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mgerstein
Making Value Work

By now, many (or most or all) of you know I don't advocate using any factor in isolation. An example I often use is Value, where I derive the ideal P/E as E / (R-G) where R is risk/quality and g is growth.

I did a quick back of the envelope empirical study to test some of this.

I started with the PRussell3000 universe.
I used a 5-years ago as of date (1/30/13)
I screened for stocks that back then Ranked above 90 for "Basic: Value"

So as of 1/30/13, all of these stocks could have been considered good value plays. And since the ranking system I used (it's available as a pre-set on p123) is pretty generic, I figure any other ranking system would produce a list with very heavy overlap.

I then measured performance over the next 5 years; well, actually, since this is spit and chewing gum, I roughed it out by fast forwarding to today and computing close(0)/close(1200) assuming 240 trading days in a year.

After knocking out 16 stocks that didn't have full 5-year histories, the average % return for the group was 63% and the median was 54%. But the maximum was +397% and the minimum was -91%. Remember, this range is only for stocks that were ranked above 90 for value. That's a pretty big range and one I'm sure many have wrestled with as models were taken from backtest to live trading.

I then ordered the 90+ Value Rank 2013 stocks into five buckets based on the future 5-year returns that were actually delivered. For each bucket, I computed (as of today) the 5-year rates of sales and EPS growth tat actually occurred. Here are the results:

Bucket # Avg % Return Avg 5Y Rev Growth Rate Avg 5Y EPS Growth Rate
1 +171% +10.4% +20.0%
2 +98% +7.2% +15.4%
3 +56% +9.9% +8.3%
4 +19% +11.6% +3.1%
5 -32% +7.0% +3.0%

What does this mean for p123 users?

Obviously, this is not anything you can literally apply because I'm matching returns with KNOWN future growth rate (we see sales is meh but EPS growth is important). But it conforms the strategic roadmap I've been advocating. When it comes to value, don;t just look for good value. You also need clues that allow your models to make reasonable assumptions about future growth prospects. The difference between a successful and unsuccessful value strategy has little and probably nothing to do with the value rank you use. It probably depends more on how good a job you do (1) creating a pre-qualified list of companies against which you'll apply your value ranks and/or (2) how good a combo rank you develop; one that effectively combines value with growth.

How do you model for clues to future growth? That's the challenge. If I knew the answer, I'd be rich enough to own the world. But I suggest ways to move models in the right direction is to focus on clues provided by fundamental capacity for growth (returns on capital, etc.) and sentiment measures that let you tap into investment community expectations such as estimate revision, projections and good solid technical analysis. What about historical growth rates? I've had so-soi success at this, but it's fertile ground for testing (Are growth rates persistent? If not, what might you discover and measure that might allow you to decide some growth rates are likely to be more persistent than others?)

Marc Gerstein
Director of Research, Chaikin Analytics
Blogs: https://actiquant.com, https://portfoliowise.com/portfoliowise-blog/ , https://www.chaikinanalytics.com/blog/
Twitter: @MHGerstein
I predict the future, as soon as it becomes the past

Jan 30, 2018 2:53:36 PM       
geov
Re: Making Value Work

I have just launched this DM: 40-Russell3000 Dividend-Growth Stocks: Moderate-Reverse-Cap-Weighted
https://www.portfolio123.com/app/r2g/summary?id=1518465

Basically this model selects Value stocks which also pay a reasonable dividend. The moderate-reverse-cap weighting gives higher weights to the smaller stocks than the bigger ones. I used the Position Weight Formula in the new rebalancing module.

This is a 40-position model which produced a simulated return of about 26% with very low turnover of about 170%, without market-timing. It is interesting that a 20-position model produces similar returns with 130% turnover.

Equal weight produces much lower returns of about 17% annualized. So there is a good case made for reverse-cap-weighting.

I don't think that anybody would want to subscribe to a 40 position model, but I thought it is a good demonstration of what can be done with the Position Weight Formula.

Attachment Reverse-Cap-Weighted 40 Russell3000 Div-Gro Stocks.png (191928 bytes) (Download count: 464)


Jan 30, 2018 5:11:38 PM       
nisser
Re: Making Value Work

I agree with the premise that you can't look at value alone. However, I'm not sure that your results show that value is the prevailing factor. In fact, it's showing that it was growth that gave you the better returns and that there was in fact a linear response to it (i.e. stocks with the highest growth rate gave you the best returns)

What would the results show if you divided the original pool of stocks into 5 buckets according to their growth rates in 2013 and looked to see what happened to them in time?

