<THE EVENING NEWS>
Tuesday, August 18, 1998
MARKET CLOSE
DJIA            8714.65   +139.80      (+1.63%) 
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 Nasdaq          1855.10    +37.06      (+2.04%) 
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 30-Year Bond    99 5/32     -5/32  5.56% Yield 
 

HEROES

Hewlett-Packard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %>, maker of computing, Internet and intranet, communications, and measurement products, moved up $1 3/4 to $57 after reporting Q3 EPS of $0.58, $0.04 ahead of analysts' already lowered estimates. Analysts reduced estimates in late July after H-P warned that for Q3 it expected mid-single-digit revenue growth and earnings to be "flat to moderately lower" than the year-ago period. In fact, revenues did rise 5%, while per-share earnings remained flat. The company's earnings were helped by the progress it made in cutting its expense growth rate -- expenses grew 4% during the quarter compared with 17% growth in the first half of the year. H-P said the improvement exceeded its internal goals but that "we're not yet where we need to be, and expense management remains a top priority." The company also remained cautious in its outlook, citing intense competition, no signs of a quick turnaround in Asia, and uncertainty about macro-economic conditions in the U.S. and Latin America. The better-than-expected earnings prompted Salomon Smith Barney to upgrade its rating on the company to "buy" from "outperform" and ABN AMRO to raise its rating to "buy" from "hold." Both set a $70 price target.

Global fashion brand Tommy Hilfiger <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TOM)") else Response.Write("(NYSE: TOM)") end if %> gained $2 3/4 to $56 3/8 after Merrill Lynch raised its rating on the company to "near-term buy" from "near-term accumulate," citing that Hilfiger's recent results have borne both strong earnings and a hefty backlog. Recent selling in the wake of a Liz Claiborne <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LIZ)") else Response.Write("(NYSE: LIZ)") end if %> announcement that retailers are cutting back on orders of women's clothing and a Barron's article that said men will only need to make "replacement" purchases for casual clothing have weighed on the segment, dragging down some premiere fashion brands along with weaker names. Merrill asserted today that Tommy Hilfiger has been unfairly maligned during the whole affair. With department stores offloading much of their fashion risk on the big fashion names, large collections such as Tommy Hilfiger are garnering a majority of department store business (70-80%). Plus, in its latest quarter, Tommy doubled its sales of women's products -- introducing a line of women's jeans and opening its first three women's clothing outlets.

Diversified electronics manufacturer SCI Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SCI)") else Response.Write("(NYSE: SCI)") end if %> picked up $2 3/4 to $31 1/4 after CS First Boston named the company as one of the best stocks to buy in what it views as a solid technology sector. Yesterday, BA Robertson Stephens reiterated its "buy" rating on the company, saying it is trading at an "historic discount to comparables." As of yesterday, the company was trading at a 35% to 45% discount to other large-capitalization electronic manufacturing services (EMS) companies, based on calendar 1999 enterprise value-to-EBITDA and P/E multiples. Other EMS companies moved up with SCI and as part of improved expectations for Intel and the PC sector. Solectron <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SLR)") else Response.Write("(NYSE: SLR)") end if %> gained $1 7/8 to $51 15/16, Flextronics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: FLEXF)") else Response.Write("(Nasdaq: FLEXF)") end if %> climbed $2 to $37 1/2, and Jabil Circuit <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: JBL)") else Response.Write("(Nasdaq: JBL)") end if %> added $1 7/8 to $33. Circuit board and backplane assembly company Sanmina <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SANM)") else Response.Write("(Nasdaq: SANM)") end if %> also tacked on $3 to $45 7/8.

QUICK TAKES: Compaq Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CPQ)") else Response.Write("(NYSE: CPQ)") end if %> picked up another $2 1/2 to $37 1/2 after BT Alex. Brown upgraded its rating on the computer maker to "buy" from "market perform"... Computer networking equipment company Cisco Systems <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CSCO)") else Response.Write("(Nasdaq: CSCO)") end if %> added $2 1/16 to $100 3/16 as it announced that America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> has chosen the Cisco 12000 series Gigabit Switch Router for deployment throughout AOL's busy TeraPOP traffic exchange point... Software giant Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> gained $3 15/16 to $111 1/4 as the company is expected to unveil a second test version of its Windows NT operating system, keeping it on schedule to release a final version as early as the second quarter of next year... Apple Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AAPL)") else Response.Write("(Nasdaq: AAPL)") end if %> rose yet another $5/8 to $42 9/16 on optimism that strong sales of its new iMac personal computer will boost profits.

