This In Practice piece gives a practitioner’s perspective on the article “Facts about Formulaic Value Investing,” by U-Wen Kok, CFA, Jason Ribando, CFA, and Richard Sloan, published in the Second Quarter 2017 issue of the Financial Analysts Journal.
What’s the Investment Issue?
Value investing, based on a company’s fundamental intrinsic value, is one of the most popular and enduring styles of investing. But can investing strategies based merely on formulaic ratios, such as book to market, deliver the performance investors expect?
Security Analysis, the classic value-investing text by Graham and Dodd (1934), which advocated buying stocks trading at a significant discount to intrinsic value, specifically avoided a formulaic approach. Graham and Dodd’s comprehensive approach to value investing is still used by many investors, but the advent of computers has resulted in the term “value investing” now often being used to describe mechanical investment strategies based on simple ratios of accounting numbers to stock prices. Mechanical products have become ubiquitous. Vanguard’s Value Index Fund, for instance, manages some $44 billion of assets, while Blackrock’s iShares Russell 1000 Value ETF manages $31 billion.
The authors set out to examine whether mechanical formulaic strategies equate to traditional value strategies or whether an approach involving a comprehensive study of a company’s “intrinsic value” is more successful in identifying temporarily underpriced securities.How Do the Authors Tackle the Issue?
Replicating and extending previous findings, the authors re-examined the performance of the Fama–French value factor, which is based on the book-to-market ratio, by applying more detailed and granular analysis to the same data. The Fama and French findings, published in 1998 in the Journal of Finance, are highly regarded by some asset management practitioners. To better understand the source of the returns to the Fama–French value factor, the authors reported the returns by size of company.
As well as book value, the authors examined two other common fundamental-to-price ratios: trailing earnings and forward earnings. Trailing earnings are defined as earnings per share before extraordinary items and discontinued operations for the most recent fiscal year, whereas forward earnings are the mean sell-side analyst forecast for the current fiscal year. The sample included all companies in the Russell 3000 Index from 2002 to 2014.
In addition, the authors analysed the correlation between fundamental-to-price ratios and subsequent changes in fundamentals to test whether a comprehensive strategy, along the lines of Graham and Dodd’s original thesis, could add more value than formulaic strategies.What Are the Findings?
There is no compelling evidence that buying US equities that are underpriced based on simple fundamental-to-price ratios provides better investment performance than investing in broad market indexes.
There is some evidence of a premium for the book-to-market ratio in the 1963–81 period, although this premium is absent for large-cap stocks. Outside this period, a premium is weak to nonexistent. There is no proof of a significant value effect in the 1926–62 period. There is a premium in the more recent 1982–2015 period, but it is primarily attributable to small-cap stocks.
In addition, small-cap stocks that appear expensive on fundamental ratios have underperformed. Shorting these stocks to take advantage of this finding is not easy: They are relatively capacity constrained, illiquid, and costly to borrow.
The weak evidence of a value premium, at least using the time frames in this article, suggests that instead of identifying underpriced securities, simple ratios of accounting fundamentals to prices merely identify securities in which the accounting numbers are temporarily inflated. The authors found, for instance, that
• the book-to-market ratio tends to identify securities with overstated book values that are subsequently written down,
• the trailing-earnings-to-price ratio systematically identifies securities with temporarily high earnings that subsequently decline, and
• the forward-earnings-to-price ratio tends to identify securities for which sell-side analysts have optimistic forecasts of future earnings.
Sophisticated fundamental analysis could significantly increase returns to investors relative to formulaic strategies. Although the simple book-to-market formula yields an insignificant annualized return of 4.1%, adjusting for expected changes in book values yields a highly significant return of 17.8% a year. Of course, this result implies that analysts are capable of near-perfect foresight of changes in book value. That implication is open to question.What Are the Implications for Investors and Investment Managers?
The clear conclusion for investors is that quantitative investment strategies based on ratios are not good substitutes for value-investing strategies using additional screening or a more comprehensive approach to identifying underpriced securities.
The failure of formulaic strategies represents an opportunity for skilled fund managers. The authors conclude that skilled analysts should enhance simplified quantitative approaches with the same type of fundamental security analysis proposed by Graham and Dodd to demonstrate they can add value. The study shows that formulaic value-investing strategies identify stocks with inflated accounting numbers that subsequently mean revert, which itself may be potentially useful information for company analysts.
The study also provides a reminder about the potential dangers of backtested performance. After all, more than 80 years ago, Graham and Dodd argued that trading strategies based on simple valuation ratios were unlikely to generate superior investment performance. With the advent of computers and financial databases, that lesson seems to have been unlearnt. Thousands of mechanical strategies have been backtested, and it is not surprising that some have worked in some markets over some time periods. The authors caution against using evidence from data mining to conclude that formulaic strategies can deliver healthy outperformance in the future.