Or what would the results show if you followed the bottom 10% of the value stocks and looked at their returns according to their future growth rates?

Edit: or further yet, if you took 10% of random stocks from the original pile and looked at the return based on their growth rate?

Jan 30, 2018 9:52:06 PM       
Edit 1 times, last edit by nisser at Jan 31, 2018 12:43:34 AM
primus
Re: Making Value Work

Marc,

Thank you for your thoughts on differentiating undervalued securities from "value traps".

I think your explanation is a good reason for incorporating "quality" factors with value. In fact, I think that this factor interaction underlies the selection of variable in Fama-French's 5 factor model which incorporates investment aggressiveness (i.e., asset growth) with profitability (operating return on book equity). Quality factors tend not to work as well on their own as when they are paired up against factors which attempt to make sense of investor expectations. I.e, a low P/B or P/E does not portend that security is cheap, but rather than expectations are low.

And since investor beliefs can be fallible, it makes sense to try to determine cases where incorrect beliefs are more likely than not.

As per the textbook, the long term (sustainable) growth of earnings converge to reinvested return on capital (e.g., (NetIncBXor - DivPaid)/BookVal). The assumption behind this is that incremental returns on capital equal the average returns on capital. However, in the real world, we know that a) returns usually diminish with greater reinvestment, and b) incremental returns are determined by a confluence on real opportunity, luck, and skill. I think that this explains why historical earnings growth rates tend not to persist and, if anything, diminish over time.

In any case, I was hoping to get your thoughts on a means by which to differentiate growth and sustainment reinvestment. I think that this distinction could further your intent to identify factors that contribute to the persistence of future growth and profitability.

"The world is. The world is. Love and life are deep maybe as his eyes are wide." - Rush, "Tom Sawyer"

Jan 30, 2018 9:52:44 PM       
Edit 1 times, last edit by primus at Jan 31, 2018 12:09:05 AM
Miro
Re: Making Value Work

One time to consider using Basic Value by itself: when there is blood in the streets.

On a 52-week hold starting March 8, 2009, the Top 2% Basic Value stocks of the S&P 500, S&P 1500 and Russell 3000 each gained at least 450% vs 71% for SPY.

On a 52-week hold starting March 9, 2003, the Top 2% Basic Value stocks of those 3 universes gained between 111-145% vs 45% for SPY.

On a 52-week hold starting Feb 14, 2016, the Top 2% Basic Value stocks of those 3 universes gained between 68-80% vs 25% for SPY.



Jan 31, 2018 5:06:46 AM       
yuvaltaylor
Re: Making Value Work

The "basic value" ranking system does not include any enterprise-value-based ratios. In other words, it looks only at the value of a company's equity. Graham and Dodd made it very clear that one cannot look at equity in isolation--one must consider the company as a whole when assessing its value. That's why the standard measure of value, DCF valuation, looks at enterprise value, not just equity. This is especially important in the present day when so many companies have bought back shares, thus reducing equity, and increased their debt load. If you put in EBITDA to EV, unlevered free cash flow to EV, sales to EV, and/or gross profit to EV, you'd get better results and would avoid a few of those value traps.

I also think it's important to look not only at the performance of the top decile, but the ninth and eighth--and first, for that matter.

Yuval Taylor
Product Manager, Portfolio123
invest(igations)
Any opinions or recommendations in this message are not opinions or recommendations of Portfolio123 Securities LLC.

Jan 31, 2018 9:37:54 AM       
Jrinne
Re: Making Value Work

The "basic value" ranking system does not include any enterprise-value-based ratios. In other words, it looks only at the value of a company's equity. Graham and Dodd made it very clear that one cannot look at equity in isolation--one must consider the company as a whole when assessing its value. That's why the standard measure of value, DCF valuation, looks at enterprise value, not just equity. This is especially important in the present day when so many companies have bought back shares, thus reducing equity, and increased their debt load. If you put in EBITDA to EV, unlevered free cash flow to EV, sales to EV, and/or gross profit to EV, you'd get better results and would avoid a few of those value traps.

I also think it's important to look not only at the performance of the top decile, but the ninth and eighth--and first, for that matter.

Thanks Yuval! I agree with this but I have some questions.

