Tuesday, June 24, 2014

the most important metric

What is the most important metric tied to stock performance?

The complexity of the investment field makes it difficult to ever determine a “right” answer to this question. Benjamin Graham’s exploration in ‘The Intelligent Investor’ was the first work to provide convincing answers. But the 80 years following the book’s release have seen thousands of ever more complex theories and models all trying to answer this same inherent question. From the Nifty Fifty to the Dogs of the Dow to The Little Book That Beats the Market, it seems like everyone has offered a simple solution that
temporarily outperforms.

Wall Street has of course taken it several steps further with stock-correlation algorithms, momentum trading systems, and multi-variable back testing. But their long history of excessive fees and embarassing underperformance leaves little envy for their methods – at least in the minds of sophisticated investors. As value investors, we are wise enough to know that additional complication does not result in superior results.

But given the amount of data and calculation we are now able to perform, it makes sense to re-visit this age old question and finally produce a definitive result.

Two works of research will be referenced in this article. The first is by in-house GuruFocus analyst Vera Yuan. Her article, ‘Earnings, Free Cash Flow, Book Value? Which Parameters Are Stock Prices Most Correlated To?’, examined the stock price correlation to eight fundamental metrics across a full business cycle.

The picture here couldn’t be much clearer. When it comes to banking, investment and other financial stocks, book value is king. Book and tangible book were the consistent winners here across all four market periods.

Non-financial stocks produced similar results, albeit less overwhelmingly than the previous group.

However, one research study is not a sufficient basis from which to base our entire investment philosophy.

The second test for the validity of book value superiority was constructed by Tobias Carlisle of Greenbackd. He back tested this topic using 87 years of equity data in ‘Investing Using Price-to-Book Value Ratio or Book Equity-to-Market Equity Multiple (Backtests 1926 to 2013)’.

Carlisle’s research examined book value to stock price correlations back to 1926. Using a 3,715 stock sample with complete financial data, stocks were grouped into a value decile representing the 459 lowest price-to-book multiples and a glamour decile containing the 404 highest multiples. Unsurprisingly, the value group outperformed the higher multiple glamour group for the period.

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Looking at my copy of What Works on Wall Street, "Over the long term, the market rewards low price-to-book ratios and punishes high ones.  Yet the data show why investors are willing to overlook high price-to-book ratios -- for 20 years, large stocks with high price-to-book ratios did better than the Large Stocks universe.  A high price-to-book ratio is one of the hallmarks of a growth stock, so high price-to-book ratios alone shouldn't keep you from buying a stock.  But the long-term results should caution you against the highest price-to-book ratio stocks.

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