Friday, July 22, 2016

The Arbitrage of Price-to-Book: Introducing Value Composite 4

The trending value strategy buys the top 25 stocks by their 6 month price momentum among the top decile of stocks ranked by value composite 2 (VC2), a combination of price-to-earnings ratio, price-to-sales ratio, price-to-book ratio, earnings before interest tax depreciation and amortization to enterprise value ratio (EBITDA/EV), price-to-cash flow ratio, and shareholder yield.

Price-to-book was touted by Ben Graham, the father of value investing, in his book The Intelligent Investor ("By far the best book on investing ever written." - Warren Buffet) as a cornerstone of his rules for investing. Eugene Fama and Ken French published their famous three-factor model in 1992, which identified price-to-book as one of three factors that can explain the performance of a portfolio. They created a growth portfolio, comprised of stocks with the highest (top 30%) price-to-book ratios, and a value portfolio comprised of the lowest (bottom 30%) price-to-book ratios.

Since its publication, low price-to-book ratio has become the cornerstone of value indices, including the Russell 1000 Value (see page 25), the MSCI US Prime Market Value Index, and others, which are now tracked by hundreds of billions of dollars of value ETFs and mutual funds.

Any factor that is widely identified risks the chance of arbitrage. Essentially, as investors become aware of an anomaly (low price-to-book stocks performing well, in this case) and start tilting their portfolios toward that anomaly, it tends to be eroded away. Below is the recent performance of the top decile of stocks ranked by the various value factors of VC2.


Nominal Return %, Top Decile of Various Value Factors (Jan 1999 - July 2016)
The first thing that stands out is how well each factor has performed against the S&P 500 over the last 16 years (it has be too good to be true, right?). The second thing that stands out is that price-to-book has been eroded as a value factor. It's reasonable to believe that the erosion is due at least in part to its identification and wide use as a value factor.

This erosion, in addition to historical long periods of underperformance, is reason for concern for the trending value strategy. It's reasonable to expect better performance if price-to-book was removed from VC2.


Nominal Return %, Trending Value with and without Price-to-Book (Jan 2010 - July 2016)
Removing price-to-book from VC2 does improve performance, though the trending value strategy has been pretty flat for the last 2 years, as stock prices continue to rise and the bull market continues.

In addition to dropping price-to-book from his value composite of evaluating stocks, it appears from his mutual funds' fact sheets that James O'Shaughnessy has replaced price-to-cash flow ratio with free cash flow to enterprise value.


Nominal Return %, Top Decile of Various Value Factors (Jan 1999 - July 2016)
Free cash flow to enterprise value has been pretty much on par with price-to-sales and price-to-cash flow for the past 16 years, with price-to-cash flow actually outperforming free cash flow to enterprise value from about 2010 to 2015. But O'Shaughnessy has access to much larger datasets than I have available through Portfolio123, which may indicate larger advantages outside of the past 16 years. Additionally, free cash flow to enterprise value seems to have advantages over other traditional value factors, at least in theory.

Mimicking O'Shaughnessy by dropping price-to-book and replacing price to cash flow with free cash flow to enterprise value, value composite 4 (VC4) is born (VC3 was already named by O'Shaughnessy, as briefly mentioned here).


Nominal Return %, Trending Value (VC2, VC2 - PB, & VC4) (Jan 2010 - July 2016)
The trending value strategy that uses VC4 finishes a touch ahead of the benchmark for this time period, and has exhibited a much flatter trend over the last ~2 years than trending value using VC2 or VC2 without price-to-book.

How these perform moving forward remains to be seen, and I'll continue to track both. But O'Shaughnessy himself altering the value composite from the one he published in 2011 is pretty strong evidence that he has acknowledged the arbitrage of price-to-book.

Sunday, July 10, 2016

Consumer Staples Strategy - July 2016 Signals

The current stock signals for the consumer staples strategy introduced here are below. They are also published here. I used Portfolio123 to generate this screen.

HLF, Herbalife Ltd
NPD, China Nepstar Chain Drugstore Ltd
SENEA, Seneca Foods Corp.
CCE, Coca-Cola European Partners Plc
MED, Medifast Inc.
ADM, Archer-Daniels-Midland Co
GMCR^16, Keurig Green Mountain Inc
IMKTA, Ingles Markets Inc
MHG, Marine Harvest ASA
UVV, Universal Corp
USNA, USANA Health Sciences Inc
PM, Philip Morris International Inc
KMB, Kimberly-Clark Corp
AVP, Avon Products Inc.
NUS, Nu Skin Enterprises Inc.
ABEV, Ambev SA
GIS, General Mills Inc.
VGR, Vector Group Ltd
EPC, Edgewell Personal Care Co
PEP, PepsiCo Inc
CHD, Church & Dwight Co. Inc.
BTI, British American Tobacco PLC
WFM, Whole Foods Market Inc
FDP, Fresh Del Monte Produce Inc.
BG, Bunge Ltd

