Colombia's Q2 GDP at 6.87%

Sep 21, 2007 - Colombia's economy grew nearly 7 percent in the second quarter of this year, aided by strong foreign investment and the financial, communications and transport sectors, the government said on Friday.

The Andean country's gross domestic product expanded 6.87 percent with illicit crops during the three-month period and 6.97 percent not including those figures, the DANE government statistics agency said in a statement.

The economy grew 8.11 percent in the first quarter of this year and 5.79 percent in the second quarter of last year.

"Domestic demand, which was worrying the central bank, has moderated, and that gives more arguments for the bank not to raise its interest rates today. The investment side is very strong," Bank of Bogota analyst Lorena Lizarazo said.

The central bank is due to decide on key interest rate policy later on Friday. Analysts expect the bank to keep the rate steady at 9.25 percent, according to a Reuters poll earlier this week.

Colombia is the world's top producer of cocaine, most of which is shipped to the United States and Europe. The government receives millions of dollars each year to help fight armed groups and eradicate coca used to manufacture cocaine.

Foreign investment is flowing into the country drawn by the improved security situation under President Alvaro Uribe. Aided by U.S. funds, Uribe has cracked down on leftist rebels fighting Latin America's oldest guerrilla insurgency.

Weekly Indicators - Sep 20

Sep 20th 2007
From The Economist print edition

The Federal Reserve cut its benchmark interest rate by half a percentage point, to 4.75%. The reduction came amid a further weakening in America's housing market. The National Association of Home Builders index of expected sales fell to a 16-year low. Housing starts fell 2.6% in August to their lowest level since June 1995.

Consumer prices in America fell by 0.1% in August, leaving them 2.0% higher than a year earlier. The core measure, which excludes food and energy, rose by 2.1% in the year to August, the lowest rate in 17 months.

China's central bank raised its one-year lending and deposit rates by 0.27 percentage points, to 7.29% and 3.87% respectively. The move followed the biggest rise in consumer prices in more than a decade.

The Bank of Japan's policy board voted to keep its benchmark interest rate unchanged at 0.5% on September 19th.

Consumer prices in Britain rose by 1.8% in the year to August, down from 1.9% in July and the lowest rate in over a year. There was a downward effect on inflation from falls in the cost of financial services, following new guidelines for home mortgage charges by Britain's financial regulator.

The euro area's trade surplus rose to €4.6 billion in July from €1.1 billion a year earlier.

Switzerland's central bank raised its three-month interest-rate target by a quarter of a percentage point, to 2.75%.

Euro Zone Current Account Surplus Declines In July

Sep 21, 2007 - The Euro zone current account surplus declined more than expected in July, official data showed Friday.

The European Central Bank, or ECB, revealed that the current account surplus declined to a seasonally adjusted 1.7 billion euros in July, from the 7.3 billion euros registered in June. The number for June was revised up from the 5.9 billion euros estimated earlier. Economists expected the surplus to decline to 3.5 billion euros in July. Surpluses in goods, services and income were partly offset by a deficit in current transfers in July.

The surplus in goods as well as service decreased in July. Trade in goods showed a surplus of 2.6 billion euros in July, down from the 7.9 billion euros in the previous month. Surplus in services declined to 3.0 billion euros from 4.6 billion euros. The shortfall in current transfers widened to 5.2 billion euros from the 5.0 billion euros deficit recorded in June. Meanwhile, the income account showed a surplus of 1.3 billion euros, reversing a deficit of 0.2 billion euros in the prior month.

In the financial account, combined direct and portfolio investment recorded net inflows of 37 billion euros in July, reflecting net purchases of euro area equity securities by non-residents. Within portfolio investment, net inflows in equity securities accounted for by net purchases of euro area equity securities by non-residents. Net outflows in debt instruments resulted mainly on account of net purchases of foreign bonds and notes by euro area residents. Other investment showed net inflows of 28 billion euros.

