Fundamental Valuation

What kinds of fundamental and technical indicators play well together? In their August 2018 paper entitled “When Buffett Meets Bollinger: An Integrated Approach to Fundamental and Technical Analysis”, Zhaobo Zhu and Licheng Sun test performance of six stock portfolios that jointly exploit one of three popular fundamental indicators and one of two popular technical indicators, as follows:

1. Piotroski’s FSCORE – each quarter long (short) stocks having high (low) scores summarizing a composite of accounting variables.
2. Standardized unexpected earnings (SUE) – each quarter long (short) the fifth of stocks with the highest (lowest) earnings surprises.
3. Return on equity (ROE) – each quarter long (short) the fifth of stocks with the highest (lowest) ROEs.
4. Moving averages (MA) – each month long (short) stocks with 20-day MAs above (below) 125-day MAs at the end of the prior month.
5. Bollinger bands (BOLL) – long (short) stocks below (above) one standard deviation of daily prices below (above) the average prices over the past 20 trading days.

Specifically, for each of six fundamental-technical pairs, they each month reform a portfolio that is long (short) stocks with both fundamental and technical buy (sell) signals. For risk adjustment, they employ widely used 5-factor (market, size, book-to-market, profitability, investment) alpha. Using accounting data and stock returns for a broad sample of U.S. common stocks priced at least $5, plus monthly factor returns, during January 1985 through December 2015, they find that:

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Can stock return forecasts from fundamental analysis make conventional mean-variance stock portfolio optimization work? In their December 2018 paper entitled “Optimized Fundamental Portfolios”, Matthew Lyle and Teri Yohn construct a portfolio that combines fundamentals-based stock return forecasts and mean-variance optimization and then compare results with portfolios from each employed separately. To suppress implementation costs, they focus on long-only portfolios reformed quarterly. Their fundamentals return forecasting model uses cross-sectionally normalized versions of book-to-market ratio, return on equity, change in net operating assets divided by book value and change in financial assets divided by book value. They update fundamental variables quarterly at the end of the reporting month. They generate stock return forecasts via a complicated multivariate regression of cross-sectionally normalized versions of the variables based on five years of rolling historical data. They then form a portfolio of the tenth (decile) of stocks with the highest expected returns, either value-weighted or equal-weighted. They consider several portfolio optimization methods, including minimum variance (requiring no return forecasts); mean-variance optimization with target expected return; and, Sharpe ratio maximization. Their combined approach employs fundamental stock return forecasts as inputs to those portfolio optimization methods that require returns. They use data from 1991-1995 to generate initial model inputs and 1996-2015 for out-of-sample testing. Using end-of-month data for a broad but groomed sample of U.S. common stocks with at least three years of historical data during January 1991 through December 2015, they find that:

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Is value of a firm’s patents a reliable predictor of its stock returns? In their November 2018 paper entitled “Patent-to-Market Premium”, Jiaping Qiu, Kevin Tseng and Chao Zhang investigate firm patent-to-market (PTM) ratio (percentage of market value attributable to patents) as a predictor of stock returns. They specify PTM ratio for each firm as follows:

1. Measure stock reaction to each patent grant date.
2. Depreciate each patent since grant date via an inventory depreciation method.
3. Estimate cumulative market value of all patents held by adding current depreciated values.
4. Divide cumulative patent value by firm market value.

They then at the end of June each year reform a hedge portfolio that is long (short) the tenth, or decile, of stocks with the highest (lowest) PTM ratios. Using market and lagged accounting data for a broad sample of U.S. common stocks/firms and intersecting patent data (5,475 distinct firms) during 1965 through 2010, they find that: Keep Reading

Does active stock factor exposure management boost overall portfolio performance? In their November 2018 paper entitled “Optimal Timing and Tilting of Equity Factors”, Hubert Dichtl, Wolfgang Drobetz, Harald Lohre, Carsten Rother and Patrick Vosskamp explore benefits for global stock portfolios of two types of active factor allocation:

1. Factor timing – exploit factor premium time series predictability based on economic indicators and factor-specific technical indicators.
2. Factor tilting – exploit cross-sectional (relative) attractiveness of factor premiums.

