In the world of investing, conventional wisdom often tells us to chase high return-on-equity (ROE) businesses. Investors are naturally drawn to companies that boast impressive profit margins and efficient capital allocation.
However, as legendary value investor David Einhorn highlighted in his 2006 speech at the Value Investing Congress, there’s a compelling case to be made for focusing on the underdogs—capital-intensive businesses with low ROEs that have room to improve.
“Coming back to my main theme, I believe it is very important to analyze ROE and marginal returns on capital—but only in capital-intensive businesses,” Einhorn stated.
His perspective challenges the common investor bias against low-ROE companies. Instead of dismissing these businesses as inefficient, he argues that they often present the greatest opportunity for growth.
Einhorn further explains, “The problem with high ROEs in capital-intensive businesses is that it is hard to sustain the ROEs. Here, high returns attract competition both from new entrants that come with new capital and existing competitors that try to see what the better-performing competitor is doing to copy it.”
This cycle of competition can be devastating. When a 25% ROE business is forced to lower its margins due to increased competition, its profitability can quickly dwindle. “Really bad things happen to earnings when a 25% ROE turns into a 10% ROE,” he warns.
On the flip side, the magic happens when a struggling company manages to turn things around. “Great things happen to earnings when a 10% ROE becomes a 15% ROE,” Einhorn explains.
This shift can occur in three primary ways: improving asset turnover, increasing profit margins, or utilizing financial leverage more effectively. Investors who can identify businesses with multiple levers for ROE expansion stand to benefit significantly.
The takeaway? Investors should rethink their aversion to capital-intensive businesses with modest returns.
Companies in this category may not be market darlings today, but if they have the right conditions for improvement, they can deliver outsized returns in the future.
The challenge lies in identifying the right opportunities—those businesses with untapped potential, operational improvements on the horizon, or strategic financial maneuvers that will enhance returns.
As value investors, we must be willing to look beyond the obvious winners. Sometimes, the most lucrative opportunities lie where others aren’t looking—among the low-ROE businesses poised for transformation.
You can find a transcript of the speech here:
David Einhorn Speech – Value Investing Congress 2006 (Graham & Doddsville)
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