On an unadjusted basis, the surplus in current account amounted to 3.3 billion euros, smaller than a revised 12.6 billion euros posted in the previous month. The number for June was revised from 11.4 billion euros initially estimated.

During twelve months till July, combined direct and portfolio investment had cumulated net inflows of 188 billion euros compared to a net outflow of 43 billion euros a year ago.

Mexico Holds Rate on Signs of Slowing U.S. Growth

Sep 21, 2007 - Mexico's central bank kept its benchmark interest rate unchanged as a slowing economy in the U.S., the biggest destination for Mexican goods, eased pressure to control rising local food costs.

The five-member board held the benchmark rate at 7.25 percent, matching estimates from 23 of 24 economists surveyed by Bloomberg. The bank maintained a "restrictive bias" that has been in place since May, citing rising food prices and legislation that will introduce a fuel tax.

The U.S. Federal Reserve's cut in borrowing costs to forestall a recession increased concern that a slowdown there will erode Mexico's expansion. Lower U.S. interest rates also make Mexican assets more attractive, potentially strengthening the peso and easing inflation as imports become cheaper.

"The measures taken by the Fed may make it easier for the Bank of Mexico to stay put," said Omar Borla, a senior Latin America economist with Dresdner Kleinwort in New York, in a telephone interview. "The amount of the Fed cut also signals U.S. activity might be slowing more than expected, which would certainly have an impact on Mexico."

Mexico's peso extended gains after the central bank announcement, gaining 0.4 percent to 10.9473 per dollar at 10:14 a.m. New York time.

Future Increase

Mexico's Finance Ministry on Sept. 8 lowered its 2007 growth estimate to 3 percent from 3.3 percent, citing waning demand from the U.S., which buys about 80 percent of Mexico's exports.

A deceleration in the U.S. next year will trim demand for Mexican exports and restrain growth in Mexico to 3 percent even after legislators passed a tax bill aiming to spur economic growth, Shelly Shetty, senior director for sovereign ratings at Fitch Ratings, said yesterday in an interview.

While the bank had reasons to hold rates unchanged today, policy makers said today the inflation outlook has worsened. The bank said it will revise inflation forecasts for the next two years in its quarterly report to be published next month.

"Pressure from food prices has increased more than expected (particularly dairy and wheat)," the central bank said in its statement today. "What's more, we must assess the consequences of the recently approved tax reform."

Banco de Mexico may still have to raise rates again before year-end to reach the bank's inflation targets, said economists such as Borla, Banco UBS Pactual's Guillermo Aboumrad, JPMorgan Chase & Co.'s Alfredo Thorne and Morgan Stanley's Gray Newman.

Rising costs of food staples from tortillas to sugar have pushed inflation to above 4 percent, which policy makers define as the upper limit of their acceptable range, in eight of the past 12 months.

The central bank predicts inflation will fluctuate between 3.75 percent and 4.25 percent during the third quarter before falling to between 3.25 percent and 3.75 percent in the fourth.

Indian inflation falls to near five-year low

Sep 21, 2007 - India's annual inflation rate has fallen to a near five-year low, official data on Friday showed, but soaring global crude prices threaten to push the cost-of-living higher, economists said.

Inflation slowed to 3.32 per cent for the week ended Sept 8 from 3.52 for the previous week, according to the wholesale price index, India's closest watched cost-of-living monitor. It was the lowest level since December 2002.

But economists said they expected no early easing of interest rates which are riding at five-year highs amid worries that record oil prices could trigger a rise in state-set domestic fuel prices.

'You'd think rates would fall but I don't see the Reserve Bank doing that now with crude prices heading north and food prices hardening,' said HDFC chief economist Abheek Barua.

The drop in inflation was driven by lower prices of vegetables, energy and some minerals. An acceleration in prices a year ago also helped make the fall look sharper.

Inflation stood at 5.22 per cent in the same week a year earlier.

