Fundamental Valuation

What fundamental measures of business success best indicate the value of individual stocks and the aggregate stock market? How can investors apply these measures to estimate valuations and identify misvaluations? These blog entries address valuation based on accounting fundamentals, including the conventional value premium.

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Models, Trading Calendar and Momentum Strategy Updates

We have updated the Earnings Forecast to incorporate preliminary actual S&P 500 operating earnings for the second quarter of 2014.

We have updated the S&P 500 Market Models summary as follows:

  • Extended Market Models regressions/rolled projections by one month based on data available through July 2014.
  • Updated Market Models backtest charts and the market valuation metrics map based on data available through July 2014.

We have updated the Trading Calendar to incorporate data for July 2014.

We have updated the the monthly asset class momentum winners and associated performance data at Momentum Strategy.

High Growth in Operating Costs Bad for Stocks?

Does growth in a firm’s operating costs signal trouble for its stock? In their June 2014 preliminary paper entitled “Cost Growth and Stock Returns”, Dashan Huang, Fuwei Jiang, Jun Tu and Guofu Zhou examine the relationship between growth in operating costs and future stock returns. They measure operating cost growth as the annual percentage change in costs of goods sold plus selling, general and administrative expenses. They speculate that high cost growth warns of deteriorating profitability. Since analysts and investors focus on earnings and cash flows, they may not fully appreciate the import of cost growth. To ensure that cost growth data is available for public signaling, they relate stock return for July through June of year t+1 to accounting data as of the end of firm fiscal year t-1. Using accounting data from 1963 through 2012 and associated stock returns during July 1968 through 2013 for a broad sample of U.S. common stocks, they find that: Keep Reading

Aggregate Asset Growth as a Stock Market Indicator

Research (see “Asset Growth Rate as a Return Indicator” and “Asset Growth a Bad Sign for Stocks Everywhere?”) indicates that stocks of firms with high asset growth rates tend subsequently to underperform the market. Does this finding translate to the overall stock market? In the April 2014 version of his paper entitled “Asset Growth and Stock Market Returns: a Time-Series Analysis”, Quan Wen examines whether the asset growth anomaly observed at the firm level applies in aggregate to the U.S. stock market. He also investigates whether any aggregate effect is predominantly behavioral or risk-based. He estimates aggregate growth rate quarterly as the market capitalization-weighted sum of firm-level percentage changes in book value of total assets. To ensure all asset data is known to investors, he relates asset growth rate to returns two quarters later. Using quarterly U.S. stock market excess returns (relative to the risk-free rate), asset growth rates for listed U.S. firms that employ calendar year accounting, analyst forecasts/revisions, stock returns around earnings announcements, and data required for comparison of asset growth with other U.S. stock market indicators during 1972 through 2011, he finds that: Keep Reading

A Few Notes on Global Value

In the introduction to his 2014 book entitled Global Value: How to Spot Bubbles, Avoid Market Crashes, and Earn Big Returns in the Stock Market, author Mebane Faber, ponders: “Can we or can’t we predict when a bubble is occurring? Below we [try] to find an objective way to identify bubbles, avoid their popping, and invest in their aftermath.” He focuses on the the cyclically adjusted price-to-earnings (CAPE) ratio (or P/E10) as a bubble indicator, including a variety of charts. Based on concepts originally developed and refined by Benjamin Graham, David Dodd, Robert Shiller and many others, he concludes that: Keep Reading

Successfully Exploiting the ex-Dividend Effect?

Can the best traders reliably exploit the ex-dividend effect (the tendency for dividend-paying stocks to fall by less than the dividend amount after paying the dividend)? In their March 2014 paper entitled “Ex-Dividend Profitability and Institutional Trading Skill”, Tyler Henry and Jennifer Koski examine whether highly skilled traders bearing very low transaction costs (some institutions) successfully exploit this effect. They use actual transaction prices and actual transaction costs. They segment their sample period into three regimes: Regime 1 is pre-decimalization and pre-tax reform that equalizes capital gains and dividend tax rates; Regime 2 is post-decimalization and pre-tax reform; and, Regime 3 is post-decimalization and post-tax reform. They specify the ex-dividend trading window as days -5 through +5 relative to ex-dividend day 0. Using a large proprietary set of institutional common stock buy and sell transactions and associated transaction costs, and contemporaneous dividends, returns, bid/ask prices and trading volumes for those stocks, during 1999 through 2007 (24,741 ex-dividend events for 1,351 firms), they find that: Keep Reading

