Tag Archives: valuewalk

Take Valuations Seriously And You Will Discover Things That You Were Not Initially Even Seeking To Discover

By Rob Bennett I learned about Sabermetrics (the empirical analysis of baseball) by reading Bill James’ Baseball Abstract many years ago. In those days, it was a curiosity. James would argue that a hitter who hits .260 and walks in 10 percent of his at-bats is better than one who hits .290 and walks in 2 percent of his at-bats and the “experts” would dismiss his work as so much foolishness. Today, of course, Sabermetrics has revolutionized the sport. Valuation-Informed Indexing is the Sabermetrics of investing analysis. Once upon a time, we all knew that the stock market is efficient, that price changes are caused by economic developments, that investing risk is stable, the timing never works and that stock returns cannot be effectively predicted. Then this crazy Shiller fellow came along and stood everything we once thought we knew about stock investing on its head. Well, that’s in fact not quite true as of today. But we are getting there, slowly but surely. We are in the early years of a “revolution” (Shiller’s word) in our understanding of how stock investing works. Valuation-Informed Indexing (the model for understanding how stock investing works rooted in Robert Shiller’s “revolutionary” [Shiller’s word] finding that valuations affect long-term returns and that stock investing risk is thus variable rather than constant) is the first true research-based investing strategy. Buy-and-Holders claim that Buy-and-Hold is a research-based investing strategy. But if the valuation level that applies when you make a stock purchase is 80 percent of the story, as the last 34 years of peer-reviewed research shows, it’s not possible to develop effective strategies without taking valuations into account and it’s the first rule of Buy-and-Hold that valuations may never be taken into account (timing doesn’t work, remember?). I came across an article in the Wall Street Journal (” Bill James and Billy Beane Discuss Big Data in Baseball “) that reminded me of one of the most exciting aspects of these revolutionary breakthroughs in our understanding of a field of human endeavor: Revolutions change everything, not just the stuff that we were seeking to change when we began the investigations that led to the revolutions. James started out making the case for on-base-percentage as a better metric for assessing hitters’ skills and arguing that the relief pitchers who close games are not as important as most of us once thought they were and that the best hitter should generally be placed higher up in the line-up. Today insights developed by Sabermetricians are used to inform decisions regarding all sorts of matters that were not on the minds of the pioneers. Most teams use fielding shifts today; that change was brought on through the use of Sabermetrics. Sabermetrics is being used today to prevent injuries to players. Sabermetrics can be used to assess when is the right time to move a player up from the minor leagues. And on and on. So it is has been with my 13-year study of Valuation-Informed Indexing. In 2002, I was posting at a Retire Early discussion board and we all wanted to know when we had saved enough money to hand in our resignations to high-paying corporate jobs. We turned to the safe withdrawal rate studies that were responsible for the infamous “4 percent rule.” I noted one day that those studies do not contain an adjustment for the valuation level that applies on the day the retirement begins. Oopsies! Thirteen years later, the 4 percent rule is universally reviled and most of us are still too ashamed of the mistake to acknowledge that we have sent millions on their way to experiencing failed retirements by our reluctance to correct the mistake we made promptly and openly. But that was really just the first wave of knowledge generated by our decision to start taking valuations seriously. I remember the day when one of my critics demanded that I say what the safe withdrawal rate was when calculated accurately. I didn’t know. It’s easy to say that a study that fails to consider valuations cannot possibly get the numbers right. But I am no numbers guy. I knew that the correct number had to be something significantly less than 4 percent. I guessed that it was perhaps 3 percent when valuations are high, being sure to tell people that I was speculating. There was enough interest in the question that some people offered to work with me to come to develop more precise responses to the question “What is the correct safe withdrawal rate today?” I learned that the safe withdrawal rate can drop to a lot lower than 3 percent. Try 1.6 percent (the number that applied at the top of the bubble). If I had been asked in the early days how high the safe withdrawal rate can rise, I would have probably said that it could rise to something in the neighborhood of 5 percent. Not close! The correct answer is – 9 percent! That’s the safe withdrawal rate that applied in 1982, when valuations were at one-half of fair value. It took me a long time to let that one in. 9 percent! That means that someone with a $1 million portfolio can take out $90,000 per year to live on with virtually no risk of seeing his retirement money run out before he dies. Who’d a thunk it? And that’s still not all. We’ve learned that stocks are not as risky as bonds (for those willing to take valuations into consideration when setting their stock allocations). We learned that economic crises are caused by bull markets. We learned that one form of market timing (long-term timing) ALWAYS works and in fact is required for those seeking a realistic chance of achieving long-term investing success. We learned that stock prices do not play out in the pattern of a random walk AT ALL in the long term, that we always see about 20 years of steadily rising prices (with lots of short-term price drops mixed in, to be sure) followed by 15 or 20 years of steadily dropping prices (with lots of short-term price rises mixed in). Once a revolution gets started, you never know where it is going to take you.