I first encountered EBITDA/EV in Greenblatt's "The Magic Formula." And Ross et. al. make similar arguments in their text "Fundamentals of Corporate Finance." As Greenblatt points out this makes sense if you are considering buying a company. EV is one measure of how much you would have to pay to own a company. And why are you buying a company in the first place? To get the earnings (or EBITDA). The information is all there if you are going to purchase all of the company (including the debt obligation). And it is both simple and intuitive: the larger the ratio the more earnings for each dollar you invests. If nothing will change in the future just buy the company with the largest EBITDA/EV. Or maybe you prefer something a little different than EBITDA (insert your own preferred metric for discussion purposes).

If I am going to purchase a few stocks is there an additional question that I need to incorporate into my port? Do I have to try to figure out what part of the earnings or EBITDA goes to the stock holders vs the bond holders? Or does that all get factored out in some "identity" that I missed in the Ross text book or in the "Magic Formula?"

Edit: It could be a simple identity. Perhaps the reduced revenue stream to the equity holders— instead, going to the bond holders--is fully accounted for by the increased cost over and above the purchase of the stock which is incorporated in the EV. The EV in the denominator—which is greater than the market cap—may reflect this perfectly. Maybe the numerical value of this ratio is reduced by just the right amount and reflects the decreased revenue stream to the stock holders perfectly. That would be my guess at this point.

The above does leave out the question of differences in CAPEX between companies, I think. If you assume similar depreciation between the companies then CAPEX is incorporated—to a large extent—in the EV. Of course, this assumption could be very wrong in some instances. But I would be happy, for now, to understand the effect of revenue to bond holders.

Thanks for any ideas.

-Jim

Great theory, "and yet it moves."
-Quote attributed to Galileo Galilei (1564-1642) gets my personal award for the best real-world use of an indirect proof or reductio ad absurdum.
`

Jan 31, 2018 10:28:39 AM       
Edit 20 times, last edit by Jrinne at Jan 31, 2018 11:53:11 AM
mgerstein
Re: Making Value Work

The "basic value" ranking system does not include any enterprise-value-based ratios.


True. And I've had occasion to use other approaches, particularly EV/Sales.

I think though that when all is said and done, the most important element of value is a rational relationship between price paid for the asset (company or stock) and sound measure of wealth generated by the asset for which you're paying. How we define price and wealth generated can be defined many ways and I've come to believe the definitional details are less crucial in live-money investing than the way we determine the reasonableness of the relationship.

I believe if we can model in such a way as to effectively distinguish between more or less likely to grow in the future, we'll do well regardless of which measures of prices and wealth we choose to connect. At least that's the hypothesis of a research effort/project that's taking shape in my mind. (In a serious study, I'll also have to account or control for the risk-quality factor and also consider the possibility that very high valuation ratios signal strong growth expectations - which may or may not be correct. See what happens when my favorite football team sucks and now have weekends free!!).

Marc Gerstein
Director of Research, Chaikin Analytics
Blogs: https://actiquant.com, https://portfoliowise.com/portfoliowise-blog/ , https://www.chaikinanalytics.com/blog/
Twitter: @MHGerstein
I predict the future, as soon as it becomes the past

Jan 31, 2018 10:59:02 AM       
kumar
smile Re: Making Value Work

I thought my Rev2 value model is a failure, It is proving i am wrong.
It returns 40+% since launch; not significant draw down, it lagged performance with the bench mark for last 1 year.

then i came with value blend.
Value Rev3 - (Refined Value Rev2)
Value + RS
Value + Quality + Growth

It is too early, but last 3-6 months performance looks promising for all of my models.

Thanks
Kumar cool

Attachment KumarDM - SP500 Value Blend - 2018-01-31.png (43773 bytes) (Download count: 392)


Warren Buffett — 'Risk comes from not knowing what you're doing'
'Should you find yourself in a chronically leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks'

Jan 31, 2018 11:09:56 AM       
Edit 2 times, last edit by kumar at Jan 31, 2018 11:24:57 AM
mgerstein
Re: Making Value Work

[quote
In any case, I was hoping to get your thoughts on a means by which to differentiate growth and sustainment reinvestment. I think that this distinction could further your intent to identify factors that contribute to the persistence of future growth and profitability.

That's the magic question . . . and a research topic that should keep me off the street and out of trouble for a while. :-)

Marc Gerstein
Director of Research, Chaikin Analytics
Blogs: https://actiquant.com, https://portfoliowise.com/portfoliowise-blog/ , https://www.chaikinanalytics.com/blog/
Twitter: @MHGerstein
I predict the future, as soon as it becomes the past

Jan 31, 2018 11:23:20 AM       
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