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primus
Re: Making Value Work

ALCON,

Motivated by this discussion, I recently posed a question to Stack Exchange, "Are the causes of momentum uniform for various asset classes?". I was surprised to find the lack of academic research of whether price leads fundamentals. I am aware of prevailing theories which link momentum to limitations in market efficiency and behavioral pattern. I am not, however, aware of much evidence which links prices changes to information asymmetry which is a violation of both strong and semi-strong forms of EMH.

So I did an initial experiment which regressed annual changes in return on assets versus annual logarithmic price changes over the same period over a ten year period. The population was stocks in the NYSE, NYSEMKT, and NASD universes. I am using the screener, so survivorship bias is present. The initial results are interesting, though I am not sure they are not conclusive.

The results of 10 year study:
# firms included: 2143
Correlation coefficients between annual earnings growth and price returns:
Median: .32
Average: .28
Cap-weighted average: .21

For the cap-weighted average:
T-stat (T[null: rho !< 0]): 9.81
Fisher Z-transform (1 tailed): 9.73
Fisher p-value: 1.00

In other words, there is a 1 probability that the size-weighted correlation between price changes and changes in returns are not less than 0.

Interesting, yes. But there are few problems that I can see:
- Survivorship bias
- Limited time horizon (10 years is relatively small)
- "Post ergo propter hoc" (correlation does not lead to causation). Just because price is correlated to fundamental shocks does not imply that price leads fundamentals. We just can't tell until we a) look at quarterlies (which would presume fundamental information is not diffused before it is publicly released); and, b) introduce lags.

Someone with some greater statistical acumen can probably take this up and perform a Granger causality test or something like that. In the meantime though, I am pretty convinced that one cause of momentum involves the diffusion of accurate information regarding fundamental shocks.

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

Feb 5, 2018 1:42:24 PM       
Edit 1 times, last edit by primus at Feb 5, 2018 4:46:30 PM
yuvaltaylor
Re: Making Value Work

I was surprised to find the lack of academic research of whether price leads fundamentals.
- "Post ergo propter hoc" (correlation does not lead to causation). Just because price rises in the periods in which fundamentals improve does not imply the direction of causation. Either fundamentals lead price, or price leads fundamentals. We just can't tell until we a) look at quarterlies (which would presume fundamental information is not diffused before it is publicly released); and, b) introduce lags.

Someone with some statistical acumen can probably take this up and perform a Granger causality test or something like that.


I'm probably misunderstanding you but I just can't conceive of a scenario in which changes in the price of a stock would lead to or cause changes in a company's return on assets. They might ANTICIPATE such changes using analyst reports and close reading of other fundamentals that cause changes in a company's earnings, but how could the price changes themselves possibly CAUSE changes in earnings? It seems to me that the question of causality is settled.

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

Feb 5, 2018 2:00:38 PM       
primus
Re: Making Value Work

You're right, Yuval. Poor word choice.

I meant to say that price changes anticipate fundamentals.

On a somewhat related note, I also think its possible for price changes to cause changes in fundamentals.

Take, for example, a capitally constrained and distressed firm. Higher prices lower the cost of capital, thus allowing the firm to refinance and fund growth projects. Tesla comes to mind. But, no, this was not what I intended by my former statement on causality.

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

Feb 5, 2018 2:41:29 PM       
Jrinne
Re: Making Value Work


- "Post ergo propter hoc" (correlation does not lead to causation). Just because price rises in the periods in which fundamentals improve does not imply the direction of causation.

David,

I agree about correlation and this is what I was try to say in my own way—lurking variables being one possible explanation for correlation without causation.

BTW, as per Wikipedia: Post hoc ergo propter hoc (Latin: "after this, therefore because of this") is a logical fallacy that states "Since event Y followed event X, event Y must have been caused by event X." It is often shortened simply to post hoc fallacy. But whatever it means I agree with you on that too.

My apologies for focusing on only one potential cause for momentum: I am not married to any particular explanation.

-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.
`

Feb 5, 2018 2:45:30 PM       
Edit 4 times, last edit by Jrinne at Feb 5, 2018 6:46:57 PM
davidbv
Re: Making Value Work

Speaking of correlation.
Anyone notice that ALL equity markets are moving together right now?

An unintended consequence of globalization.

So much for global diversification...

David

Feb 5, 2018 3:31:31 PM       
MisterChang
Re: Making Value Work

The NUMBER-ONE predictor of future earnings growth is LOW PROFIT MARGIN. I just happened across it accidentally, but it makes perfect sense. Companies with low profit margins have very strong sales and terrible earnings. So those companies are the most likely to experience earnings growth. Just use NPMgn%TTM with lower values being better.

In a VERY CLOSE SECOND PLACE is LOW ROA. This works for the same reason. I would think almost anything with net income in the numerator and something good in the denominator would work well here. These two factors beat all other factors by a mile.


Does this include negative earnings?

I've read in books/papers that profit margins are mean-reverting, but I didn't expect profitability such as ROA to be. A problem I have with using these types of metrics is some companies, like software companies are consistently high profitability, while some companies that rely on heavy investment in machinery and manufacturing are consistently low profitability, but I could be wrong.


Number three, lagging significantly behind those, is comparing the current quarter's analyst EPS estimate with the same quarter last year.

Number four is comparing the current year's analyst EPS estimate with last year's.


Did you use current ESP estimate minus previous ESP estimate? Or some other formula, such as a ratio? And did it result in higher is better?

Feb 5, 2018 4:15:10 PM       
yuvaltaylor
Re: Making Value Work

The NUMBER-ONE predictor of future earnings growth is LOW PROFIT MARGIN. I just happened across it accidentally, but it makes perfect sense. Companies with low profit margins have very strong sales and terrible earnings. So those companies are the most likely to experience earnings growth. Just use NPMgn%TTM with lower values being better.