Economists believe there could be a rise soon in government-set retail prices to staunch heavy losses at state-owned oil firms, a move that would boost inflation, although opposition from the ruling Congress party's communist allies could delay such a step.

U.K. Retail Sales Annual Growth Accelerates In August

Sep 20, 2007 - UK retail sales posted a seasonally adjusted 4.9% growth in annual terms in August, the Office for National Statistics, ONS said, Thursday. Retail sales grew 4.4% last month. Analysts were looking for a 4% annual increase in August.

Compared to July, retail sales gained 0.6% in August, pushed by growth in food stores, clothing stores and other non-food stores. Monthly growth rates were volatile, the ONS cautioned. Retail sales grew a sequential seasonally adjusted 1.3% in constant prices in the three months to August. Retail sales in the three months to July advanced 1.2%. Sales in the same prior period of the last year were a little higher at 1.5%.

In the three months to August, sales volumes in non-food stores grew 2.2% sequentially, while sales volumes in food stores slipped 0.1%. Sales in household goods stores jumped 5.3%, the biggest increase since April 2001, the ONS said. Sales in non-specialized stores, including department stores gained 5.1%, the highest three-monthly growth for this sector since records began to be maintained in 1986, the ONS noted. The previous high was the 5.0% growth in the three months to July.

On an annual basis, the seasonally adjusted volume of retail sales gained 4.3% in the June to August period, compared to 4.1% in the three months to July. Sales in food stores edged up 0.1%, recovering from a 0.1% fall in sales in the previous period. Sales in non-food stores climbed 6.5% in the three months to August, after rising 6% in the three months to July. This was the highest growth since the three months to November 2004, when retail sales grew 7%, the ONS said.

Consumer price inflation was likely to remain in the 2% target region, the Monetary Policy Committee of the Bank of England, BoE, said at its September meeting. Employment growth continued to be strong and manufacturing had posted solid gains in output. The present turmoil in financial markets would also be contained, the Committee had opined.

Yet, analysts felt that retail sales were riding a high before a fall. They pointed out that the high summer sales were achieved by aggressive price discounting. Further, economic conditions were now tighter as acknowledged by the BoE in its latest meeting. However, given the low 1.8% inflation in August, there was a possibility of a rate cut in the coming months by the BoE, which would boost sales, experts said.

Hong Kong Consumer Prices Rise In August

Sep 20, 2007 - Hong Kong consumer prices rose 1.6% in August from last year compared to an increase of 1.5% in July, the Census and Statistics Department said Thursday. Economists expected an annual increase of 1.7% for the month of August. The increase was due to higher food prices, which rose to 4.6% in August from the 3.6% growth in July.

During the three months ended August, the consumer price index climbed 1.5% annually. Meanwhile, the index increased 1.7% for the twelve months ended August.

Swiss Producer And Import Prices Rise In August

Sep 20, 2007 - Swiss producer and import prices rose 0.3% month-over-month in August, the statistical office said Thursday. Economists were looking for a monthly growth of 0.1%. Compared to last year, producer and import prices climbed 2.7%, while economists expected only 2.6% rise.

The import price index and producer price index advanced 0.3% each from the prior month. On a yearly basis, import prices moved up 2.9% and producer prices were up 2.6%.

New Zealand's Current Account Deficit Narrows As Imports Fall In Second Quarter

Sep 20, 2007 - New Zealand's second quarter current account deficit stood at NZ$3.415 billion, down NZ$162 million from the previous quarter, the Statistics New Zealand said Thursday. The fall in current account deficit was attributed to smaller trade deficit and higher net inflows of current transfers. Meanwhile, investment income showed larger outflow during the June quarter.

The seasonally adjusted trade deficit in goods fell NZ$45 million to NZ$767 million, while services surplus rose NZ$43 million to NZ$177 million in the second quarter.

