Objective research to aid investing decisions

Value Investing Strategy (Strategy Overview)

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Allocations for November 2023 (Final)
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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.

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

Progressively Comprehensive Payout Metrics

Do firm efforts to pay shareholders directly (via dividends) and indirectly (via share repurchases and paydown of debt) translate to stock outperformance? In their May 2012 paper entitled “Enhancing the Investment Performance of Yield-Based Strategies”, flagged by a subscriber, Wesley Gray and Jack Vogel compare aggregate performance statistics of stocks ranked by the following four progressively comprehensive yield metrics:

  1. DIV: dividend yield.
  2. PAY1: payout encompassing dividend plus share repurchase yield.
  3. PAY2: payout encompassing dividend plus net repurchase (repurchase minus issuance) yield.
  4. SHYD: comprehensive shareholder yield encompassing dividend plus net repurchase plus net debt paydown (annual difference in debt load divided by market capitalization) yield.

They focus on annually rebalanced, value-weighted portfolios with financial stocks excluded. Using monthly return, dividend, stock repurchase/issuance, debt load and other accounting data for a broad sample of U.S. stocks during 1971 through 2011, they find that: Keep Reading

CFO Insights on Earnings Manipulation Red Flags

What do insiders regard as red flags for corporate earnings manipulation? In their May 2013 paper entitled “Earnings Quality: Evidence from the Field”, Ilia Dichev, John Graham, Campbell Harvey and Shiva Rajgopal report earnings quality insights from Chief Financial Officers (CFO) of publicly owned companies via 169 responses to an anonymous online survey, plus 12 telephone interviews. They invited survey participation via emails in late October 2011 and closed the survey in early December 2011. Firms of responding CFOs are mostly from the manufacturing (38%), banking/finance/insurance (16%) and healthcare/pharmaceuticals (8%) sectors, and about 27% have annual revenues greater than $10 billion. Based on survey results, CFOs believe that: Keep Reading

Implications of Worldwide P/E10s

What is the state of cyclically adjusted price-earnings ratios (CAPE, P/E10 or Shiller PE), stock index level divided by average real earnings over the past ten years, across country equity markets worldwide? In his October 2013 paper entitled “What the Shiller PE Says About Global Equity Markets: Update 2013”, Joachim Klement updates expected returns for equity markets around the world based on P/E10 (see “Predictive Power of P/E10 Worldwide”). He adjusts P/E10 for economic conditions for each country via regression of P/E10 versus real GDP growth, real per capita GDP growth, real interest rate and inflation. Using stock index level, P/E10 and economic data for 20 developed and 18 emerging equity markets as available through September 2013, he finds that: Keep Reading

Stock Screening Power of Long-term Average Valuation Ratios

Which long-term smoothed (10-year average) stock valuation metric works best to screen stocks? In the end-of-September 2013 version of their paper entitled “On the Performance of Cyclically Adjusted Valuation Measures”, Wesley Gray and Jack Vogel compare the abilities of five valuation ratios expressed as yields to predict U.S. stock returns, as follows: 

  1. 10-year average real earnings to market capitalization (CA-EM)
  2. 10-year average real book values to market capitalization (CA-BM)
  3. 10-year average real earnings before interest, taxes, depreciation and amortization to total enterprise value (CA-EBITDA/TEV)
  4. 10-year average real free cash flow to total enterprise value (CA-FCF/TEV)
  5. 10-year average real free gross profits to total enterprise value (CA-GP/TEV)

They adjust for inflation using the monthly U.S. Consumer Price Index (CPI). Each year on June 30 (with accounting data lagged to ensure availability), they sort stocks into tenths (deciles) based on each ratio. They then calculate monthly decile returns over the next 12 months based on equal initial weights, with either annual (next June 30) or monthly decile reformation. For monthly reformation, they recalculate market capitalizations (but not valuation ratios) each month. They also test a stock return momentum overlay, each month splitting each valuation ratio top decile into high-momentum and low-momentum halves, with momentum defined as cumulative return from 12 months ago to one month ago. They do not account for trading frictions or taxes. Using stock prices and accounting data for U.S. firms with at least 10 years of the required accounting data and market capitalizations above the 40th percentile for NYSE-listed stocks, and contemporaneous CPI data, during 1962 through 2012, they find that: Keep Reading

Reward for the Risk of Value Worldwide?

