflation, and restructuring may pressure profitability. Therefore, AVP is not planning for margin recovery this year. Elsewhere, the company verified that the quarterly dividend payment (currently yielding 4.8%) will remain intact for 2012.
Also, allegations that ex-employees in China and other emerging markets paid bribes to officials have taken a monetary toll, amounting to over $130 million in charges, thus far. These claims are being investigated by the company, a U.S. grand jury, and the SEC.
Although Avon clearly has near-term challenges ahead, the rock bottom valuation, strong brand name, and prospects for a recovery give this equity a favorable risk-and-reward scenario and limited downside risk, in our view. If new management is successful at executing a turnaround, investors should see strong returns on equity continuing over the coming three to five years. Still, the stock is NOT for the faint of heart, as it will likely be a bumpy road to recovery. Thus, less-aggressive investors should wait for more evidence of a turnaround before attempting to capitalize on this equity’s impressive recovery potential.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.