Tag Archives: david trainer

Why PE Ratios Are Not A Good Measure Of Value

Summary PE ratios are commonly used as a metric to determine “value”. However, PE ratios are unreliable for a number of reasons and earnings actually have no correlation with valuations. Return on invested capital is a better measure of value and has significant correlation with valuation. We’ve pointed out the flaws in the price to earnings (PE) ratio many times before. Chief among these flaws is the fact that the accounting earnings used in the ratio are unreliable for many reasons: Accounting rules can change, shifting reported earnings without any real change in the underlying business. The large number of accounting loopholes makes it easy for executives to mislead investors. PE ratios overlook assets and liabilities that have a material impact on valuation. It should come as no surprise that empirical research shows accounting earnings have almost no impact on long-term valuations. No Correlation Between Earnings And Value If accounting earnings actually drove valuations, then companies with high EPS growth should command higher multiples, and companies with low or negative EPS growth should have lower PE multiples. As Figure 1 shows, this correlation is nearly nonexistent. Figure 1: EPS Growth Has Almost No Impact On Valuation (click to enlarge) Sources: New Constructs, LLC and company filings. The r-squared value of 0.0006 in Figure 1 shows that EPS growth over the past five years explains less than one tenth of one percent of the difference in price between stocks in the S&P 500. Stocks can see their PE multiples expand and contract in a manner that has almost nothing to do with changes in EPS, which makes looking at these metrics a poor indicator of valuation or future returns. The Market Cares More About ROIC Many other studies have found the same lack of correlation between earnings growth and stock price. Instead, we find that valuations tend to be driven largely by return on invested capital ( ROIC ). Figure 2 shows that ROIC is highly correlated with Enterprise Value/Invested Capital (a cleaner version of price to book). Figure 2: ROIC Is The Primary Driver Of Stock Price (click to enlarge) Sources: New Constructs, LLC and company filings. ROIC explains nearly two thirds of the difference in valuations between various companies. That means companies that can improve their ROIC are more likely to grow their stock price in the market. Short Term Vs. Long Term Drivers “But wait!” you might be saying. “I know accounting earnings have an impact on valuations. I’ve seen stock prices rise and fall dramatically based on a company’s quarterly earnings report.” This is true. It’s clear that headline numbers can have an immediate and sometimes dramatic influence on stock prices. The key word in that sentence is “immediate”. A big increase in EPS might drive short-term gains in stock prices, but it won’t create long-term value. To understand the cause of this divergence, you have to understand the different types of investors in the market. Brian Bushee from the Wharton School of Business wrote an excellent paper back in 2005 that highlighted the behavioral differences among institutional investors. His research found that: 61% of institutional investors are “Quasi-Indexers”. They hold many small stakes with low turnover, so they have little impact on market valuations. 31% of institutional investors are “Transients”. They have small stakes but a high turnover, so their high volume of trading can impact valuations in the short term. 8% of institutional investors are “Dedicated”. They take large stakes and hold them for a very long time. These are the investors that drive long-term valuations. A big earnings beat might cause a lot of “Transient” investors to buy that stock, pushing up the price, but most of these investors will sell their stakes not long after, pushing the price back down. They can create spikes, but their impact on the long-term performance of the stock is next to nothing. Instead, it’s that small percentage of “Dedicated” investors that are responsible for the majority of long-term performance. These are highly sophisticated individuals that take a long time evaluating stocks before taking large positions that they hold through bouts of volatility. Why You Have To Look At The Balance Sheet And Cost Of Capital The central flaw of the PE ratio holds true for many of the other common ratios such as: Enterprise Value/EBITDA Price to Earnings Growth (PEG) Price to Operating Cash Flow Price to Sales All of these ratios ignore the cost of the capital that the company uses to drive profits. To understand why cost of capital is so important, imagine this hypothetical scenario: you have an infinitely wealthy investor who is willing to offer you an unlimited source of equity capital. You take the money from this investor and put it in a low-yielding savings account. The more money you take from this investor, the more your interest payments, or “earnings”, will grow, but you’re not actually creating any value. In fact, by earning such a low return on that money compared to what they could earn elsewhere, you’ve actually destroyed value. The use of these flawed metrics perpetuates the irrelevant distinction between growth and value investing . Earnings growth without an ROIC above the weighted average cost of capital ( WACC ) destroys value, and value without growth limits upside. While ROIC is, by far, the most important driver of value, it is not the only factor. One must also consider revenue growth and duration of profit growth, i.e. growth appreciation period ( GAP ). These three drivers comprise everything that defines the profitability and, therefore value, of a company. PE and PEG are driven by these drivers, not the other way around. The same concept applies to companies that grow EPS by deploying capital at suboptimal rates of return. As we discussed in ” The High-Low Fallacy “, an acquisition can be accretive to earnings but destructive to shareholder value. Recent Danger Zone pick Expedia (NASDAQ: EXPE ) has managed significant EPS growth through $3.2 billion in acquisitions, but these acquisitions have actually hurt the long-term interests of shareholders by earning an ROIC that falls short of WACC. For that reason, investors need to be looking at ROIC rather than EPS, and they need to recognize that a PE multiple tells you next to nothing about the actual value of a stock. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme.