Internet browser, portal, and software company Netscape Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NSCP)") else Response.Write("(Nasdaq: NSCP)") end if %> was lifted $1 13/16 to $32 1/8 in advance of reporting breakeven Q3 EPS, which was the same as in Q2 and slightly better than analysts' expectations of a loss of $0.02 a share... Internet portal company Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %> surged $5 1/4 to $97 1/4 after announcing the launch of Yahoo! Clubs, which allows clubs and organizations to create Web pages for free. Yahoo!'s Internet cohorts also gained ground. Excite <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: XCIT)") else Response.Write("(Nasdaq: XCIT)") end if %> jumped $2 11/16 to $44 13/16, Infoseek <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SEEK)") else Response.Write("(Nasdaq: SEEK)") end if %> soared $2 9/16 to $28 3/4, Lycos <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LCOS)") else Response.Write("(Nasdaq: LCOS)") end if %> leaped $5 3/4 to $68, and Amazon.com <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMZN)") else Response.Write("(Nasdaq: AMZN)") end if %> advanced $9 to $128 11/16... Heart medical devices maker Arterial Vascular Engineering <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AVEI)") else Response.Write("(Nasdaq: AVEI)") end if %> was pumped up $1 15/16 to $41 after the FTC okayed the company's planned acquisition of C.R. Bard's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BCR)") else Response.Write("(NYSE: BCR)") end if %> coronary catheter lab business, according to Bloomberg.

Home-improvement retailer Home Depot <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HD)") else Response.Write("(NYSE: HD)") end if %> built up $2 to $44 13/16 after reporting Q2 EPS of $0.31 versus $0.24 in the year-earlier period. Comparable store sales gained 7% year-on-year... Sears, Roebuck & Co. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: S)") else Response.Write("(NYSE: S)") end if %> charged up $3 11/16 to $52 3/4 after announcing it will sell its Western Auto unit to auto parts retailer and distributor Advance Auto Parts in exchange for $175 million in cash plus a 40% stake in Advance. In addition, current investors in Advance will invest an additional $70 million in the company... Cosmetics company Estee Lauder <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EL)") else Response.Write("(NYSE: EL)") end if %> dabbed on $3 7/16 to $64 1/2 after announcing Q4 EPS of $0.32, up from $0.26 a year ago and a penny ahead of analysts' estimates... Clothing retailer TJX Cos. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TJX)") else Response.Write("(NYSE: TJX)") end if %> rang up $1 3/8 to $25 7/8 after reporting Q2 EPS of $0.25, up from $0.15 in the prior-year period and beating analysts' expectations of $0.23.

Interactive entertainment software company Electronic Arts <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ERTS)") else Response.Write("(Nasdaq: ERTS)") end if %> advanced $1 11/16 to $53 7/16 after announcing it will acquire Westwood Studios Inc. and certain other studio assets of Virgin Interactive Entertainment, a division of Spelling Entertainment Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SP)") else Response.Write("(NYSE: SP)") end if %>, for $122.5 million in cash. Spelling inched up $3/16 to $7 3/16... Electrical products, tools, and hardware manufacturer Cooper Industries <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CBE)") else Response.Write("(NYSE: CBE)") end if %> rose $1 5/8 to $48 3/16 after announcing it will sell its automotive business to Federal-Mogul Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FMO)") else Response.Write("(NYSE: FMO)") end if %> for about $1.9 billion in cash... Spyglass <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SPYG)") else Response.Write("(Nasdaq: SPYG)") end if %>, a developer of Internet software and technologies for TV set-top boxes, network computers, and cellular phones, gained another $1 11/16 to $12 15/16 on news of a licensing agreement with Motorola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MOT)") else Response.Write("(NYSE: MOT)") end if %> worth "multiple millions" of dollars.

Jones Apparel Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: JNY)") else Response.Write("(NYSE: JNY)") end if %> climbed $1 to $25 after Merrill Lynch raised its near-term rating on the company to "buy" from "accumulate" while keeping a long-term "buy" rating... Fruit and vegetable processing company Seneca Foods <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SENEA)") else Response.Write("(Nasdaq: SENEA)") end if %> moved up $1 to $13 1/2 after announcing it will sell its juice division to juice products maker and cranberry grower Northland Cranberries <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CBRYA)") else Response.Write("(Nasdaq: CBRYA)") end if %> for $30-$35 million... Recruitment advertising agency TMP Worldwide <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TMPW)") else Response.Write("(Nasdaq: TMPW)") end if %> tacked on $2 5/16 to $36 1/8 after announcing it will acquire executive selection and search firm Morgan & Banks Ltd. of Sydney, Australia... Specialty labels and tapes maker Brady Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BRCOA)") else Response.Write("(Nasdaq: BRCOA)") end if %> added $1 1/2 to $18 5/8 after Salomon Smith Barney started coverage of the company with a "buy" rating and a 12-month price target of $24.

