I recently updated my Return on Equity backtest. One of the suggestions I received was to test the 5-year average return on equity. I decided to test that out and compare it to the trailing twelve-month return on equity ratio backtest performance.

I used the data and backtesting tool provided by Portfolio123. The Portfolio123 backtesting eliminates the problem of survivorship bias by using point-in-time and retaining data on stocks that have gone to zero. This backtest uses the same filtered universe of stocks as my recent Price to Sales Ratio Backtest. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:

No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges. No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count. Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested. Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company. Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks. ROE 5-Year Average != NA. This filter insures we are looking at stocks that actually have valid data for the 5-year average Return on Equity ratio.

After these filters are applied, we are left with approximately 2,500 to 3,300 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing 5-Year Average Return on Equity. The lowest 20 percent of stocks ranked by 5-year average return on equity are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following 5 charts display the quintile returns for 5-yr. average ROE in red and the S&P 500 Equal Weight Index in blue. The first quintile includes the companies that had the lowest 5-year average ROE and the 5th quintile includes the companies that had the highest 5-year average ROE.

Return on Equity 5-Year Average Quintile Returns – 2000 – 2014

Summary of Results for the 5-Year Average Return on Equity Backtest

The results for my backtest of the 5-Year Average Return on Equity is quite different than the previous trailing twelve-month ROE results. While the first quintile produced the lowest returns, the 2nd quintile produce the highest returns and then returns declined for each higher quintile in a linear fashion. This is not the type of pattern you want to see in a metric you use for fundamental analysis, unless it is combined with other factors. I was not really expecting this outcome.

It appears that positive single-digit returns on equity averaged over five years, outperforms higher long-term average ROE stocks when held for one-year. Maybe those steady slow growing tortoise like stocks are really the way to go. However, I wouldn’t really look to deeply into these results. What are your thoughts on these unexpected results?