This value of exports and imports of goods fell due to the appreciating New Zealand dollar in the second quarter, the report said. Imports fell more than exports, reflecting lower consumption of foreign goods.

The value of imports was NZ$9.473 billion in the June quarter, a decrease of NZ$349 million in the prior quarter. The value of goods exports fell NZ$305 million to NZ$8.706 billion over the same period.

Investment income earned by foreigners increased due to higher dividend payout amounting to NZ$1.483 billion.

New Zealand's current account deficit was funded by a financial net inflow of NZ$2.7 billion in the June quarter. This combined with NZ$2.9 billion of net changes in the valuation of international assets and liabilities, pushed New Zealand's net international debtor position by 3.9% to NZ$148.6 billion from the previous year.

The rise in net international position was contributed mainly by the banking sector. The net international debt position of the corporate sector also rose in recent quarters due to merger and acquisition activity.

For the year ended March 2007, the current account deficit was revised down to NZ$13.5 billion from the initial deficit of NZ$13.9 billion. The deficit was equivalent of 8.5% of GDP in the first quarter. The GDP ratios for the latest data will be released on September 27, the report said.

Swiss August Trade Surplus Weakens More Than Expected

Sep 20, 2007 - The Swiss trade surplus amounted to CHF637.1 million in August, the Federal Administration of Customs said Thursday. The number came in weaker than the expected surplus of CHF0.93 billion. The trade surplus narrowed from CHF1.51 billion recorded in July. However, the trade surplus showed an annual growth of 15.5%

Exports grew 9.7% in real terms and imports climbed 6.3% in August. In nominal terms, exports were up 9.1% to CHF14.54 billion and imports increased 8.8% to CHF13.90 billion.

Taiwan Central Bank Raises Discount Rate To 3.25%

Sep 20, 2007 - The central bank of Taiwan or the central bank of the Republic of China decided to increase discount rate by 12.5 basis points to 3.25% in its Monetary Policy Meeting Thursday.

Also, the rate on accommodations with collateral and the rate on accommodations without collateral rose 12.5 basis points each to 3.625% and 5.5%, respectively. The changes will be effective from September 21.

The central bank said market forces would determine the NT dollar exchange rate. But, the CBC will step in to maintain an orderly foreign exchange market, when seasonal or irregular factors such as hot money or irrational expectations disrupt the market.

The monitory policy committee took these decisions considering increasing CPI inflation, solid economic growth, improvement in the job market, appropriate monitory growth and low-level real interest rates that are still below the neutral level.

HK Monetary Authority cuts base rate by 0.50 percentage point

Sep 19, 2007 - The Hong Kong Monetary Authority (HKMA) cut its base rate by 0.50 percentage point to 6.25 percent on Wednesday.

The move comes after the US Federal Reserve decided overnight to cut its benchmark interest rate by 0.50 percentage point to 4.75 percent to stimulate an economy imperiled by housing and credit market stress.

Hong Kong's currency peg to the US dollar links its monetary policy to that of the US so the HKMA generally follows in lockstep any interest rate adjustments by the Fed.

Fed slashes interest rates to buffer economy

Sep 18, 2007 - The Federal Reserve on Tuesday slashed U.S. interest rates by a hefty half-percentage point in a bold bid to shield the economy from a housing slump and financial turbulence, sparking a big rally on Wall Street.

The unanimous decision by the central bank's policy-makers took the benchmark federal funds rate, which governs overnight loans between banks, down to 4.75 percent, its lowest since May of last year. The Fed also cut the discount rate it charges for direct loans to banks by a half-point to 5.25 percent.

It was the first cut in the federal funds rate -- the Fed's main tool to influence the economy -- since June 2003 and the first half-point cut since November 2002.

Financial markets had widely expected the Fed to lower overnight borrowing costs, but were surprised by the aggressive half-point move, the first rate cut since Ben Bernanke took over as chairman of the central bank in February last year.