Thursday, July 7, 2016

What Wilt Chamberlain Can Teach Us About Investing (The Irrational Investor Part 2)

On March 2, 1962 Wilt Chamberlain set an NBA record by scoring 100 points in a game. He scored 28 points in free throws alone, another NBA record, going 28 for 32 (87.5%) from the line. While 100 points in a game is no small task, Wilt averaged 50.4 points per game and had already scored 78 points in a game that season.

What was more impressive in that game was his free throw percentage. Why? Wilt Chamberlain's career average from the free throw line was 50.4%. So how did he shoot 87.5% that night? By shooting his free throws underhanded. So why didn't he permanently adopt the underhanded free throw permanently? Because, in his words, it made him "feel silly, like a sissy." 

Malcolm Gladwell explored this and Wilt's inexplicable aversion to shooting underhanded in a recent podcast. (A Q&A with Gladwell that touches on the same issue with other NBA players is here). Ira Glass explores this topic, including other examples of people "choosing wrong", despite evidence suggesting a better outcome if they choose otherwise, in a recent episode of This American Life.

Gladwell ties Wilt's choice to rebuff the underhanded free throw to Mark Granovetter's threshold theory. In short, people with low thresholds are much more likely to follow the crowd, despite the advantages of not doing so. People with high thresholds are much more likely to ignore the social context of a behavior.

So how can this help you be a better investor? By being aware of our innate irrationality, we can avoid the herd mentality that led to the dotcom bubble. Awareness of this phenomenon can help you resist the latest trendy stock or strategy and to not lose sight of the underlying fundamentals of an asset. 

Knowing that your brain is working against you will hopefully prevent you from selling low and buying high, like so many millions of investors still seem to do.

Friday, June 24, 2016

Minimizing Downside Risk: Quantitative Strategies for Conservative Investors

In What Works on Wall Street, James O'Shaughnessy looked at how different factors fared within individual sectors of the stock market. He found the best performing factor for the utilities sector was a composite of several factors, called "value composite 2" (VC2), and the best performing factor for the consumer staples sector was shareholder yield (SHY). Both VC2 and SHY were introduced here.

To replicate the utilities value strategy, simply purchase the top 25 stocks in the all stocks universe (market cap >$200M in 2008 $) sorted by highest VC2 score. For the consumer staples strategy, purchase the top 25 stocks in the all stocks universe sorted by highest SHY. Both strategies rebalance annually, as with all the strategies in the book.

What's amazing about these strategies is not only do they outperform the market, they do it at a lower risk.


Strategy Performance (1968 - 2009)
Both strategies outperformed the market with lower standard deviation (see out-of-sample, 2010-2016 performance here).  A limitation of just looking at standard deviation is that it accounts for upside risk and downside risk, but since upside risk is a good thing, a more useful measure is downside deviation, which only measures downside risk.

The lower the downside deviation, the less likely the return will be lower than expected. In other words, the lower the downside deviation, the less risk the strategy has when stock prices are falling.

That's all there is to it. If you have any questions, post them in the comments below.

Monday, June 13, 2016

The Irrational Investor (Why Isn't Everyone Doing It?)

If you read my last post, one of your first reactions might have been, "If these strategies are so effective, why isn't everyone doing it?" Or, why aren't you in charge of a big hedge fund, why isn't every pension/trust fund using it, etc. (these are actual responses I've heard from people).

And while O'Shaughnessy covers this very question brilliantly in the first three chapters of What Works on Wall Street, I will make a feeble attempt in this post to begin to answer the skeptics. (He also has commentary on these topics, including "The Myth of the Most Efficient Market" and many others, on his asset management firm's website).

To begin, let's review the obvious: everyone isn't doing it, especially not managers of equity funds.


% of actively managed funds underperforming the S&P 500 on a 10-year return
On average between 1991 and 2009, 70% of actively managed funds had 10-year returns worse than the S&P 500. Vanguard has more recent (and more complete) data in its case for index-fund investing, shown below.


% of actively managed funds underperforming their benchmark on a 5-year return
(click to enlarge)
For the data and time period Vanguard looked at, actively managed funds underperformed their benchmarks two-thirds of the time on a 5-year return (a pretty strong case to not invest in actively managed funds).

So why, if strategies like trending value and the other 222 strategies that outperformed the S&P 500 between 1964 and 2009 are so lucrative, aren't these equity fund managers able to beat the market?