MedQuist <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MEDQ)") else Response.Write("(Nasdaq: MEDQ)") end if %> finished up $2 7/16 to $25 5/8 after Gruntal & Co. rated the document management and transcription services firm a "buy" in new coverage... Tractor-mounted mowers manufacturer Alamo Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ALG)") else Response.Write("(NYSE: ALG)") end if %> sped ahead $1 3/4 to $17 3/4 after privately held Woods Equipment Co. agreed to acquire the company for $180 million, or $18.50 a share... Maker of optoelectronic, magnetic and fiber optic sensor products Optek Technology <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: OPTT)") else Response.Write("(Nasdaq: OPTT)") end if %> ticked up $1 7/8 to $21 3/4 after reporting Q3 EPS of $0.34, down from $0.41 the year before but beating analysts' expectations of $0.31... Auto claims software developer CCC Information Services Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CCCG)") else Response.Write("(Nasdaq: CCCG)") end if %> jumped $2 to $14 after announcing plans to buy back up to 2.5 million shares, or 10% of its outstanding shares.

U.S. Virgin Islands-based phone company Emerging Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: ECM)") else Response.Write("(AMEX: ECM)") end if %> surged $1 5/8 to $9 15/16 after its chairman agreed to buy the 48% of the company's stock he doesn't already own for $10.25 a share, or about $54.9 million... Computer software services company Analysts International Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ANLY)") else Response.Write("(Nasdaq: ANLY)") end if %> added $2 29/32 to $26 5/32 after reporting Q4 EPS of $0.29, up from $0.20 a year ago and topping analysts' mean First Call estimate of $0.26... Gerber Childrenswear <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GCW)") else Response.Write("(NYSE: GCW)") end if %> skipped up $1 1/2 to $14 1/8 after reporting Q2 pro forma earnings of $0.23, a nickel higher than a year ago and $0.02 ahead of estimates.

GOATS

PC maker and direct seller Dell Computer <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %> slipped $1 to $109 9/16 in advance of reporting second quarter earnings after trading in positive territory for most of the day. After the bell, Dell announced that Q2 EPS increased 72% to $0.50 from $0.30 last year and topped the analysts' mean estimate of $0.46. Net earnings rose to $346 million, up 62% from $214 million a year ago, while revenues grew 54% to $4.33 billion. Chairman and CEO Michael Dell said the company grew at more than six times the industry rate, as it was able to take advantage of falling component costs and pass the savings on to customers. The company's return on invested capital (ROIC) was an impressive 217%, and it is operating with eight days of inventory on hand, meaning it turns over its inventory 46 times a year. The Round Rock, Texas-based company also announced a 2-for-1 stock split, the sixth split in as many years, payable Sept. 4. During the quarter, Dell bought back 11 million more shares.

Gadzooks <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GADZ)") else Response.Write("(Nasdaq: GADZ)") end if %> was zapped $1 3/16 to $9 13/16 after reporting fiscal Q2 EPS of $0.07 compared to $0.02 a year ago, which was at the bottom of the $0.07 to $0.10 range forecast by the company in its earnings warning on July 22. Initially, the First Call mean estimate had called for EPS of $0.22 in the period. The teenage apparel retailer said sales declined "dramatically" in July, wrecking its quarterly results and contributing to a 0.6% slide in same-store sales during the period. Moreover, Gadzooks doesn't see the situation improving in the near term. Even though teens everywhere are currently in the midst of their annual wardrobe overhauls, Gadzooks will be left out of the back-to-school party like a freshman sporting an Alfalfa haircut and Hush Puppies. The company said promotional activities to boost slumping August sales will cut into gross margins, which will likely lead to Q3 results below its earlier expectations.

Insurance holding company PennCorp Financial Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PFG)") else Response.Write("(NYSE: PFG)") end if %> lost another $3 9/16 to $5 3/16 today after reporting a fiscal Q2 loss of $5.60 per share yesterday, down from earnings of $0.45 per share a year ago. The company blamed the loss on Year 2000 compliance expenses and what it categorized as a "mortality spike," or a surge in deaths among its policyholders. That appeared to be an omen of bad tidings, as yesterday PennCorp also said an investment group that had been considering a $75 million stake in the firm balked when a final agreement could not be hammered out. Moreover, the company said it reduced the book value of its Career Sales unit, which has been on the selling block since February, by $140.5 million. On the bright side, PennCorp indicated that it now has two bidders for the unit, albeit at the reduced "blue light special" asking price.