Stock prices surged as the decision gave investors hope the housing and credit turmoil wouldn't drag the economy down. The blue-chip Dow Jones industrial average closed up 335.97 points, or 2.51 percent, at 13,739.39. It was the Dow's best daily percentage gain since 2003.

However, prices for long-term government debt fell, suggesting some investors worried the Fed would fail to keep inflation tamped down, although prices for short-term notes rose in anticipation of further rate reductions.

"The Bernanke Fed has finally cast its unwarranted caution aside; we applaud this bold move," said Ian Shepherdson, chief U.S. economist at High Frequency Economics, in Valhalla, New York.

LIMITS TO RATE CUTS SEEN

But others worried the Fed may be prematurely abandoning its vigilance against inflation to soothe markets.

"This should make people less confident for the Fed to achieve their No. 1 objective, which is keeping inflation at bay," said Robert MacIntosh, chief economist at Eaton Vance Management, in Boston. "They overreacted."

Commercial banks swiftly followed the Fed and cut the prime rate they charge their best customers for loans.

Often when the Fed begins to lower credit costs, a heavy cycle of rate-cutting is in store. But economists on Wall Street appear to think the course kicked off by the Fed on Tuesday would prove limited.

A Reuters poll of 18 top bond firms that trade directly with the Fed in the markets showed a median forecast for a 4.5 percent federal funds rate by the time the central bank's easing cycle ends -- just a quarter-point below where the Fed left rates on Tuesday.

PRE-EMPTIVE STRIKE

In a statement outlining its decision, the Fed said its move was a pre-emptive strike to neutralize the impact of market turmoil on the economy.

"Today's action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time," it said.

The central bank said it still believed the economy faced some risk of inflation, but said market developments since its last meeting in early August had increased the uncertainty surrounding the outlook.

"The committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth," it said.

There has been accumulating evidence that a prolonged U.S. housing market downturn and a wild financial market ride over the summer have taken a toll on broader economic activity.

A decline in employment in August, the first drop in four years, appeared to confirm that housing-related strains were weighing on businesses and households.

In addition, reports on retail sales and industrial output in August also showed some softness.

At its previous regular meeting on August 7, the U.S. central bank had said its predominant concern was inflation, even as it noted tighter credit and financial market volatility.

Within days, financial markets unraveled as French bank BNP Paribas froze three funds with U.S. subprime mortgage market exposure. The Fed on August 10 said it would pump cash into the banking system as needed to keep markets functioning normally.

Even so, stock markets tumbled the following week, at one point plumbing declines of more than 10 percent below 52-week highs before rebounding.

The Fed then stepped in on August 17 with a surprise cut to the discount rate and an explicit acknowledgment that risks to economic growth had "increased appreciably."

Tuesday's rate cut seeks to address those risks.

"I think it was the right move," said Martin Feldstein, head of the National Bureau of Economic Research, who had called for rate cuts. "It can't solve the problems that are weakening the economy (but) it can help offset them."

Argentina 2008 budget sees 7.3 pct inflation

Sep 17, 2007 - Argentina's 2008 budget bill, presented to Congress on Friday, sees annual inflation of 7.3 percent and calculates gross domestic product growth at 4 percent.

Inflation is expected to average 7.7 percent over the course of 2008.

Latin America's number-three economy is in its fifth straight year of expansion at about 8 percent. In the country's 2007 budget bill, the center-left government of President Nestor Kirchner had also underestimated growth.

The strategy has allowed the government to announce economic results that have exceeded the budget's stipulations.

A central bank survey carried out among analysts last month gave a median outlook for 2008 growth of 6.2 percent, with inflation for the year estimated at 10 percent.

High inflation has dogged Kirchner's government. Last year's budget included estimates for inflation in a range of 7 percent to 11 percent.

Inflation has come in below market expectations since January, when the government replaced the head of the consumer price unit at INDEC, the national statistics unit, with a political ally, prompting fears of government meddling with the data.