Identifying the factors that outperform the market is easy. It's a well documented fact that value investing over long periods of time will outperform the market (even Warren Buffet knows the value of value investing!). This is the basis for the trending value strategy I previously discussed. If the underlying indicators are obvious, who is left to blame? The investor's brain is a good place to start.

Indexing the S&P works because it's a strategy that never varies. Day in and day out, it the S&P 500 is an index of large cap stocks. It doesn't decide one year, "Oh small stocks are doing well recently, maybe I'll become a small cap index!" No, it stays the course.

As an individual investor (or as the manager of an equity fund, where it's literally your job to not lose your clients' money), would you have stayed the course through the 7 years between 1964 and 2009 that the trending value strategy underperformed the S&P 500?

Difference in CAGR, Trending Value Strategy minus All Stocks
When the strategy lags 20%+ behind the rest of the market (like it did in 1999 and 2009, shown above), are you really going to stick with it? Not likely -- fear/risk avoidance is wired into the deepest parts of your brain, an extremely useful feature for species survival, but not so useful for being disciplined in your investment strategy. (And if you stuck with it as a professional asset manager, you'd be fired).

A 2005 study found that brain-damaged people make better investment decisions than able-brained people, by being more willing to take risks and less likely to react emotionally to losses. The brain-damaged people ended up with 13% more money on average at the end of 20 mock investment rounds.

This is a brilliant market-timing game that shows you just how difficult it is to try to beat the market on a short-term basis. If you don't do well on that game, don't feel bad, not even Isaac Newton could to outsmart the market in the short-term. Or millions of other investors, as evidenced by recent history.

At the bottom of the Great Recession in Feb/March 2009, there was a net outflux of equity of over $50B (in just those 2 months; $9B net outflow over the year), as the influx into the bond market that year was $375B. Those who sold at the bottom not only realized their 50% losses, but missed out on the 159% rebound since then. They did it despite decades of past data and experience suggesting that the market would rebound.

So what's the takeaway? Discipline is the key to the individual investor hoping to implement a strategy proven to outperform the market over the long term.

"Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disclination to do so."
          - Douglas Adams

Sunday, June 5, 2016

Trending Value: Breaking Down a Proven Quantitative Investing Strategy

What I'm about to introduce to you is not black magic. And I say that because if you're a realist like me, anytime someone comes to you with something that sounds too good to be true, it's almost always too good to be true (or a pyramid scheme). Update: see my post attempting to answer the skeptics.

But this strategy is rigorously backtested and rooted in common sense. It isn't about finding correlations between obscure financial metrics and stock performance to formulate a otherwise seemingly random strategy.

Every metric in this strategy is commonly used by millions of investors every day; but when they are combined in a specific way, the results can be extraordinary.


Cumulative % Return, Trending Value vs All Stocks (1964 - 2009)

Portfolio Performance, Trending Value vs All Stocks (1965 - 2009)

The trending value strategy was developed by James O'Shaughnessy and detailed in his book What Works on Wall Street as one of the best performing strategies, using a combination of value and growth metrics, terms you've probably heard of or seen marketed in ETFs or mutual funds.

Value investing is a well-known investment strategy that aims to select stocks that the market has undervalued - that is, the stock's price is lower than what its fundamentals suggest it is actually worth.

O'Shaughnessy begins by backtesting strategies using one value metric at a time. For example, a strategy that is only invested in the stocks in the top decile (lowest 10%) of price-to-earnings ratios (P/E) and rebalanced every year. And likewise using price-to-book ratio (P/B), price-to-sales ratio (P/S), and price-to-cash flow ratio (P/CF). He also looks at enterprise value to EBITDA (earnings before interest, taxs, depreciation and amortization) ratio (EV/EBITDA), which was the single best performing value factor he backtested. (For each of these 5 factors, low values are better).

Another factor he looked at was shareholder yield (SHY), which is buyback (how many stocks are repurchased by the company (i.e., decrease in number of outstanding shares)) plus dividends divided by market capitalization. (For shareholder yield, higher is better). The results for the top decile of these factors (lowest (or highest for SHY) 10%, rebalanced annually) are below (with all stocks for comparison).
Performance (1965 - 2009)
By themselves, all of these factors beat the overall stock market. But combining the factors, coming up with a composite score and investing in the top decile of composite scores, yields even better results. To develop the composite scores, a ranking for each factor is given to each stock in the universe of stocks. So the stock with the lowest P/E gets a score of 100, the stock with the lowest SHY gets a 1, and so on (this can be done with the PERCENTRANK function in Excel (or 1 - PERCENTRANK for SHY, since higher numbers are better), or much more seamlessly using a more powerful tool like Portfolio123).

