Style Anomaly: Pure Value

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This previous article in our Equity Market Anomalies series focused on the Value versus Growth investing conundrum (Style Anomaly: Value Versus Growth), and it showed that Value typically outperforms Growth by an average of 11% per year since 2000.

So what are the various ways to measure value? Which ones work best? And do combinations work better?

The ways to measure value are numerous and only limited by your imagination. However, the 10 most popular approaches are Cash Flow-to-Price, Book Value-to-Price, Sales-to-Price, Earnings-to-Price, Assets-to-Price, PEG (Price divided by earnings per share plus expected growth), Cash-to-Price, EBITDA-to-EV, Sales-to-EV, and Estimated Growth Rates (:EGR).

Let's take a look at these definitions. As shown in the prior article, low EGR equates to value. EV (Enterprise Value) is market value + long term debt + preferred stock – cash. EBITDA is earnings before interest, taxes, depreciation, and amortization. The rest of the variables should be self evident. There are, however, a couple different techniques for calculating the Earnings-to-Price ratio. The earnings component could be either historical or forward looking. Historical earnings are just that; the most recently reported four quarters of earnings. Forward looking earnings focus on next year's earnings estimates. Both of these will be reviewed.

Beginning with a universe of the largest 3000 stocks, I conducted tests from January 2000 until June 2011 by building portfolios of the best 300 stocks based on each of these valuation measures. I used 300 stocks in these portfolios to capture the factor's effect and reduce the influence of any individual stock. (Think Law of Large Numbers.) The average annualized return and standard deviation are below:

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Based on the above results, we can see that the best single valuation metric based on return is Cash Flow-to-Price. The next four in order are: Historical E/P, Estimated E/P, EBITDA/EV, and Sales-to-Price. Since Historical E/P shows better than Estimated E/P and both capture the same E/P effect, Historical E/P will be our keeper between these two. Same logic applies when looking at Sales/P and Sales/EV, so Sales/P will be considered in a possible combo.

So let's focus in on Cash Flow-to-Price, Historical E/P, EBITDA/EV, Sales/P and BV/Price and see if a combination of these is better than Cash Flow-to-Price by itself.

I tested various combinations of these five factors and, try as I might, I was unable to find a combination that outperformed Cash Flow-to-Price by itself. The other factors are just too similar (98%+ correlations) to provide any synergy and improve performance. Other types of styles (e.g. momentum, fundamental) could be added to improve performance in a multi-anomaly effect, but it's hard to improve Cash Flow-to-Price from a strictly value perspective.

Here's how to find the best Cash Flow-to-Price stocks:

 

  • First, create a liquid, investible set of the stocks with the largest 3000 market values and average daily trading volume greater than or equal to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade it).
  • Next, due to the uncertainty regarding these issues, remove Chinese stocks listed on U.S. exchanges. (There's some bad stuff out there, so let's avoid it.)
  • Add another filter by selecting those stocks with a Zacks Rank of less than or equal to 3. (Let's also avoid any falling knives by requiring the stock to be at least moderately if not highly rated.)
  • Finally, select the top 30 stocks with the highest Cash Flow-to-Price ratio.

Here are 5 stocks with a high Cash Flow-to-Price (07/14/11):

LYB LyondellBasell Industries
HTZ Hertz Global Holdings Inc.
MERC Mercer International Inc.
ALR Alere Inc.
CNO CNO Financial Group Inc.

The value anomaly is just one of many types of investment anomalies. Other examples might include anomalies based on analyst data, insider trading and earnings surprises. To explore the world of stock investing anomalies and the basis for professional research, please visit a website dedicated to their explanation and discussion: hema.zacks.com. You'll also be able to interact with various authors. Learn & enjoy!

 

CNO FINANCIAL GROUP INC (CNO): Read the Full Research Report

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