How To Find The Best Style Mutual Funds: Q4’15

Summary The large number of mutual funds hurts investors more than it helps as too many options become paralyzing. Performance of a mutual funds holdings are equal to the performance of a mutual fund. Our coverage of mutual funds leverages the diligence we do on each stock by rating mutual funds based on the aggregated ratings of their holdings. Finding the best mutual funds is an increasingly difficult task in a world with so many to choose from. How can you pick with so many choices available? Don’t Trust Mutual Fund Labels There are at least 806 different Large Cap Value mutual funds and at least 5514 mutual funds across all styles. Do investors need 459+ choices on average per style? How different can the mutual funds be? Those 806 Large Cap Value mutual funds are very different. With anywhere from 15 to 735 holdings, many of these Large Cap Value mutual funds have drastically different portfolios, creating drastically different investment implications. The same is true for the mutual funds in any other style, as each offers a very different mix of good and bad stocks. Large Cap Value ranks first for stock selection. Small Cap Blend ranks last. Details on the Best & Worst mutual funds in each style are here . A Recipe for Paralysis By Analysis We firmly believe mutual funds for a given style should not all be that different. We think the large number of Large Cap Value (or any other) style mutual funds hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many mutual funds. Analyzing mutual funds, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each mutual fund. As stated above, that can be as many as 735 stocks, and sometimes even more, for one mutual fund. Any investor worth his salt recognizes that analyzing the holdings of a mutual fund is critical to finding the best mutual fund. Figure 1 shows our top rated mutual fund for each style. Figure 1: The Best Mutual Fund in Each Style (click to enlarge) Sources: New Constructs, LLC and company filings How To Avoid “The Danger Within” Why do you need to know the holdings of mutual funds before you buy? You need to be sure you do not buy a fund that might blow up. Buying a fund without analyzing its holdings is like buying a stock without analyzing its business and finances. No matter how cheap, if it holds bad stocks, the mutual fund’s performance will be bad. Don’t just take my word for it, see what Barron’s says on this matter. PERFORMANCE OF FUND’S HOLDINGS = PERFORMANCE OF FUND If Only Investors Could Find Funds Rated by Their Holdings… The Calvert Social Investment Fund: Calvert Large Cap Core Portfolio (MUTF: CMIIX ) is the top-rated Large Cap Blend mutual fund and the overall top-rated fund of the 5514 style mutual funds that we cover. The mutual funds in Figure 1 all receive an Attractive-or-better rating. However, with so few assets in some, it is clear investors haven’t identified these quality funds. Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.

How To Find The Best Style ETFs: Q4’15

Summary The large number of ETFs hurts investors more than it helps as too many options become paralyzing. Performance of an ETFs holdings are equal to the performance of an ETF. Our coverage of ETFs leverages the diligence we do on each stock by rating ETFs based on the aggregated ratings of their holdings. Finding the best ETFs is an increasingly difficult task in a world with so many to choose from. How can you pick with so many choices available? Don’t Trust ETF Labels There are at least 60 different All Cap Blend ETFs and at least 281 ETFs across all investment styles. Do investors need 23+ choices on average per style? How different can the ETFs be? Those 60 All Cap Blend ETFs are very different. With anywhere from 29 to 3792 holdings, many of these All Cap Blend ETFs have drastically different portfolios, creating drastically different investment implications. The same is true for the ETFs in any other style, as each offers a very different mix of good and bad stocks. Large Cap Value ranks first for stock selection. Small Cap Blend ranks last. Details on the Best & Worst ETFs in each style are here . A Recipe for Paralysis By Analysis We firmly believe ETFs for a given style should not all be that different. We think the large number of All Cap Blend (or any other) style ETFs hurts investors more than it helps because too many options can be paralyzing. It is simply not possible for the majority of investors to properly assess the quality of so many ETFs. Analyzing ETFs, done with the proper diligence, is far more difficult than analyzing stocks because it means analyzing all the stocks within each ETF. As stated above, that can be as many as 3792 stocks, and sometimes even more, for one ETF. Any investor worth his salt recognizes that analyzing the holdings of an ETF is critical to finding the best ETF. Figure 1 shows our top rated ETF for each style. Note there are no All Cap Growth or All Cap Value ETFs under coverage. Figure 1: The Best ETF in Each Style (click to enlarge) Sources: New Constructs, LLC and company filings How to Avoid “The Danger Within” Why do you need to know the holdings of ETFs before you buy? You need to be sure you do not buy an ETF that might blow up. Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad. Don’t just take my word for it, see what Barron’s says on this matter. PERFORMANCE OF ETF’S HOLDINGS = PERFORMANCE OF ETF If Only Investors Could Find Funds Rated by Their Holdings The ValueShares US Quantitative Value ETF (BATS: QVAL ) is the top-rated All Cap Blend ETF and the overall best ETF of the 281 style ETFs that we cover. The worst ETF in Figure 1 is the State Street SPDR S&P Small Cap Growth ETF (NYSEARCA: SLYG ), which gets a Neutral rating. One would think ETF providers could do better for this style. Disclosure: David Trainer and Blaine Skaggs receive no compensation to write about any specific stock, style, or theme