They consider 20 factors spanning value, momentum, quality and size. For each factor each month, they reform a hedge portfolio that is long (short) the equal-weighted fifth, or quintile, of stocks with the highest (lowest) expected returns for that factor. For implementation of factor timing, they consider: 14 economic indicators standardized by subtracting respective past averages and dividing by standard deviations; and, 16 technical indicators related to time series momentum, moving averages and volatilities. They suppress redundancy and noise in these indicators via principal component analysis separately for economic and technical groups, focusing on the first principal component of each group. They translate any predictive power embedded in principal components into optimal factor portfolio weights using augmented mean-variance optimization. For implementation of factor tilting, they overweight (underweight) factors that are relatively attractive (unattractive) based on valuations of factor top and bottom quintile stocks, top-bottom quintile factor variable spreads, prior-month factor returns (momentum) and volatilities of past monthly factor returns. Their benchmark portfolio is the equal-weighted combination of all factor hedge portfolios. For all portfolios, they assume: monthly portfolio reformation costs of 0.75% (1.15%) of turnover value for the long (short) side; and, annual 0.96% cost for an equity swap to ensure a balanced portfolio of factor portfolios. For monthly factor timing and tilting portfolios only, they assume an additional cost of 0.20% of associated turnover. Using monthly data for a broad sample of global stocks from major equity indexes and for specified economic indicators during January 1997 through December 2016 (4,500 stocks at the beginning and 5,000 stocks at the end), they find that: Keep Reading

Does Cyclically-Adjusted Price-to-Earnings ratio (CAPE, or P/E10) usefully predict stock portfolio returns? In their October 2017 paper entitled “The Many Colours of CAPE”, Farouk Jivraj and Robert Shiller examine validity and usefulness of CAPE in three ways: (1) comparing predictive accuracies of CAPE at different horizons to those of seven competing valuation metrics (ratios of an income proxy or book value to price); (2) exploring alternative constructions of CAPE based on different firm earnings proxies; and, (3) assessing practical uses of CAPE for asset allocation and relative valuation (supporting rotation among asset classes, countries, sectors or individual stocks). They employ a total return CAPE, assuming reinvestment of all dividends. For forward testing, they lag earnings and related data to ensure real time availability for investment decisions. Using quarterly and annual U.S. stock market data from Shiller since the first quarter (Q1) 1871 dovetailed with end-of-quarter data since Q4 1927, and data as available for other valuation metrics, all through the Q2 2017, they find that: Keep Reading

Is there a single variable based on accounting data that reliably captures expected returns of individual stocks? In their October 2018 paper entitled “A Fundamental Factor Model”, Stephen Penman and Julie Zhu construct and test a fundamental expected returns factor based on array of accounting inputs, encompassing earnings, book value and items that sum to these income statement and balance sheet totals. They focus on a robust version of this factor incorporating eight of these inputs (ER8), but consider simpler versions relying on only four (ER4) or two (ER2) inputs. They calculate a premium based on a portfolio that is each month long (short) the equally weighted stocks of firms ranked in the top (bottom) three tenths, or deciles, of the fundamental factor. They update fundamentals yearly three months after firm fiscal year ends from numbers published in annual financial statements. In terms of smart beta terminology, their approach replaces market capitalization weights with fundamentals weights. Using monthly returns and annual financial statements for a broad sample of non-financial U.S. common stocks during April 1981 (or June 1975 or April 1966 for simplified factors) through December 2015, they find that:

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What is the best way to construct equity multifactor portfolios? In the November 2018 revision of their paper entitled “Equity Multi-Factor Approaches: Sum of Factors vs. Multi-Factor Ranking”, Farouk Jivraj, David Haefliger, Zein Khan and Benedict Redmond compare two approaches for forming long-only equity multifactor portfolios. They first specify ranking rules for four equity factors: value, momentum, low volatility and quality. They then, each month:

• Sum of factor portfolios (SoF): For each factor, rank all stocks and form a factor portfolio of the equally weighted top 50 stocks (adjusted to prevent more than 20% exposure to any sector). Then form a multifactor portfolio by equally weighting the four factor portfolios.
• Multifactor ranking (MFR): Rank all stocks by each factor, average the ranks for each stock and form an equally weighted portfolio of those stocks with the highest average ranks, equal in number of stocks to the SoF portfolio (again adjusted to prevent more than 20% exposure to any sector).