Stock Market Valuation Ratio Trends

To determine whether the stock market is expensive or cheap, some experts use aggregate valuation ratios, either trailing or forward-looking, such as earnings-price ratio (E/P) and dividend yield. Operating under a belief that such ratios are mean-reverting, most imminently due to movement of stock prices, these experts expect high (low) future stock market returns when these ratios are high (low). Where are the ratios now? Using the S&P 500 Index level as of the close on 3/20/14 and the most recent actual and forecasted earnings and dividend data from Standard & Poor’s, we find that: Keep Reading

NASDAQ vs. NYSE Dividend Capture

Is the conventional wisdom that traders can scalp part of cash dividends by buying stocks just before ex-dividend day and selling just after reliable across exchanges? In their January 2014 paper entitled “Ex-Dividend Day Stock Price Behavior – the NASDAQ Evidence”, Shishir Paudel and Sabatino Silveri investigate whether dividend-paying NASDAQ stocks exhibit ex-dividend day price behaviors similar to those of more closely studied dividend-paying NYSE stocks. They measure ex-dividend day price drops with the price-drop ratio (PDR), the ratio of the change in stock price to the amount of the cash dividend. Using a sample of 49,325 (90,867) cash dividends for NASDAQ (NYSE) stocks during 1983 through 2011 (ignoring dividends less than $0.05), they find that: Keep Reading

Stock Markets Have Quality, Too?

Are “quality” country stock markets good places to invest? In his December 2013 paper entitled “Quality Investing and the Cross-Section of Country Returns”, Adam Zaremba investigates whether aggregate financial quality determines country stock market performance. Specifically, he uses two-month lagged 12-month data for listed firms to calculate the following eight quality metrics at the country level in each of 66 countries:

  1. Return on Assets (ROA) – ratio of net income to average assets.
  2. Return on Equity (ROE) – ratio of net income to average common equity.
  3. Profit Margin (PM) – ratio of net income to sales.
  4. Operating Margin (OM) – ratio of operating income to sales.
  5. Gross Margin (GM) – ratio of gross income (sales minus cost of goods sold) to sales.
  6. Assets to Debt (AD)- ratio of total assets to short-term plus and long-term borrowings.
  7. EBITDA to Debt (ED) – ratio of EBITDA to short-term plus long-term borrowings.
  8. Current Ratio (CR) – ratio of current assets to current liabilities.

He uses MSCI country indexes to measure country market returns. He also calculates for each country the total market capitalization, aggregate book-to-market ratio and 12-month market return momentum. He tests relationships between country-level quality factors and returns by constructing portfolios of the equally weighted top 30% (high-quality), middle 40% (mid-quality) and bottom 30% (low-quality) of country markets based on each quality metric. He also measures for each quality metric the performance of a fully collateralized portfolio that is each month long (short) the equally weighted 30% of country markets with the highest (lowest) quality. To test sensitivity to the currency used, he perform all calculations separately in U.S. dollars, euros and yen. Using monthly accounting and return data as specified during May 2000 through October 2013, he finds that: Keep Reading

Gross Profitability Strategy Return Drivers

Why does the gross profitability stock-screening strategy work? In their December 2013 paper entitled “Factoring Profitability”, Michael Branch, Lisa Goldberg and Ran Leshem explore the drivers of the gross profitability strategy for U.S. stocks. Specifically, they examine the contributions of factors in the conventional Fama-French-Carhart four-factor (FFC4) model of equity returns and the Barra USE4 12-factor model of equity returns to an idealized, industry-neutral gross profitability strategy. They define gross profitability as revenue minus cost of goods sold divided by assets. Idealized means a hedge portfolio that is each month long (short) stocks of firms in the top (bottom) fifth of gross profitability with no rebalancing frictions. Industry-neutral means constraining industry weights in the portfolio to equal those in the market index. Using stock price and accounting data and contemporaneous asset pricing model factor values as available during July 1963 through December 2012, they find that: Keep Reading

RTV and REY Model Updates

We have updated the details of the Reversion-to-Value (RTV) Model and the Real Earnings Yield (REY) Model of the U.S. stock market to incorporate data available through December 2013.

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