QUICK CUTS: Discount retailer Dollar General Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DG)") else Response.Write("(NYSE: DG)") end if %> was shredded $7/8 to $34 15/16 after Morgan Stanley Dean Witter downgraded the firm to "neutral" from "strong buy"... Professional staffing services firm StaffMark <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: STAF)") else Response.Write("(Nasdaq: STAF)") end if %> dropped $1 7/16 to $24 1/4 after agreeing to acquire Britain's Robert Walters PLC for about $179 million in stock. The deal is expected to add to StaffMark's fiscal 1999 earnings... Women's clothing retailer AnnTaylor Stores <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ANN)") else Response.Write("(NYSE: ANN)") end if %> fell $1 3/4 to $27 3/16 after reporting fiscal Q2 EPS of $0.27, which was in line with the Street's upwardly revised estimate... Nerve stimulation and medical devices company Cyberonics <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CYBX)") else Response.Write("(Nasdaq: CYBX)") end if %> slipped $3 3/16 to $8 9/16 after reporting a fiscal Q4 loss of $0.30 per share, which was worse than the $0.14 per share loss expected by the Street.

Internet advertising agency 24/7 Media <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TFSM)") else Response.Write("(Nasdaq: TFSM)") end if %> lost another $2 3/8 to $15 7/8 after jumping 45% following its initial public offering on Friday at a price of $14 per share... Public warehousing and logistics services firm Christiana Cos. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CST)") else Response.Write("(NYSE: CST)") end if %> dropped $2 to $19 1/8 after the completion of its proposed cash and stock merger with oilfield equipment maker EVI Weatherford <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EVI)") else Response.Write("(NYSE: EVI)") end if %> was postponed due to EVI's lower share price... Thermo Sentron <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: TSR)") else Response.Write("(AMEX: TSR)") end if %> slipped $3/8 to $10 after John G. Kinnard lowered its rating on the precision weighing and inspection equipment firm to "neutral" from "buy"... Oil pipeline operator Buckeye Partners <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BPL)") else Response.Write("(NYSE: BPL)") end if %> slid $2 5/16 to $26 7/16 following a Goldman Sachs downgrade to "market outperformer" from "recommended list."

Small appliance original manufacturer Global-Tech Appliances <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GAI)") else Response.Write("(NYSE: GAI)") end if %> was toasted for a $7/8 loss to $8 1/8 after reporting fiscal Q1 EPS of $0.27 yesterday, which was a penny shy of the Street's estimates... Car battery maker Exide Corp. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EX)") else Response.Write("(NYSE: EX)") end if %> stalled $1 1/16 to $11 3/4 after deciding yesterday not to go through with a planned recapitalization. The company also said it is not for sale... Extended stay real estate investment trust (REIT) Innkeepers USA Trust <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KPA)") else Response.Write("(NYSE: KPA)") end if %> lost $1/2 to $11 3/16 after saying a new accounting policy will cause it to restate its fiscal Q1 and Q2 earnings as losses... Tableware manufacturer Oneida Ltd. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OCQ)") else Response.Write("(NYSE: OCQ)") end if %> slipped $15/16 to $22 13/16 after reporting fiscal Q2 operating EPS of $0.30, missing the Street's mean estimate of $0.37.

Securities with ties to Russia were knocked down as the Russia Trading System index dropped to a 27-month low following a devaluation of the ruble. Telecommunications company Rostelecom <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ROS)") else Response.Write("(NYSE: ROS)") end if %> slid $13/16 to $6 1/4, Vimpel-Communications <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: VIP)") else Response.Write("(NYSE: VIP)") end if %> slipped $1 1/8 to $24 15/16, Templeton Russia Fund <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TRF)") else Response.Write("(NYSE: TRF)") end if %> lost $3/8 to $16 5/16, and Morgan Stanley Russia & New Europe <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RNE)") else Response.Write("(NYSE: RNE)") end if %> dropped $3/8 to $12 7/8... Arlington, Virginia-based investment bank Friedman Billings Ramsey Group <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FBG)") else Response.Write("(NYSE: FBG)") end if %> fell $1 15/16 to $9 7/16 on concern that its bread-and-butter business of bringing companies public may be hurt by weakness in the market for initial public offerings, which has seen several cancelled offerings recently.

