Page 2 explains the basic setup: 71 high ROE companies had an average ROE of 28.9% over the decade to 31-Dec-1990. They had an average 18.8% CAGR in EPS.
What they found: Over the next 7 years, 33% of the companies reported lower EPS in 1997 than in 1990. 26% had 7% CAGR in EPS or less. 22% had 8.5%-14.7% CAGR in EPS. Only 19% had a growth rates of at least 15%.
A similar pattern was noted in "intrinsic value", defined as 10X EBIT + net cash. Despite 7 years of cash generation, IV was lower in 1997 than in 1990 for 28% of the companies. Only 15% were able to increase IV at a rate of 15% or more.
Basic conclusion: consistently high past ROEs does not indicate future ones.
On page 5, they did their own estimates and concluded:
In Schedule IV, the author’s “best guess” estimated growth rate for sales and EBIT over the next seven-year 1990–1997 period can be compared to the actual growth rate in intrinsic value (10x EBIT value) and e.p.s. that occurred over the 1990–1997 period. The author’s best guess about future growth, which was based solely upon examination and extrapolation of historical financial information (and without any qualitative information), was an extremely inaccurate predictor of the actual growth that subsequently occurred over the seven-year 1990–1997 period.Page 11:
Aside from increases in EBIT that can be generated by price increases or cost cuts, which areAlso:
often one-time turnaround type changes, the engine that drives EBIT growth over the long term is sales growth. And more sales generally require more operating assets such as inventory and
property, plant and equipment.
Companies that grow a lot over a long, long period of time, have to have sufficient opportunities to reinvest earnings at high rates of return in order to generate more sales and earnings. The math is easy. The hard part is unearthing, sifting, weighing and assessing the qualitative information that drives financial numbers. Isn’t it a paradox that most of what is written about investment analysis in textbooks and journals is about quantitative information, and so little is written about digging up and analyzing the qualitative information that ultimately drives the financial numbers?