As a result, investors have become increasingly wary of the country's inflation-indexed bonds, which account for more than 40 percent of total public debt.

Inflation in the first eight months of the year stands at 5 percent, with 12-month inflation through August of 8.7 percent.

In relation to the local currency, the budget bill for next year envisages an exchange rate of 3.21 pesos per dollar. The peso closed on Friday at 3.1950/3.1975 against the dollar in informal trade as measured by Reuters.

The budget will be in force for the first year of a new government following a presidential election on Oct. 28. First lady and senator Cristina Fernandez de Kirchner has a wide lead in opinion polls.

It calculates a primary budget surplus of 3.15 percent of gross domestic product and a $10.06 billion trade surplus.

Official details of the bill broadly confirmed those given by an Economy Ministry source earlier this week.

Singapore's non-oil exports up 10.9% in August on-year

Sep 17, 2007 - Singapore's key exports rose 10.9 percent in August on-year, boosted by increased shipments of pharmaceuticals which tempered a sustained decline in electronics, the government said on Monday.

The increase in non-oil domestic exports (NODX) for the fourth straight month was in the upper range of analysts' forecasts and double the 5.4 percent growth registered in July, the trade promotion body, International Enterprise Singapore, said.

NODX for August totalled S$15.16 billion (US$10.04 billion), IE Singapore said.

Exports of pharmaceuticals surged 105.8 percent from the same period last year to S$2.07 billion, it said.

This offset a 1.3 percent decrease in electronics exports to S$6.43 billion.

IE Singapore said it was the seventh consecutive month of decline for electronics, which is dependent on global demand.

Except for consumer electronics exports which climbed 35.6 percent, four other key electronics products posted declines, led by telecommunications equipment which fell 39.2 percent.

Shipments of disc drives dropped 26.3 percent, integrated circuits were down 5.2 percent and computer parts contracted 6.5 percent, IE Singapore said.

On a month-on-month seasonally adjusted basis, NODX expanded 2.1 percent, faster than the 0.5 percent rise in July, it said.

Total trade was up 0.7 percent to S$72.43 billion, but this was slower than the 6.2 percent expansion in July, the agency said.

Exports totalled S$38.87 billion, up 2.6 percent, while imports shrank 1.4 percent to S$33.56 billion.

NODX is a closely watched measure of the health of Singapore's trade-reliant economy, which is tipped by the government to grow between 7.0 and 8.0 percent this year after expanding 7.9 percent in 2006.

Super stock returns: ROE/PTB v ROE v PTB

A company that is able to generate a high return on equity - one that exceeds its cost of equity - should trade at a higher price than the book value of its equity. And vice versa. But if a company generates a relatively high ROE, yet is trading at a relatively low price-to-book ratio (PTB), careful analysis is warranted.

There could be legitimate reasons for the low valuation. For example, the earnings were due to exceptional items. If not, the stock may be under-priced.

But without any detailed analysis other than simply grouping stocks based on ROE/PTB, I found that investors can actually generate super returns.

By investing in the 10 per cent of stocks with the highest ROE/PTB every year between 1990 and 2006, and holding each portfolio for a year, one could have turned $100 into $34,000 over the past 17 years. That's a compounded return of 41 per cent a year. All the calculations exclude transaction costs.

If we assume that the investor had lost 10 per cent of the portfolio value to transaction costs every year, the return is still a respectable 27 per cent a year. But in absolute terms the portfolio value today, at $5,678, is significantly less than the $34,000 which excludes transaction costs.

From the above, we can see that ROE/PTB is a good screening tool.

Separate rankings

If we pick stocks just based on ROE or just based on PTB, do we get results that are as good?

I decided to test this based on the same set of data last week. This time around, I ranked stocks based purely on their ROEs first. Again, I grouped them into 10 portfolios, with the first 10 per cent or first decile being stocks with the lowest ROEs. The 10th decile was made up of stocks with the highest ROEs.