In a VERY CLOSE SECOND PLACE is LOW ROA. This works for the same reason. I would think almost anything with net income in the numerator and something good in the denominator would work well here. These two factors beat all other factors by a mile.


Does this include negative earnings?


I used EPS%ChgTTM, which measures earnings growth whether the earnings are negative or positive. So, yes, this definitely includes negative earnings.

I've read in books/papers that profit margins are mean-reverting, but I didn't expect profitability such as ROA to be. A problem I have with using these types of metrics is some companies, like software companies are consistently high profitability, while some companies that rely on heavy investment in machinery and manufacturing are consistently low profitability, but I could be wrong.


The only difference between profit margin and ROA is that one has sales in the denominator and the other has assets. So they're going to behave very similarly over time. What we're looking at here is companies with strongly negative or low earnings and high sales or assets. Those are the companies whose earnings are going to grow the most.


Number three, lagging significantly behind those, is comparing the current quarter's analyst EPS estimate with the same quarter last year.

Number four is comparing the current year's analyst EPS estimate with last year's.


Did you use current ESP estimate minus previous ESP estimate? Or some other formula, such as a ratio? And did it result in higher is better?


No, I used current EPS estimate minus GAAP EPS divided by the absolute value of the latter. And yes, higher better.

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

Feb 5, 2018 10:16:19 PM       
mgerstein
Re: Making Value Work

The NUMBER-ONE predictor of future earnings growth is LOW PROFIT MARGIN. I just happened across it accidentally, but it makes perfect sense. Companies with low profit margins have very strong sales and terrible earnings. So those companies are the most likely to experience earnings growth. Just use NPMgn%TTM with lower values being better.

In a VERY CLOSE SECOND PLACE is LOW ROA. This works for the same reason. I would think almost anything with net income in the numerator and something good in the denominator would work well here. These two factors beat all other factors by a mile.


Interesting. Have you checked this against trends in turnover?

Low/high margin by itself is not good or bad. Low margin combined with high turnover is just as good as high margin combined with low turnover. A benefit of ROA etc. is that these numbers combine margin and turnover.

That's fundamentals and value. On the other hand, there's the noise component of stock pricing. Turnover and its role is not nearly as widely understood as margin, so at times, the market may excessively favor high margins and neglect turnover plays.


Does this include negative earnings?


I'd say yes, definitely. Some of the best opportunities I've encountered are among rotten companies becoming good companies, or even rotten companies working their way up to mediocrity. Also, shares of good or ok companies can do quite well as the market looks for them to move beyond temporary bad spells.


I've read in books/papers that profit margins are mean-reverting, but I didn't expect profitability such as ROA to be. A problem I have with using these types of metrics is some companies, like software companies are consistently high profitability, while some companies that rely on heavy investment in machinery and manufacturing are consistently low profitability, but I could be wrong.


ROA etc. do tend to be mean reverting but very slowly and towards a norm that reflects the nature of a company's business. So i think modeling based on this concept might be most productive if you think of ROA trending toward ROAInd, or something like that.

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

Feb 6, 2018 9:27:10 AM       
Jrinne
Re: Making Value Work

So, how do momentum factors affect real-world investing at P123 if you use value ratios too?

In other words: what is the effect of momentum--in the node of a ranking system--if you also use a value ratio?

Using momentum could have nothing to do with how momentum, by itself, affects stock returns in your system. Let me give a simple example to illustrate.

Suppose you use the ratio Earnings(TTM)/P in the rank for a port and stock XYZ pops up on you buy list for the first time because the E(TTM)/P ratio has increased (increasing the rank for that stock). Does your port recommend buying XYZ because E(TTM) has increased or is it because P has decreased?

You do not know right? Could be either. I understand this is not an actual formula at P123. Insert your own fundamental value for discussion.

What if you add close(0)/ Close(252) to your rank? The chance that XYZ's earnings have increased over the last year—assuming your port still recommends this stock—just increased dramatically.

If your port, with momentum factors, is doing well it could be because momentum, by itself, is having a positive effect. Equally plausible is that your port is doing well because momentum is interacting with the value ratio. Maybe it is both. Specifically, the port now has you selecting stocks that have a high E(TTM)/P ratio when the ratio has increased because of improving fundamentals. Because price has increased over the last year the denominator (price) will be greater than last year--for the stocks your port selects--and the numerator (fundamental) is much more likely to have increased. Your port might be working only because you are buying stocks with increasing fundamentals—the fundamentals in your value ratio. Momentum may have nothing to do with it.

You are not doing just finance at P123—unless you are fully aware of how your factors are interacting in the ranking system. Even then there are some quirky things that can effect a linear regression/factor analysis/supervised machine learning automated system (that have nothing to do with finance).

-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.
`

Feb 6, 2018 9:32:29 AM       
Edit 25 times, last edit by Jrinne at Feb 6, 2018 2:46:18 PM
abwillingham
Re: Making Value Work


Here's an experiment. Create a ranking system with, say, 50 or 100 factors. Weight one of them at 100% and the rest at 0%.

Then create a screen on the Russell 3000 universe using that ranking system with just two rules:

rankprev(52) > 80
eps%chgttm > 15

Press the "totals" key and write down the number. Then weight a different factor at 100% and repeat.

The factors with the highest totals will be the ones that have worked the best in the last year.

Repeat for a few previous "as of" dates to weed out flukes.

Does that seem like a sensible way to model for future growth? Obviously, the factors would have to make good financial sense.

If anyone has any suggestions for improving this experiment, I'd welcome them.


Yuval, this may answer a major question I have had about testing emerging factors.
Have you found this method to be effective?

Sep 18, 2021 2:56:18 PM       
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