Fundamental Valuation

Wesley Gray (founder and executive managing member of Empiritrage LLC and Turnkey Analyst LLC) and Tobias Carlisle (founder and managing member of Eyquem Investment Management LLC) describe their 2013 book, Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, as “first and foremost about value investment–treating stock as part ownership of a business valued through analysis of fundamental financial statement data. …There are several quantitative measures that lead to better performance…: enhancing the margin of safety, identifying the highest quality franchises, and finding the cheapest stocks. We canvass the research in each, test it in our own system, and then combine the best ideas in each category into a comprehensive quantitative value strategy.” Using price and fundamental data for a broad sample of U.S. stocks (over about 40 years ending with 2011) to confirm and refine key findings of value investing research streams, they argue and find that: Keep Reading

Are there exploitable long-term cycles in U.S. stock market returns? In the January 2013 update of his paper entitled “Secular Mean Reversion and Long-Run Predictability of the Stock Market”, Valeriy Zakamulin explores mean reversion of the S&P Composite Index over intervals ranging from two to 40 years. He then runs an out-of-sample horse race using inception-to-date data to compare three regression-based models for forecasting long-term stock market returns: (1) mean reversion over the dynamically optimal horizon; (2) the random walk (future mean return equals (evolving) historical mean return); and, (3) valuation based on Robert Shiller’s cyclically adjusted price-to-earnings ratio (P/E10). Using real (Consumer Price Index-adjusted) S&P Composite Index total annual returns and earnings over the period 1871 through 2011 (141 years), he finds that: Keep Reading

Does market-driven deviation of the price of an exchange-traded fund (ETF) from its net asset value (NAV) predict an exploitable future return? In the September 2012 draft of their paper entitled “Reading Tomorrow’s Newspaper: Predictability in ETF Returns”, Jon Fulkerson and Bradford Jordan examine the relationship between price-to-NAV ratio and next-day return for ETFs. Using daily opening and closing prices for 762 equity ETFs and their components as available during January 2000 through early February 2011 equity, with the extreme 1% of recorded price-to-NAV values trimmed to exclude data entry errors, they find that: Keep Reading

The authors of the study summarized in “Exploit ETN Deviation from Indicative Value?” argue that deviations of prices for exchange-traded notes (ETN) from their indicative (immediate redemption) values may be useful as trading signals. How well does this mispricing concept work for the very liquid iPath S&P 500 VIX Short-term Futures ETN (VXX)? To check, we consider several mispricing thresholds and measure the short-term profitability of both long and short trades based on these thresholds. Using daily split-adjusted opening and closing prices and closing indicative values for VXX from inception at the end of January 2009 through mid-September 2012 (916 trading days), we find that: Keep Reading

Issuers of exchange-traded notes (ETN) publish daily indicative (immediate redemption) values for these debt instruments. Does deviation of the market price of an ETN from its indicative value represent an exploitable mispricing? In their September 2012 paper entitled “Mispricing and Trading Profits in ETNs”, Dean Diavatopoulos, Helyette Geman, Lovjit Thukral and Colby Wright investigate the gross profitability of a simple weekly trading strategy that buys (sells) ETNs priced under (over) associated indicative values. Specifically, they identify mispricings at the close each Tuesday (to avoid holiday and weekend effects), enter equally weighted positions at the next open and exit one week later. They test mispricing thresholds ranging from 0.50% to 20%. To assure liquidity, they specify target ETNs based on minimum average daily share volumes of 20,000 (34 ETNs), 50,000 (15 ETNs), 100,000 (12 ETNs) or 250,000 (seven ETNs). They ignore trading frictions, liquidity issues and shorting costs/constraints. Using Tuesday closing prices and indicative values and Wednesday opening prices for the specified ETNs during June 2006 through January 2012 (5.7 years), they find that: Keep Reading

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

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

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

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

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