As can be seen from the chart, screening stocks using just their ROE still yields good returns. $100 invested in the highest ROE portfolio every year would grow to $8,752 today. That's a compounded annual return of 30 per cent.

But it would lag the performance of the basket of stocks with high ROE yet low PTB.

For both the first and second screening, I excluded loss-making companies.

Next, I ranked the stocks based on their PTB ratios. For this, I did not remove loss-making companies. The first decile is made up of stocks with the lowest PTB ratios. Some could even have negative PTB ratios. And the 10th decile consists of stocks with high PTB ratios.

As you can see from the third chart, there is a clear distinction in performance as well. The lower the PTB, the higher the return. And conversely, the higher the PTB, the lower the return. The lowest PTB stocks generated about 15 per cent return a year, while the highest PTB stocks chalked up a 7.3 per cent loss a year.

However, the returns of portfolio ranked purely on PTB ratio lagged those screened by ROE/PTB or purely on ROE.

One of the reasons for the under-performance could be the continued poor performance of loss-making companies. Other studies previously have found PTB to be the best predictor stock performance. Particularly so when there is a turnaround in the economy. This is also evident in five portfolios that The Business Times tracks every Monday.

But it takes guts to go against the crowd and buy into downtrodden stocks.

So perhaps, the ROE/PTB is a more comfortable approach for many. And as the results above indicated, it is rather rewarding as well.

It does, however, require a little more work. The use of ROE/PTB takes into consideration not only the underlying earnings capacity of a company, but also how much of that has been factored into its stock price.

So if a company can rake in good earnings and good growth and its share price has fully reflected that, it may not be a good stock to buy. What one wants is good earnings growth that is not recognised by the market.

Variations

A reader pointed out that with some simplifications, ROE is earnings per share (EPS) divided by net tangible assets (NTA). And PTB is price per share divided by NTA.

Dividing the former by the latter gives us EPS divided by price per share, which is earnings yield. So stocks with high ROE/PTB are also those with high earnings yield.

And we could go one step further. Earnings yield is the inverse of price-earnings (PE) ratio. So stocks with high earnings yield are also low PE stocks.

'Notwithstanding the mathematical accuracy, ROE relative to value is an interesting approach to investing,' he wrote. 'I have been using something similar for some time to good effect (ROE divided by PE coupled with some other criteria like minimum dividend payout and low debt to equity).

'A variation was also suggested in the book The Little Book That Beats The Market by Joel Greenblatt which uses ROE divided by return on invested capital (to correct for the use of excessive financial leverage). He even has a website www.magicformulainvesting.com to automatically select US stocks that meet the criteria.'

The reader added that the most comprehensive book he has come across on this is What Works On Wall Street by James P O'Shaughnessy.

Below is a table - using data from Bloomberg - showing 30 stocks with high ROE/PTB. Some of the numbers may be skewed by one-off items, so some analysis is advised before any action is taken.

Go for stocks with high return on equity but low price-to-book ratio

ONE way to value a company is to ascertain how much abnormal earnings - that is, earnings above the cost of its capital - it will be able to generate in the future. This stream of abnormal earnings is then discounted to its present value. Add that number to the current book value of the capital and you arrive at how much the company is worth.

This way of calculation has intuitive appeal. It implies that if a company can earn a rate of return that is equivalent to its cost of capital, then investors should be willing to pay no more than the book value for the stock.

Book value is the original capital invested by the company in its various assets to start up its business after taking into account depreciation.

On the other hand, if the company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will only invest in the company if it is trading below its book value.

We can see how much the market is valuing a company by comparing the market value of its equity, that is its market capitalisation, with the book value of its equity.

So if a company's market cap is $100 million, and the book value of its equity is $50 million, then this company is trading at two times its book value. This measure is also referred to as the price-to-book (PTB) ratio.

