Fundamental Valuation

Can financial statement analysis expose stocks that investors incorrectly view as value or growth (glamor)? In their February 2011 paper entitled “Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach”, Joseph Piotroski and Eric So investigate stock misvaluation by contrasting firm performance expectations implied by value/growth classification with a simple financial statement metric that differentiates improving versus deteriorating financial performance. This metric (FSCORE, scale 0 to 9), based on nine binary financial statement parameters, measures both the overall financial condition of a firm and the degree to which the firm has improved this condition over the prior year. The authors examine how FSCORE interacts with five widely used relative valuation metrics (book-to-market ratio, cash flow-to-price ratio, earnings-to-price ratio, sales growth and equity share turnover) and with momentum. Using annual financial data and stock returns for a broad sample of firms over the period 1972 through 2008 (117,412 firm-year observations), they find that: More…

Is it feasible to isolate and exploit the value of entrepreneurial spirit among publicly traded stocks? In his Fall 2009 article entitled “Investing in Troubled Times: Entrepreneurs are Your Safest Bet”, Joel Shulman defines, filters and analyzes the performance of entrepreneurial stocks. Building on prior research, he defines “entrepreneurial” based on the following 15 attributes, several of which do not accommodate mechanical quantitative screening:

1. Organic growth opportunities
2. Above-average ownership stakes among key stakeholders
3. Low selling, general, and administrative expenses
4. Above average return on invested capital
5. Sustainable growth
6. Manageable debt
7. Active strategic alliances/partnerships/licensing deals
8. Aligned executive compensation packages
9. Low executive turnover
10. Transparent governance
11. Long duration of key managers
12. Low or no dividends
13. Family involvement
14. Strong earnings before interest, taxes, depreciation and amortization
15. Other significant stakeholder relationships (such as key board members)

Using  information for 9,000 publicly traded firms worldwide for which sufficient financial, stock return and other data are available over the period January 1997 through August 2009, he finds that: More…

Is company financial leverage a useful indicator of future stock returns? In their October 2010 paper entitled “Would You Follow MM or a Profitable Trading Strategy?”, Brian Baturevich and Gulnur Muradoglu test company leverage (gearing ratio) as a predictor of stock outperformance, controlling for market capitalization, price-to-earnings ratio, market-to-book value ratio and beta. At the beginning of May each year, they construct ten equally weighted portfolios ranked on gearing ratio as of the end of the preceding December and hold the portfolios for three years. They further sort each of these portfolios into ten sub-portfolios ranked on controlling variables as of the end of the preceding December (creating 100 sub-portfolios). Using stock return and accounting data for 413 non-financial S&P 500 companies over the period May 1985 through April 2004, they find that: More…

What are the implications for investors of a trend toward strategic and tactical allocation to index proxies (exchange-traded funds and derivatives) rather than individual securities? The July 2010 paper entitled “On the Economic Consequences of Index-Linked Investing” by Jeffrey Wurgler provides an overview of the effects of index-linked investing on stock prices, risk-return trade-offs, investor portfolio allocation decisions and fund manager skill assessments. The September 2010 paper entitled “Index Investment and Financialization of Commodities” by Ke Tang and Wei Xiong investigates the effects of increased investing during the last decade in commodity indexes. The October 2010 paper entitled “The Financialization of Commodity Futures Markets or: How I Learned to Stop Worrying and Love the Index Funds” by Scott Irwin and Dwight Sanders surveys research on the impact of commodity index fund growth on commodity price behavior. Using results of prior research and recent data on indexation investment levels, index returns and component asset returns, these papers find that: More…

Does high-frequency trading amplify noise and thereby reduce the signal-to-noise ratio in stock returns? In his August 2010 paper entitled “The Effect of High-Frequency Trading on Stock Volatility and Price Discovery”, Frank Zhang examines the effect of high-frequency trading on stock price volatility and on incorporation of fundamental news into price. He defines high-frequency trading as that driven by fully automated trading strategies with very high trading volume and extremely short holding periods ranging from milliseconds to minutes and possibly hours (typically not overnight). He estimates the volume of high-frequency trading as the residual after accounting for institutional and individual investor activities. Using price, trading and institutional holdings data for a broad sample of U.S. stocks from the first quarter of 1985 through the second quarter of 2009, he finds that: More…

Conventional wisdom is that company management can maximize stock price by issuing weak guidance for future earnings that sets low expectations, and then reporting earnings that beat the low expectations. Does evidence support this belief? In their September 2010 paper entitled “The Stock Price Effects from Downward Earnings Guidance Versus Beating Analysts’ Forecasts: Which Effect Dominates?”, Lynn Rees and Brady Twedt investigate the net effect on stock price of downward earnings guidance that enables a subsequent positive earnings surprise. Using a sample of 8,635 guidance-earnings observations for 2,751 firms during 1993 through 2006, along with a matched control sample, they find that: More…

Both stock price momentum and asset growth rate exhibit empirical value as return predictors for individual stocks. Does combining these indicators offer enhanced value to investors? In their September 2010 paper entitled “Firm Expansion and Stock Price Momentum”, Peter Nyberg and Salla Pöyry investigate the interaction between firm-level asset growth (change in balance sheet total assets) and stock price momentum. Specifically, they measure returns for a monthly strategy that buys (sells) the prior winners (losers) within groups of stocks sorted first on on asset growth rates and then on 11-month past returns with skip-month. Using data for a broad sample of U.S. firms listed on NYSE, AMEX and NASDAQ over the period 1964-2006, they find that: More…

The Mojena Market Timing model, developed and maintained by retired professor Richard Mojena, is a method for timing the broad U.S. stock market based on a combination of 11 monetary, fundamental, technical and sentiment indicators to predict changes in intermediate-term and long-term market trends. He adjusts the model annually to incorporate new data year by year. Professor Mojena offers a hypothetical backtest of the timing model since 1970 and a live investing test since 1990 based on the S&P 500 Index (with dividends). To test the robustness of his model’s performance, we consider a sample period bounded by the availability of Standard and Poor’s Depository Receipts (SPY) as a conveniently investable proxy for the S&P 500 Index. As benchmarks, we consider both buying and holding SPY and trading SPY based on the 10-month simple moving average (SMA) of the S&P 500 Index. Using the trade dates from the Mojena Market Timing live test, daily dividend-adjusted closes for SPY and daily yields for 13-week Treasury bills (T-bills) over the period 1/29/93 through 8/27/10 (nearly 18 years), we find that: More…

Does a surge in innovation predict a surge in equity value, or instead creative destruction of equity value, over the next few years? To explore this question, assuming patent applications need not be approved to be exploited, we examine relationships between the growth rates of U.S. patent applications/patents as simple measures of innovation and U.S. stock market returns. Using U.S. patent activity (numbers of applications and patents) by calendar year for 1866-2009 as available and contemporaneous annual levels of  Shiller’s S&P Composite Index for 1871-2009  (139 years), we find that: More…

Two charts added to “Market Models”, a backtest of the 6-month forecasts and a current valuation map, offer context for the projections from the Reversion-to-Value (RTV) Model and the Real Earnings Yield (REY) Model of the U.S. stock market.