FOOL ON THE HILL
An Investment Opinion
by Dale Wettlaufer

ROE, ROE, ROE Your Boat (Pt. 1)

After checking into the Fool's most popular message boards the other day, I discovered how popular the Buffettology message board is. For those not familiar, Buffettology is a book by the former daughter-in-law of Berkshire Hathaway <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BRK.A)") else Response.Write("(NYSE: BRK.A)") end if %> chairman Warren Buffett. The book attempts to explain how Buffett determines value and identifies companies with superior economics and to "show the mathematical models and equations Buffett uses to determine the basic value and earnings potential�" of companies in which he and Berkshire invest. Subtitled "The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor," the individual investor world has snapped up this book, voracious in its appetite for all things about Buffett.

In looking through the active commentary and analysis using these "previously unexplained" methods, return on equity (ROE) is one performance measure that is frequently used by those investors who have read the book and are seeking to internalize. That led me to chapter 35 in the book, "Understanding Warren's Preference for Companies with High Rates of Return on Equity." I was disappointed by what I found in the chapter.

The reason is that not all rates of return on shareholders' equity are created equal. Two companies generating the same 20% ROE can exhibit very different economic characteristics. That's because ROE is far more than just earnings divided into owners' equity. Ah no, it's far more elegant than that. Return on equity is a function of three variables: 1. Asset turnover, 2. Net margin, and 3. Financial leverage. As an equation, ROE looks like this:

Revenues     Net Income      Assets 
 --------  x  ----------- x  -------- 
 Assets        Revenues         SE
(Note: SE = shareholders' equity. Both shareholders' equity and assets should be averaged for the year rather than just using beginning figures.)

There are three main financial levers for ROE, then. If you have a business where your inventory management is poor and your margins show that your products don't have pricing power or that you're just an inefficient producer, then you can generate a high ROE by piling on the debt. Let's look at how that works. If my company turns over its assets once every two years (0.5 times every year) and shows a net margin of 3%, then I need a bunch of debt to get to an ROE of 20%:

Asset turnover of 0.5 x net margin of 0.03 x leverage of Y = ROE of 20%. So, 0.015 x Y = ROE of 20%. And Y = 0.2 / 0.015, and finally, leverage = 13.3. For every dollar in equity, I have 13.3 dollars in assets. Put in another way, for every dollar of assets, I have 7.52 cents in equity. That sort of business might not last very long and really doesn't show great economics. Does this satisfy Buffett's tests? It sure doesn't look like the financial model of many of his longer-term investments, though God only knows what he bought in his stricter "cigar butt" investing days. What Buffett looks for is contained in the annual report every year*, and you don't need a fancy new $30 hardcover book to learn this. Buffett looks for "[b]usinesses earning good returns on equity while employing little or no debt."

The typical Buffett company is a high return on assets (ROA) company. Whoa! Huh? What Buffett is saying about a high ROE with little or no debt means that he wants companies generating a high ROA. This is because ROA times leverage equals ROE. Dissecting the above three-part equation, we can prove this:
Revenues      Net Income 
 ---------  x --------------   = ROA 
  Assets        Revenues
By taking the common elements out of the above equation, ROA can be expressed as we are used to looking at it: Net income divided by (average) assets. Taking the same inputs we used above, the company's ROA would equal 0.5 times 0.03, or 1.5% ROA. That sort of ROA is pretty bad for all but the banks and other financial services companies. For a consumer products company or a manufacturing company, it usually means something is pretty wrong. With a high return on assets company, the pathologically risk-averse management doesn't have to have any leverage to generate a satisfying return on assets. But with a little bit of leverage, the return on assets can be magnified into an excellent ROE without endangering the safety or autonomy of the enterprise. We'll look at some examples of this, including Berkshire's "Inevitables," tomorrow.

*Every year, there is an "advertisement" in the Berkshire annual report in which Buffett and Vice-Chairman Charlie Munger solicit calls from principals or their representatives of companies that are interested in being purchased by Berkshire Hathaway. Berkshire is interested in companies with more than $25 million in pre-tax earnings.

CONFERENCE CALLS

Please see the Motley Fool's Conference Calls page for call information and links to synopses.

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Contributing Writers
Yi-Hsin Chang (TMF Puck), a Fool
Brian Graney (TMF Panic), Fool Two
Alex Schay (TMF Nexus6), Fool, too
Dale Wettlaufer (TMF Ralegh), Final Fool

Editing
Brian Bauer (TMF Hoops), another Fool
Bob Bobala (TMF Bobala), a Fool's Fool
Jennifer Silber (TMF Amused), Fool at last