It Is Not Possible That Valuations Matter Only At The Margins

By Rob Bennett You will often hear people say that valuations matter only at the margins. That is, valuations matter when prices are very high and when they are very low. Outside of that, it is okay to ignore the effect of valuations. I see this as dangerous thinking. My view is that either valuations matter or they do not. If they matter, they always matter. If they don’t matter, they never do. I am not able to make sense of the idea that valuations matter in some circumstances, but not in others. The first point that needs to be made is that there is a practical sense in which the claim that valuations only matter at the margins is true. Stocks generally offer a significantly better long-term value proposition than other asset classes. So, when stocks are priced at only a bit more than their fair value price, they remain a good investing choice. In a practical sense, then, a high stock allocation makes sense until the overvaluation reaches such a point that the mispricing is extreme. The problem is that there is no one valuation level at which stocks are transformed from a good choice to a bad one. Stocks are a little less appealing when the P/E10 level is 18 than they are when the P/E10 level is 15. And they are, of course, even less appealing when the P/E10 level is 21. And then even less appealing when the P/E10 level is 24. And even less appealing when the P/E10 level is 27. What is the investor to do? When does he lower his stock allocation, and by how much? It’s tricky. Stocks became a bit less appealing when the P/E10 level rose from 15 to 18, and then again when it moved from 18 to 21, and from 21 to 24, and from 24 to 27. But as the PE10 level moved from 15 to 27, the feedback being received by the investor was all positive. The risk of owning stocks was becoming greater. The investor should have been lowering his stock allocation in an effort to keep his risk profile constant. But at the moment when the P/E10 value reached the insane level of 27, the investor who failed to lower his stock allocation as the P/E10 value moved to 18, and then to 21, and then to 24, and then to 27 was feeling good about those decisions. So he was left disinclined to changing it much, even when prices had gone to “the margins” of 27 and above. What Jack Bogle says about this is that investors should not change their stock allocations in response to price increases. But if they feel that they absolutely must change their allocation at the margins, they should not lower them by more than 15 percent. Bogle has never explained how he came up with the 15 percent figure. I use the historical return data as my guide. The data shows that stocks are likely to offer an amazing long-term return when prices are at low levels or at fair value levels, and then the long-term return drops and drops as prices continue to rise. The data shows that most investors should have been going with a stock allocation of about 80 percent in the early 1990s and about 20 percent in the late 1990s and early 2000s. That’s a change not of 15 percentage points, but of 60 percentage points. Bogle’s recommendation is off by 400 percent, according to the 145 years of historical data available to us today. How many people know that? People don’t know how dangerous it is to own stocks when they are selling at high valuation levels, because most advisors buy into the idea that valuations matter only at the margins. If you only consider valuations at the margins, you are missing out on most of the story of how the mispricing of stocks derails investor retirement plans. Stocks don’t suddenly become dangerous when the P/E10 value hits 27. They are virtually risk-free when the P/E10 value is 15. Then, they become more risky at 18. And more risky at 21. And more risky at 24. And more risky at 27. Unfortunately, the growing risk is a silent one. Stocks are far more risky when the P/E10 value is 21 than they are when it is 15. But years can go by before that risk evidences itself in portfolio destruction. Valuation risk plays out the way that cancer risk plays out for people who smoke three packs of cigarettes each day. Heavy smokers often “get away” with their behavior for decades before they contract a disease that kills them. However, the deep reality is different from the surface one. Someone who smokes three packs of cigarettes each day from age 16 to age 66 and then dies at age 67 from lung cancer was not avoiding the risk of smoking for 50 years; he was avoiding only the practical consequences of taking on a risk that would one day cause him to pay a terrible price. Disclosure: None.