Do book value-to-price ratio (B/P) and earnings-to-price ratio (E/P) indicate reward-for-risk opportunities at the country level worldwide? In their September 2013 paper entitled “Risky Value”, Atif Ellahie, Michael Katz and Scott Richardson investigate relationships among these valuation ratios, earnings growth and future returns at the country level for 30 countries over the past two decades. They construct monthly country-level valuation and earnings growth outlooks from capitalization-weighted firm fundamentals and earnings forecasts. They then relate these measures to country capitalization-weighted stock market future excess returns (relative to local risk-free rates), with the return measurement interval commencing four month after fundamentals are available. They replace negative country-level E/P values with zero. Using monthly firm-level fundamentals and stock data, as well as macroeconomic forecasts, for 30 countries during March 1993 through June 2011 (6,600 country-month observations), they find that: Keep Reading

Testing the Fed Model

The guiding belief of the Fed Model of stock market valuation is that investors use a Treasury note (T-note) yield as a benchmark for the expected (forward) earnings yield of the stock market. When the gap between the forward earnings yield and the T-note yield is positive (negative), stocks are relatively attractive (unattractive), and investors bid stocks up (down) to restore yield balance. Does evidence justify this belief? To investigate, we relate the month-end gap between the S&P 500 1-year forward operating earnings yield and the 1-year T-note yield to future returns for the S&P 500 index. We calculate the 1-year forward operating earnings yield from the Earnings Forecast and the level of the S&P 500 Index. Using end-of-month data for the two yields over the period March 1989 (limited by availability of an input variable for the Earnings Forecast) through July 2013 (over 24 years), we find that: Keep Reading

Fed Model or P/E Model for Predicting Stock Market Corrections?

Can investors rely on overvaluation signals from the market price-earnings ratio (P/E) and the Fed Model to predict major stock market corrections? Which model works better? In their July 2013 paper entitled “Does the Bond-Stock Earning Yield Differential Model Predict Equity Market Corrections Better Than High P/E Models?”, Sebastien Lleo and William Ziemba test the power of eight bond-stock earnings yield differential model (BSEYD) variants and eight market P/E model variants to predict stock market corrections. They specify the bond yield for the BSEYD model as that of the 10-year U.S. Treasury note (T-note). They define a stock market correction as a decline of 10% or more within one year. They specify the 16 model variants based on: (1) either BSEYD, the natural logarithm of BSEYD, P/E or the natural logarithm of P/E; (2) either current year or rolling 10-year average stock market earnings; and, (3) either of two ways of calculating the threshold for extreme overvaluation. Both methods of setting the extreme overvaluation threshold for the 16 indicators are out-of-sample based on indicator average and standard deviation over a rolling one-year historical window. They measure success of model variants based on both the proportion of signals followed by corrections within two years and, conversely, the proportion of crashes preceded by signals within the past two years. Using daily S&P 500 Index levels, S&P 500 earnings data and daily T-note yields during 1962 through 2012, they find that: Keep Reading

Out-of-Sample Test of What Works on Wall Street (O’Shaughnessy’s Cornerstone Strategies)

How well does stock screening research translate into performance? In the mid-1990s, James O’Shaughnessy identified “cornerstone value” and “cornerstone growth” as best-of-breed equity investment strategies. The former emphasizes dividends among large-capitalization stocks, and the latter momentum/earnings growth for a broader universe. Based on Standard and Poor’s Compustat data, he found that the value (growth) strategy returned 15% (18%) per year during 1952-1994, compared to 8.3% for the S&P 500 Index. He implemented these two strategies in late 1996 via mutual funds and publicized them in early editions of his book What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time. He subsequently sold the mutual funds (which apply slightly different portfolio formation rules from those specified in the original research) to Hennessy Funds in 2000, where they survive as the Hennessy Cornerstone Value Fund (HFCVX) and the Hennessy Cornerstone Growth Fund (HFCGX). Do these funds outperform simpler exchange-traded funds (ETF) that track their respective benchmarks funds: iShares Russell 1000 Value Index (IWD) for HFCVX and iShares Russell 2000 Index (IWM) for HFCGX? Using monthly total returns for HFCVXHFCGX, IWD and IWM during May 2000 (inception of the ETFs) through July 2013, we find that: Keep Reading

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