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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.

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Economic/Market Factor Investing Heat Map

Can an approach that describes each asset class as a bundle of sensitivities to economic/market conditions improve investment decision-making? In their March 2016 paper entitled “Factor-Based Investing”, Pim Lausberg, Alfred Slager and Philip Stork develop a “heat map” to summarize how returns for seven asset classes relate to six economic/market factors. The seven asset classes are: (1) government bonds; (2) investment grade corporate bonds; (3) high-yield corporate bonds; (4) global equity; (5) real estate; (6) commodities; and, (7) hedge funds. The six economic/market factors are: (1) change in consensus forecast of next-year economic growth; (2) change in consensus forecast for next-year inflation; (3) illiquidity (Bloomberg market liquidity indexes); (4) volatility of stock market indexes; (5) credit spread (return on investment grade corporate bonds minus return on duration-matched U.S. Treasuries); and, (6) term spread (return on government bonds of duration 7-10 years minus return on government bills of duration three months). They also provide suggestions on how to use the heat map in the investment process. Using monthly asset class returns and factor estimation inputs during 1996 through 2013, they find that: Keep Reading

Comparing CAPE to Other Stock Market Valuation Ratios

Is Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE or P/E10) a better predictor of long-term stock market performance than other valuation ratios? In his January 2016 paper entitled “Predicting Stock Market Returns Using the Shiller CAPE — An Improvement Towards Traditional Value Indicators?”, Norbert Keimling first examines whether reduced dividend payout, new accounting standards and structural changes to key stock indexes limit the comparability of current and historical CAPEs. He then investigates whether CAPE is better at forecasting long-term equity market returns than price-to-earnings ratio, price-to-cash flow ratio, price-to-book ratio, dividend yield and CAPE adjusted for payout. Based on these findings, he applies CAPE and price-to-book ratio to predict long-term total returns for 17 equity markets in local currencies. Using Shiller’s monthly data for the U.S. stock market since 1871 and monthly data for 16 other country stock market indexes since 1969, all through 2015, he finds that: Keep Reading

Breaking Down Smart Beta

What kinds of smart beta work best? In their January 2016 paper entitled “A Taxonomy of Beta Based on Investment Outcomes”, Sanne De Boer, Michael LaBella and Sarah Reifsteck compare and contrast smart beta (simple, transparent, rules-based) strategies via backtesting of 12 long-only smart beta stock portfolios. They assign these portfolios to a framework that translates diversification, fundamental weighting and factor investing into core equity exposure and style investing (see the figure below). They constrain backtests to long-only positions, relatively investable/liquid stocks and quarterly rebalancing, treating developed and emerging markets separately. Backtest outputs address gross performance, benchmark tracking accuracy and portfolio turnover. Using beta-related data for developed market stocks during 1979 through 2014 and emerging market stocks during 2001 through 2014, they find that: Keep Reading

Profitability Metric Horse Race for Stocks and Sectors

Which measure of past firm profitability is most effective for forming U.S. stock and equity sector portfolios? In their October 2015 paper entitled “Portfolio Allocations Using Fundamental Ratios: Are Profitability Measures Effective in Selecting Firms and Sectors?”, John Hughen and Jack Strauss examine portfolio strategies based on four sector and firm profitability measures: gross profit, operating profit, EBITDA and an average (composite) of the three variables. They compare these portfolios to a buy-and-hold portfolio (S&P 500 Index stocks with equal sector weights) and portfolios form on cash flow, net income and book-to-market ratio. Their rankings of sectors and individual stocks include lags to ensure public availability of profit measures. Using quarterly returns and accounting data for S&P 500 Index stocks and ten associated sectors during January 1975 through April 2014 (with out-of-sample tests commencing January 1980), they find that: Keep Reading

Valuation/Trend Hedging of a Value and Momentum Stock Portfolio

Is there a way to suppress the volatility and drawdowns of a mixed value and momentum stock strategy while retaining most of its benefit? In his September 2015 paper entitled “Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom up, and the Top Down”, Mebane Faber examines the feasibility of a strategy that combines market valuation and market trend timing (defense) with a mixed value and momentum stock selection strategy (offense). Specifically:

For offense, he each month: (1) ranks stocks by each of price-to-earnings, price-to-book and earnings before interest and taxes-to-total enterprise value ratios and then re-ranks them by the average of the three separate value rankings; (2) ranks stocks by each of 3-month, 6-month and 12-month past returns and then re-ranks them by the average of the three separate momentum rankings; and, (3) forms an equally weighted portfolio of the top 100 value and top 100 momentum stocks and holds for three months (three overlapping portfolios).

For defense, he each month: (1) hedges half of the portfolio by shorting the S&P 500 Index if the long-term real earnings yield for the S&P 500 (inverse of the Cyclically Adjusted Price-Earnings ratio, CAPE or P/E10 as calculated by Robert Shiller, minus the most recently available actual 12-month U.S. inflation rate) is in the 20% of its lowest inception-to-date monthly values; and, (2) hedges half of the portfolio by shorting the S&P 500 Index if the index is below its 12-month simple moving average. 