Value Investing: Have You Been Using The Wrong Quality Ratio?

By Tim du Toit Do you think adding a company quality ratio to your investment strategy can make a difference to your returns? As you know we are skeptical, as our experience testing quality ratios in the research paper Quantitative Value Investing in Europe: What Works for Achieving Alpha was mixed. What doesn’t work We found that Return on invested capital (ROIC) and return on assets (ROA) weren’t good predictors of returns. Even though high-quality companies did do better than low-quality companies (low ROIC and ROA) returns did not increase in a linear way as you moved from low-quality to high-quality companies. And if you only invested in high-quality companies, it would not have helped you to consistently beat the market. A better quality ratio? Our thinking on quality ratios changed when we read a very interesting research paper called The Other Side of Value: The Gross Profitability Premium by Professor Robert Novy-Marx in which he defined a company quality ratio performed as well as a valuation ratio. How calculated Professor Novy-Marx defined a quality company as one that had a high gross income ratio (let’s call it Quality Novy-Marx ), which he calculated by dividing gross profits by total assets . He defined gross profit as sales minus cost of sales and assets simply total assets as shown in the company’s balance sheet (current assets + fixed assets). Does it work? In the paper Professor Novy-Marx shows that this simple ratio has about the same predictive return value as the price to book ratio in spite of companies with a high gross income ratio (Quality Novy-Marx) being a lot different if you compare them to undervalued companies with a low price to book ratio. Companies with a high Quality Novy-Marx ratio generated significantly higher average returns than less profitable companies in spite of them, on average, having a higher price to book ratio (more expensive) and higher market values. Because value (low price to book) and profitability (high Quality Novy-Marx ratio) strategies’ returns are negatively correlated (the one goes up when the other goes down), the two strategies work very well together. So much so that Professor Novy-Marx in the paper suggests that value investors can capture the full high-quality outperformance without taking on any additional risk by adding a high quality strategy to an existing value strategy. If you do this he found that this reduces overall portfolio volatility, in spite of it doubling your exposure to the stock market. We also tested it We of course also wanted to test if the Quality Novy-Marx ratio works on the European stock markets. Our back test (on European companies) over just less than 12 years from July 2001 to March 2013 came up with the following result: Source: Quant-Investing.com 1 Quintiles 2 Compound Annual Growth Rate ( OTCPK:CAGR ) As you can see the results are (apart from Q1 to Q2) linear, which means as you move from low-quality companies (Q5) to high-quality companies (Q1) returns increase every time. Also high quality companies (Q1) did substantially better than low-quality companies (Q5). This clearly shows that the Quality Novy-Marx ratio is a very good ratio to add to how you search for investment ideas. Substantially outperformed the market High-quality companies also substantially outperformed the index. The STOXX Europe 600 index over the same period had a compound annual growth rate of -0.82%, worse than even the worse quintile, most likely because of the banks being included in the index (not in the back test universe because you cannot calculate the Quality Novy-Marx ratio for them). In summary From these two back tests you can see that adding quality companies, defined as companies with high gross profits to total assets can definitely add to your investment returns. We have not tested it but Professor Novy-Marx mentions that if you are a value investor, quality companies have the ability to increase your returns and decrease the volatility of your portfolio. But if you add this quality ratio to your screens, you will find companies that are not undervalued, which is something that value investors will have to get used to. Where can you find it? In the screener you can select the gross income ratio (called Gross Margin (Marx)) as a ratio in one of the four sliders as shown below. Or you can select the Gross Margin (Marx) as a column in your screen which will allow you to filter and sort the Gross Margin (Marx) values.