Can Smith & Nephew's high return on equity take it to the next level?

What do you think is the main role of a company’s senior management team? Long-term business strategy? Earnings growth? Or even just making sure the wheels don’t fall off?

Top analysts and investors such as Warren Buffett and Michael Mauboussin say it is capital allocation - the deployment of company time, money, ideas, and people in ways that create additional value. It is perhaps the most fundamental driver of future share price performance. If you find a company that consistently allocates its capital profitably, chances are you are onto a long-term winner.

Unfortunately, CEOs are not generally promoted based on their ability to allocate capital, even though this is what they then go on to spend time doing.

As Mauboussin writes in one of his research papers:

“Capital allocation is one of management’s prime responsibilities. Yet few senior executives are versed or trained in methods to allocate capital most effectively. Further, incentive programs frequently encourage behaviors that are not in the best interests of long-term shareholders.”

So if you’re only looking at sales and earnings growth, there is a vital question not being considered: how is this growth being funded?

Screening for upwardly mobile, high quality companies

That’s where ratios like return on equity (ROE) come in. ROE measures how efficiently a company uses Shareholders’ Equity to generate profits. It is calculated by dividing net income by book value of equity.

It’s no coincidence that Buffett is a fan of the measure - companies with high ROEs tend to exhibit the high-quality, moat-like business traits that he is so fond of gaining exposure to.

What we want to find are high ROE stocks whose fantastic business models are being rewarded by the market. One way to do this might be to screen for stocks with both positive one-year relative strength and upgraded current year broker forecasts. The former ensures these shares have been outperforming the market and the latter suggests outperformance can continue.

One of the stocks that currently qualifies for this simple screen is

Smith & Nephew (LON:SN.). The group has:

• A trailing twelve month return on equity of 14.5%
• An average current year EPS forecast upgrade of 0.40% from brokers, and
• A one-year relative strength of 34.2%
  

Stocks exhibiting these traits are typically a solid mix of quality and momentum. We can see this using the StockRanks: Smith & Nephew has a Quality Rank of 80 and a Momentum Rank of 98.

What does this mean for potential investors?

Some of the best quality stocks in the market have defensible models that can deliver high levels of shareholder returns over the long term. But there are no guarantees and it's important to do your own research. Indeed, we've identified some areas of concern with Smith & Nephew that you can find out about here.