The ranks for each factor of a stock are added up for its composite score. O'Shaughnessy looked at 3 different value composite scores: value composite 1 (VC1) used the factors described above except SHY, value composite 2 (VC2) add SHY to VC1, and value composite 3 replaces SHY with just buyback yield. The returns for top decile of each of these composite scores is below (rebalanced annually).


Performance (1964 - 2009)
Each value composite is a significant improvement over any individual factor. Composites are more powerful than just screening for the best values of the individual factors because a stock that may be deficient in one metric but excellent in the others would get eliminated from consideration by screening (e.g., a stock in the top decile of VC2 may not necessarily be in the top decile for all of the individual factors).

To implement the trending value strategy, you simply invest in the top 25 stocks sorted by 6-month % price change (the "trending" part of the name) among the top decile of stocks ranked by VC2 (O'Shaughnessy chose VC2 over VC3 because of its slightly higher Sharpe ratio, a measure of risk-adjusted return).

The universe of stocks is limited to those with a market capitalization of more than $200M (in 2009 $) to avoid liquidity problems with trading smaller stocks. It's a buy and hold strategy that is rebalanced annually with the following exceptions. If a company fails to verify its financial numbers, is charged with fraud by the Federal government, restates its numbers so that it would not have been in the top 25, receives a buyout offer and the stock price moves within 95% of the buyout price, or if the price drops more than 50% from when you bought it and is in the bottom 10% of all stocks in price performance for the last 12 months, the stock is replaced in the portfolio.

So what's the catch? There are a few:

  1. The Data: While most of the metrics described are freely available from any number of online sources, some (e.g., buyback yield) aren't as easy to come by, and I still haven't found a free way to obtain all of the data for all of the stocks at once.
  2. Psychology: While the trending value strategy has never underperformed the market for any rolling 5-, 7-, or 10-year periods between 1964 and 2009, it has underperformed the market for rolling 1-year periods 15% of the time, and 3-year period 1% of the time. If you hit a few years with less-than-stellar performance, are you going to stick it out and trust the strategy, or are you going to jump ship to bonds (as many people did in 2009, missing out on the huge subsequent rebound) or another trendy strategy that seems to be performing better at the time?
  3. Commissions (for small-time investors): At $10/trade and 25 trades per year, you need a portfolio of $100,000 to keep your commissions to a reasonable 0.25%.
Luckily for you, I'll be publishing the trending value stock picks every month from here on out, so number 1 is solved. Number 2 is on you. And number 3 is the subject of a future post.

Sunday, May 15, 2016

Why I Dumped My Index Funds (An Introduction to Quantitative Investing)

In my last post, I outlined why increasing your portfolio return is the most worthwhile investment of your time and energy. Now I'm going to introduce the investment strategies that have consistently beaten the market for decades.

The first time I heard the term "quantitative investing", I imagined mazes of cubicles with math/finance graduates working 100 hours a week at big investment banks on Wall St. But once you peel back the scary facade, you find that the reality is not very intimidating.

Instead of picking investments based on a gut feeling, what you hear on the news, what a company's logo looks like, or other qualitative indicators, quantitative investing uses cold hard numbers. That's all there is to it. 

In 1991, a strategy called Dogs of the Dow was popularized by Michael B. O'Higgins. Basically, every year you would invest in the ten stocks listed on the Dow Jones Industrial Average index that have the highest dividend to price ratio (also known as dividend yield). As you can see, this strategy beats the market most years. The Dogs of the Dow strategy has faced criticism for not being sophisticated enough. But it isn't the only quantitative strategy out there -- far from it.

Originally published in 1996 and now on its 4th edition (updated in 2011 at the 2009 recession), What Works on Wall Street takes a deep dive into dozens of quantitative strategies and is a must-read if you decide to start experimenting with any of them. This is the book that led me down the path to completely dump the contents my 401(k) and implement a quantitative strategy.

To give you a teaser to the content of this book and a preview for my next post, here is an excerpt that lists all of the strategies sorted by worst year. They were backtested from 1965 to 2009. The highlighted row is a strategy called trending value, which will be the first strategy that we explore in detail.

For the trending value strategy, the average annual return was 21.08%, more than double the S&P 500's performance. $10,000 invested in 1965 grew to more than $48M by 2009, compared to just over $500k if you'd invested in an S&P 500 index fund (so 2x the return over 40 years gets you 96x the result -- compound interest is amazing). And to implement these strategies, all you need to do is crunch some numbers once a year (with stock data and Excel), buy the stocks that the data is pointing to, hold them until next year, and repeat.

If this intrigues you as much as it did me, buy the book and stay tuned for my next post.