They consider variations in number of stocks selected for individual factor portfolios from 25 to 200, with comparable adjustments to the MFR portfolio. They assume trading frictions of 0.05% of turnover. Using monthly data required to rank the specified factors for a broad sample of U.S. common stocks and monthly returns for those stocks and the S&P 500 Total Return Index (S&P 500 TR) during January 2003 through July 2016, they find that: Keep Reading

Which economic and market variables are most effective in predicting U.S. stock market returns? In his October 2018 paper entitled “Forecasting US Stock Returns”, David McMillan tests 10-year rolling and recursive (inception-to-date) one-quarter-ahead forecasts of S&P 500 Index capital gains and total returns using 18 economic and market variables, as follows: dividend-price ratio; price-earnings ratio; cyclically adjusted price-earnings ratio; payout ratio; Fed model; size premium; value premium; momentum premium; quarterly change in GDP, consumption, investment and CPI; 10-year Treasury note yield minus 3-month Treasury bill yield (term structure); Tobin’s q-ratio; purchasing managers index (PMI); equity allocation; federal government consumption and investment; and, a short moving average. He tests individual variables, four multivariate combinations and and six equal-weighted combinations of individual variable forecasts. He employs both conventional linear statistics and non-linear economic measures of accuracy based on sign and magnitude of forecast errors. He uses the historical mean return as a forecast benchmark. Using quarterly S&P 500 Index returns and data for the above-listed variables during January 1960 through February 2017, he finds that: Keep Reading

Can investors time premiums associated with widely used stock/firm fundamental ratios? In their September 2018 paper entitled “It Takes Two to Tango: Fundamental Timing in Stock Market”, Fuwei Jiang, Xinlin Qi, Guohao Tang and Nan Huang use a simple moving average (SMA) trend indicator to time premiums associated with four fundamental stock/firm ratios: book-to-market (BM), earnings-to-price (EP), gross profitability (GP), and return-on-assets (ROA). In calculating these ratios, they lag accounting variables by six months to avoid look-ahead bias. For each ratio, they:

• At the end of each June, rank stocks into tenths (deciles).
• Each day, calculate value-weighted average returns for the deciles with the highest (highest BM, EP, GP, ROA) and lowest (lowest BM, EP, GP, ROA) expected returns and maintain price indexes for these two deciles.
• Each day, hold a long (short) position in the decile with highest (lowest) expected returns only when the decile price index is above (below) its 20-day SMA, indicating an upward (downward) trend. When not holding a decile, hold Treasury bills.

As benchmarks, they each year buy and hold four portfolios that are each long (short) the value-weighted deciles with the highest (lowest) expected returns for one of the fundamental ratios. While focusing on a 20-day SMA, for robustness they also test SMAs of 10, 50, 100 and 200 trading days. While focusing on value weighting, they also look at equal weighting. They run tests on both non-financial Chinese A-share stocks and non-financial U.S. common stocks. Using annual groomed fundamentals data and daily returns for Chinese stocks during January 2001-December 2017 and for U.S. stocks during July 1970-December 2017, and contemporaneous Treasury bill yields, they find that:

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A subscriber proposed four alternative ways of timing the U.S. stock market based on simple moving averages (SMA) of the market price-earnings ratio (P/E), as follows:

1. 5-Year Binary – hold stocks (cash) when P/E is below (above) its 5-year SMA.
2. 10-Year Binary – hold stocks (cash) when P/E is below (above) its 10-year SMA.
3. 15-Year Binary – hold stocks (cash) when P/E is below (above) its 15-year SMA.
4. 5-Year Scaled – hold 100% stocks (cash) when P/E is five or more units below (above) its 5-year SMA. Between these levels, scale allocations linearly.

To obtain a sample long enough for testing these rules, we use the monthly U.S. data of Robert Shiller. While offering a very long history, this source has the disadvantage of blurring monthly data as averages of daily values. How well do these alternative timing strategies work for this dataset? Using monthly data for the S&P Composite Index, annual dividends, annual P/E and 10-year government bond yield since January 1871 and monthly 3-month U.S. Treasury bill (T-bill) yield as return on cash since January 1934, all through August 2018, we find that: Keep Reading