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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.

Predictive Power of the Gap Between Stock Earnings Yield and T-note Yield

Does the gap between the aggregate stock market forward-looking earnings yield and the yield on 10-year Treasury notes (T-note) predict future stock market and bond returns? In the November 2008 update to his paper entitled “The FED Model and Expected Asset Returns”, Paulo Maio examines the statistical and economic significance of the Fed model as an indicator of future stock market and bond returns. Said differently, he investigates whether mean reversion in stock and bond yields results in mean reversion of the yield gap. Using monthly data for a broad U.S. stock index and T-notes, and for contemporaneous benchmark indicators, over the period July 1954 through December 2003, he concludes that: Keep Reading

Speed/Determinants of Stock Price Reversion

Do mispriced stocks systematically revert to value under the long-term guidance of information traders? If so, what factors affect the rate of reversion for a particular stock? In their March 2009 paper entitled “How Quickly do Equity Prices Converge to Intrinsic Value?”, Dennis Capozza and Ryan Israelsen investigate the predictability of the reversion of stock price to a changing fundamental valuation baseline. They use annual fundamental (intrinsic) values for stocks from AFG Research, as derived from from estimates of future earnings based on growth rate and the decay of the spread between return on equity and cost of capital. Using monthly return/trading data, annual intrinsic value data and firm characteristics for 8,845 stocks over the period 1997 through 2006, they conclude that: Keep Reading

Performance of Fundamental-weighted Indexes in Europe

Capitalization-weighted stock indexes arguably incorporate a performance drag by overweighting overvalued stocks and underweighting undervalued stocks. In their February 2009 paper entitled “Fundamental Indexing: An Analysis of the Returns, Risks and Costs of Applying the Strategy”, Roel Houwer and Auke Plantinga examine the raw and risk-adjusted returns of hypothetical indexes of European stocks weighted by dividend, book value, revenue and operating income. They take the capitalization-weighted Stoxx 600 Index as a benchmark. Using monthly stock returns and firm fundamental data for the Stoxx 600, along with relevant risk-adjustment data, for the period 1993-2007, they conclude that: Keep Reading

De-Snooping Market Timing Rules Based on Fundamental and Sentiment Indicators

Some analysts fail to account for data snooping bias in their analyses of market timing indicators. This bias amounts to incorporating pure luck into results by testing many different rule variations or parameter settings within rules (or inhaling the “secondary smoke” of other analysts who have already screened a set of rules/parameters). This luck does not persist out-of-sample. Do any market timing rules generate outperformance after correcting for this bias? In their February 2009 paper entitled “Data Snooping and Market-Timing Rule Performance”, Andreas Neuhierl and Bernd Schlusche assess the profitability of a comprehensive set of simple and complex market timing rules based on fundamental indicators and investor sentiment indicators after correcting for data snooping bias. Simple rules derive from a single indicator, and complex rules derive from multiple indicators. Using thousands of simple and complex rules based on data for the S&P 500 to time the daily close of the S&P 500 index over the period 1980-2007, they conclude that: Keep Reading

Asset Growth Rate as a Return Indicator

Is firm total asset growth rate an independently valuable indicator of future stock returns? In their January 2009 paper entitled “The Asset Growth Effect in Stock Returns”, Michael Cooper, Huseyin Gulen and Michael Schill review the evidence for a strong asset growth effect in U.S. stock returns unexplained by other widely cited effects. Using firm fundamentals and stock return data for all non-financial U.S. public companies over the period 1968-2007, they conclude that: Keep Reading

Relative Cash Holdings Premium

Does the percentage of assets held in cash by a company, as an indicator of operating and investment flexibility, predict stock returns? In his January 2009 paper entitled “Firm’s Cash Holdings and the Cross-Section of Equity Returns”, Dino Palazzo measures and interprets the significance of relative cash holdings for future stock returns. Using stock return and firm fundamentals data spanning July 1967 through June 2007, he concludes that: Keep Reading

The Profit from the Peak Portfolio

In their 2008 book, Profit from the Peak: The End of Oil and the Greatest Investment Event of the Century, Brian Hicks and Chris Nelder examine the equity investment implications of a growing gap between a post-peak worldwide supply of energy from fossil fuels and a rising international demand for energy. They identify more than 70 companies that, in their judgment, are best positioned to exploit declining oil and gas supplies or “energy alternatives poised to power the years ahead.” How have the stocks of these companies performed over the past few years and in the very recent past? Using monthly dividend-adjusted return data for the recommended stocks as available from Yahoo!Finance for the period December 2000 through December 2008, we find that: Keep Reading

Cash as a Valuation Indicator

Does the level of cash held by a company, appropriately normalized for its business characteristics, reliably indicate the prospects for its stock? If so, is a high or low level of cash better for the stock? In his January 2009 paper entitled “Excess Cash Holdings, Risk, and Stock Returns”, Mikhail Simutin investigates the relationship between excess corporate cash holdings and future stock returns. He defines “excess” via multi-factor regression to normalize for key firm characteristics. Using characteristics, fundamentals and stock return data for non-financial U.S. companies over the period 1960-2006, he concludes that: Keep Reading

Methods and Results for ValueInvestorsClub.com Members

How do professional value investors make investment decisions? Do they beat the market? In their January 2009 preliminary paper entitled “Fundamental Value Investors: Characteristics and Performance”, Wesley Gray and Andrew Kern examine the detailed investment decision process and aggregate performance of professional value investors who participate in ValueInvestorsClub.com, an “exclusive [and confidential] online investment club where top investors share their best ideas.” The founders of ValueInvestorsClub.com are Joel Greenblatt and John Petry of Gotham Capital. Using a sample of 2,912 investment recommendations by ValueInvestorsClub.com members during January 2000 through June 2008, along with associated firm fundamentals and stock return data, they conclude that: Keep Reading

S&P 500 Quarterly Aggregate Earnings Estimate Evolutions

Several readers have inquired or commented about the accuracy of  Standard and Poor’s quarterly S&P 500 earnings estimates. How accurate have they been? Since late 2005, we have tracked the evolving bottoms-up S&P 500 year-over-year quarterly operating earnings growth estimates for 2006-2009 at roughly biweekly intervals. During the early part of this period, we recorded the average of the publicly available Standard and Poor’s and Reuters earnings estimates (generally similar). During the latter part, we recorded only the Standard and Poor’s estimates. Using evolving earnings forecasts for 2006-2009, we find that: Keep Reading

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