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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.

Trading Country Stock Markets Based on Relative P/E10

Is it practical to compare valuations of different stock markets? In his August 2012 paper entitled “Global Value: Building Trading Models with the 10 Year CAPE”, Mebane Faber investigates the usefulness of 10-year cyclically adjusted price-to-earnings ratio (CAPE, or P/E10) in determining relative values for 32 country stock markets. Specifically, he ranks all country markets based on P/E10 each year starting in 1980 and reforms equally weighted portfolios annually of those market indexes with the lowest and the highest relative valuations. He uses an equally weighted, annually rebalanced portfolio of all country indexes as a benchmark. Using annual real total returns (in local currencies) and 10-year average lagged aggregate real earnings for all 32 country stock markets as available through 2011, he finds that: Keep Reading

Growth Investing Success Factors

What is growth investing, and how well does it work? How can investors enhance this investment style? In his July 2012 paper entitled “Growth Investing: Betting on the Future?”, Aswath Damodaran examines different approaches to growth investing: focusing on companies with small market capitalization; playing initial public offerings (IPO); seeking growth at a reasonable price (GARP); and, activist venture capital-like investing. He defines growth investing as pursuit of market undervaluation of future growth, looking for bargains based on overlooked growth potential. Based on the body of growth investing research, he finds that: Keep Reading

Testing P/E10 in Developed Markets

Does P/E10, current real (inflation-adjusted) level of a stock market index divided by associated average real earnings over the last ten years, usefully predict stock market returns for developed stock markets other than the U.S.? In their March 2012 paper entitled “Value Matters: Predictability of Stock Index Returns”, Natascia Angelini, Giacomo Bormetti, Stefano Marmi and Franco Nardini test the ability of P/E10 to predict future returns for 12 developed country stock market indexes: Australia, Belgium, Canada, France, Germany, Japan, the Netherlands, Norway, Sweden, Switzerland, the UK and the U.S. Using monthly stock market index levels, aggregate price-earnings ratios and consumer price indexes during January 1871 through March 2011 for the U.S. and during December 1969 through December 2010 for other markets, they find that: Keep Reading

Predictive Power of P/E10 Worldwide

Does P/E10, current real (inflation-adjusted) level of a stock market index divided by associated average real earnings over the last ten years, usefully predict stock market returns for non-U.S. markets? In the July 2012 revision of his paper entitled “Does the Shiller-PE Work in Emerging Markets?”, Joachim Klement assesses the validity of P/E10 as a long-term stock market return predictor in local currencies for 19 developed and 16 emerging equity markets. He calculates P/E10 in each market monthly using overlapping return and earnings measurement intervals. Using monthly data for country stock market indexes, earnings and inflation as available (with start dates ranging from January 1910 for the U.S. to January 2005 for China and Columbia) through April 2012, he finds that: Keep Reading

Prevalence and Indicators of Earnings Manipulation

How prevalent is earnings manipulation among U.S. public companies? What indications warn investors of the likelihood of earnings manipulation? In their July 2012 paper entitled “Earnings Quality: Evidence from the Field”, Ilia Dichev, John Graham, Campbell Harvey and Shiva Rajgopal explore earnings quality issues based on results of an anonymous survey of public company Chief Financial Officers (CFO) and in-depth interviews of a small group of CFOs and two standard setters. For context, they emphasize earnings based on Generally Accepted Accounting Principles (GAAP). Using results of 169 CFO responses to an emailed survey received during October 25, 2011 through December 9, 2011 and 12 associated CFO interviews conducted mostly via telephone, they find that: Keep Reading

Testing U.S. Equity Anomalies Worldwide

Do widely acknowledged U.S. equity market anomalies exist in other stock markets? If so, why? In his November 2011 paper entitled “Equity Anomalies Around the World”, Steve Fan investigates whether a number of equity market anomalies found among U.S. stocks (asset growth, book-to-market ratio, investment-to-assets ratio, six-month momentum with skip-month, net stock issuance, size and total accruals) also occur in other equity markets and the degree to which such anomalies relate to stock-unique (idiosyncratic) risk. He measures raw anomaly strength based on gross returns from hedge (“zero-cost”) portfolios that are long and short equally weighted extreme quintiles of stocks ranked annually for each accounting variable and every six months for momentum (with overlapping momentum portfolios). To estimate alphas, he adjusts raw returns for the three Fama-French risk factors (market, book-to-market, size) or three alternative investment-based risk factors (market, investment, return on assets). Using monthly common stock return data and associated firm characteristics/accounting data for 43 country stock markets during 1989 through 2009, he finds that: Keep Reading

Bond Market-Aggregate Earnings Interactions

Do aggregate corporate earnings predict bond market returns? In his January 2012 paper entitled “Aggregate Earnings and Corporate Bond Markets”, Xanthi Gkougkousi investigates the relationship between aggregate earnings and corporate bond market returns. Using quarterly aggregate earnings for a broad sample of U.S. stocks with fiscal years ending in March, June, September and December and total quarterly returns for ten U.S. corporate bond indexes during January 1973 through December 2010 (360,614 firm-quarter observations), he finds that: Keep Reading

Trading Options on Volatility of Fundamentals

Are realized (actual historical) and implied volatilities the whole story for equity option valuation? In their December 2011 paper entitled “Fundamental Analysis and Option Returns”, Theodore Goodman, Monica Neamtiu and Frank Zhang investigate the extent to which the equity options market fails to recognize volatility of firm operations (accounting data) and whether any such failure is exploitable. They focus tests on long, one-month-to-expiration, at-the-money straddles (long both a call and a put), which profit from large moves in underlying stock prices. They estimate future volatility in firm fundamentals via regression based on a combination of short-term sales/earnings growth and long-term sales/earnings growth volatility (standard deviation over the last six years). They isolate a “pure” expected fundamental volatility via regression versus implied volatility and the implied-realized volatility gap. Using data as available to estimate the relationship between fundamental volatility and returns on options for individual U.S. stocks during January 1996 through September 2010 (52,251 firm-quarters involving 3,481 distinct firms), they find that: Keep Reading

40-Year Valuation Ratio Horse Race

Which widely used valuation metric is best for picking individual stocks? In their November 2011 paper entitled “Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years”, Wesley Gray and Jack Vogel compare the performances of five annually reformed portfolios sorted on different valuation ratios: earnings-to-market capitalization (E/M); earnings before interest, taxes, depreciation and amortization-to-total enterprise value (EBITDA/TEV); free cash flow-to-total enterprise value (FCF/TEV); gross profit-to-total enterprise value (GP/TEV); and, book value-to-market capitalization (B/M). They also compare the performances of ratios calculated with one year of earnings versus averages of annual earnings over the past two to eight years. They include a lag of at least three months between firm reporting interval and return calculation interval. Using stock price and firm fundamentals data for NYSE common stocks with at least eight years of history (excluding financial, utilities and the 10% of stocks with the smallest market capitalizations) during July 1971 through December 2010, they find that: Keep Reading

SumZero Participant Trading Acumen

Do analysts who work for hedge funds make good calls? In their November 2011 paper entitled “Do Buy-side Recommendations Have Investment Value?”, Steven Crawford, Wesley Gray, Bryan Johnson and Richard Price III profile analysts employed by mutual funds, hedge funds and other investment firms and examine whether these experts make good trading recommendations. Using personal data and 2,135 long and short U.S. common stock investment propositions from over 1,100 participants in the SumZero community of buy-side investment professionals (mostly associated with hedge funds) during March 2008 through December 2010, and contemporaneous institutional holdings from SEC Form 13F filings, they find that: Keep Reading

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