The overall portfolio can therefore be 100% long “offense” stocks, 50% hedged or market neutral. He does not account for costs of portfolio reformations or hedging. Using monthly total returns for all NYSE stocks in the top 60% of market capitalizations, monthly levels of the S&P 500 Total Return Index and monthly values of CAPE during 1964 through 2014, he finds that: Keep Reading

Effectiveness of Stock Valuation Based on Accounting Variables

Is fundamental valuation of stocks an inherently effective investment approach? In their October 2015 paper entitled “Fundamental Analysis Works”, Sohnke Bartram and Mark Grinblatt test whether fundamental valuation usefully predict stock performance. Each month, they estimate the fair value (market capitalization) of each stock based on linear regression versus the 28 most commonly reported firm accounting variables (14 from the balance sheet and 14 from the income statement), thereby avoiding snooping of specific indicators. They then rank stocks into fifths (quintiles) based on the degree to which the market misprices them (percentage difference between actual market capitalization and estimated fair value). Finally, they measure the profitability of a monthly reformed portfolio that buys (sells) the most undervalued (overvalued) quintile. Using monthly accounting data as available from Forms 10-Q/10-K and prices for a broad sample of non-financial U.S. common stocks during January 1977 through December 2012 (432 months), they find that: Keep Reading

Professional Equity Valuation Methods

How do those whose jobs involve stock valuation perform this task? In their September 2015 paper entitled “Equity Valuation: A Survey of Professional Practice”, Jerald Pinto, Thomas Robinson and John Stowe report results of a 38-question equity valuation practices survey sent to 13,500 CFA Institute members with equity analysis job responsibilities. They guided respondents through the survey via the following introductory question:

“In evaluating individual equity securities, which of the following approaches to valuation do you use? (Select all that apply)

a) A market multiples approach (e.g., based on price-to-earnings, enterprise value-to-EBITDA, or other multiples)
b) A present discounted value approach (e.g., based on forecasts of future dividends, free cash flows, or economic value added/residual income)―also known as the income approach
c) An asset-based approach (e.g., based on book value, adjusted book value, asset market values, or asset replacement costs)
d) A (real) options approach (using options models to value equity)
e) Other (please specify)”

Using responses from 1,980 completed questionnaires, they find that: Keep Reading

Technical vs. Fundamental Investment Recommendations

Are expert technicians or fundamentalists better forecasters of short-term and intermediate-term asset returns? In the August 2015 version of their paper entitled “Talking Numbers: Technical versus Fundamental Recommendations”, Doron Avramov, Guy Kaplanski and Haim Levy assess the economic value of dual technical and fundamental recommendations presented simultaneously on “Talking Numbers”, a CNBC and Yahoo joint broadcast… “featuring fundamental and technical recommendations before and during the market open. Dual recommendations are made by highly experienced analysts representing prominent institutions.” Recommendations address both individual stocks and asset classes, including U.S. and foreign broad equity indexes, sector/industry equity indexes, bonds, commodities and exchange rates. Using 1,000 dual recommendations on 262 stocks and 620 dual recommendations on other assets, along with associated price data, during November 2011 through December 2014, they find that: Keep Reading

P/E10s Worldwide in 2015

What are current implications 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 July 2015 paper entitled “CAPE around the World: Update 2015 – Return Differences and Exchange Rate Movements”, Joachim Klement analyzes expected returns in local currencies for equity markets around the world based on an adjusted P/E10. His adjustment accounts for economic conditions in each country via regression of local P/E10 versus real GDP growth, real per capita GDP growth, real interest rate and inflation. He also examines interactions among exchange rate movements, adjusted P/E10s and expected returns. Using stock index level, P/E10, economic data and exchange rate versus the U.S. dollar for 20 developed and 18 emerging equity markets as available through June 2015, he finds that: Keep Reading

Combining Annual Fundamental and Monthly Trend Screens

Stock return anomaly studies based on firm accounting variables generally employ annually reformed portfolios that are long (short) the tenth of stocks expected to perform well (poorly). Does adding monthly portfolio updates based on technical stock price trend measurements boost anomaly portfolio performance? In the June 2015 version of their paper entitled “Anomalies Enhanced: The Use of Higher Frequency Information”, Yufeng Han, Dayong Huang and Guofu Zhou test eight equal-weighted long-short portfolios that combine annual screening based on a predictive accounting variable with monthly screening based on a simple moving average (SMA)-based stock price trend rule. The eight accounting variables (screened in June based on prior December data) are: (1) book-to-market ratio; (2) gross profitability; (3) operating profitability; (4) asset growth; (5) investment growth; (6) net stock issuance; (7) accruals; and, (8) net operating assets. The price trend screen excludes from the long (short) side of the portfolio any stock for which 50-day SMA is less than (greater than) 200-day SMA at the end of the prior month. Using accounting and daily price data for a broad sample of U.S. stocks during July 1965 through December 2013, they find that: Keep Reading

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