A PTB ratio of two times implies that investors are confident that the company can earn significantly above its cost of capital for a sustained period of time.

We can actually derive the formula for PTB from the abnormal earnings formula. The latter says that to arrive at what a company's shares are worth, we take the current book value of its equity, and add the discounted future stream of net profits which is in excess of the cost of equity. The discount rate used is the cost of equity.

So if we scale the formula with book value on both sides, we get PTB value on the left-hand side, and abnormal return on equity (ROE), among other things, on the right-hand side.

This suggests that a company's PTB ratio is a function of three factors: its future abnormal ROE, the growth in its book equity, and its cost of equity.

Abnormal ROE is defined as ROE less the cost of equity.

Firms with positive abnormal ROE are able to invest their net assets to create value for shareholders, and as mentioned earlier, will have a PTB ratio greater than one.

Strong ROE-PTB links

The whole point of what has been said so far is to show that there is a strong relationship between PTB ratios and ROEs. Companies with high ROE should trade at higher PTB ratio compared with those with lower ROE.

So perhaps one way to spot mispricings by the market is to identify stocks with high ROE but low PTB ratio.

Will such a strategy pay off? Well, I did some back-testing and the results are phenomenal.

I download the ROEs and PTBs of all the companies listed on the Singapore Exchange from 1990 until 2007. These are the yearly numbers on Jan 1 of each year.

I then divide the ROE numbers with PTBs, and rank the stocks based on that number. The top-ranked stock would have the highest ROE relative to its PTB. The lower-ranked stocks would have low ROE and high PTB.

I then split all the stocks equally into 10 groups. The first group, or the first decile, is the top 10 per cent of stocks with the highest ROEs relative to their PTB ratios. The 10th decile comprises those with the lowest ROEs and highest PTB ratios. Then there's a group of loss-making companies.

Compounded returns

Assuming that an investor did this on Jan 1, 1990. Based on data from Thomson Financial Datastream, there were 39 stocks then. After ranking them, he invested $100 in the top four stocks with the highest ROE/PTB.

On Jan 1, 1991, he did the same screening again. Then he divested the initial four stocks and reinvested the proceeds into a new batch of stocks with the highest ROE/PTB.

And he consistently did that for the past 17 years. How do you think his $100 would have grown to? A whopping $34,048.

That's a compounded return of 41 per cent a year. The above calculations did not take into consideration transaction costs. If it did, a huge chunk of profits would disappear.

But the point is, there is a very clear relationship between stock returns and ROE/PTB. As can be seen from the chart, the top 10 per cent of companies with the highest ROE/PTB turned $100 into $34,048 in 17 years.

The next 10 per cent managed to grow the pot to $4,710 - that's still quite a decent 25 per cent a year. The following 10 per cent, or the third decile, managed $958 for a return of 14 per cent a year.

And as we move to stocks with lower and lower ROE/PTBs, the return shrinks correspondingly.

The fifth decile grew only 3.8 per cent a year and the 10th decile - the 10 per cent of the market with the lowest ROE/PTB - shrank the $100 to just $25. It is very clear from the findings that it doesn't make sense buying stocks with low ROE and high PTB.

This screening process takes into consideration the underlying earnings capacity of a company in relation to how the market is valuing the company. Those with high ROE but low PTB are clear cases of mispricing. That's why the back-testing shows such a phenomenal performance.

But of course, a firm's ROE is affected by such factors as barriers to entry in their industries, change in production or delivery technologies, and quality of management. These factors tend to force ROEs to decay over time. But since in the above testing, the holding period is just one year, the decay is not so much a factor.

So the next time you study a stock, look at its ROE relative to its PTB as well. If the ROE is high, but its PTB is high as well, then perhaps the good fundamentals have been reflected in the share price. However, if you find a stock with high ROE but relatively low PTB, then you may potentially have on your hands an undiscovered gem.