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The VALUATION EDGE ™ is Applied Finance’s newsletter and program in which we share our Valuation and Wealth Creation insights with the investment community. Our goal is the 3EEE’s… Entertain, Engage, and Enlighten the investment community through what we consider to be interesting market observations, economic facts, and company expectations, to better frame the current investment environment. We can provide personal financial advising services under our VALUATION EDGE ™ program to recipients of our newsletter. Call us to learn more!
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POPULAR PAST NEWSLETTER ARTICLES
Quantitative Value Investing is Broken
Our last column, Yes Virginia, Valuation Matters, caused a bit of controversy on Twitter regarding the nature of Applied Finance’s Quantitative Valuation™ research and investment approach versus that espoused by the quantitative value approach.
- Quantitative “value” investing has no identity. While it began with the central idea to identify securities mispriced relative to book value, it has devolved into a factor hunt with no unifying theory to guide its development.
- The evidence standard used in quantitative “value” studies is low quality, consisting of observations subject to look-ahead bias and data snooping, with poor out-of-sample results.
- The theoretical motivation used to justify the “investment” factor reflects an incomplete understanding regarding valuation and wealth creation.
- Quantitative “value” investing as a discipline suffers from the fundamental research mistake of confusing correlation and causality.
Emotional Unease Creates Generational Wealth Opportunity
Only in 2008 have valuations been as attractive as now. Today, the market is essentially pricing in 0% sales growth over the next five years, not as harsh as the -15% priced in during the 2008 lows, but very harsh compared to the expected 20% to 30% growth these firms have typically delivered over a five year period. Unlike 2008 there will not be liquidity issues driving economic decisions and panicking investors. This is a confidence crisis similar to 9/11. As medical policy catches and surpasses the virus, confidence will return and economic activity will march forward. Already, in China, restaurants have reopened to crowds, and society is returning to business as usual.
Valuation Beta: Addressing the Inadequacies of Book to Price with Valuation, Stewardship, and Leverage
Asset pricing model research has been dominated by the book to price (HML) factor following its introduction in the Fama French 3 Factor model in 1992. Over the initial study horizon of 1963 to 1991, book to price delivered performance characteristics that essentially absorbed the cross-sectional return information of numerous other factors, including leverage and earnings to price, on an ex-ante basis. Ongoing refinements to asset pricing models tend to build upon the foundation of this initial three factor research, highlighting the broad acceptance of these specific factors when seeking to explain cross-sectional returns. It has also become commonplace to refer to book to price simultaneously as a valuation factor (cheap vs. expensive, Asness, Frazzini, Israel and Moskowitz, 2015), a style factor (value vs. growth, Zhang, 2015, as well as Russell, S&P, and Morningstar style methodologies), and a leverage factor (high vs. low leverage, Penman, Richardson, and Tuna, 2005). In this paper, we provide compelling evidence that asset pricing models based on direct measures of intrinsic value, stewardship (which loosely aligns with style based on the reliance on external financing for early-stage growth stocks and the return of capital to shareholders for mature value stocks) and leverage offer substantial improvements in minimizing residual alpha compared to models that conflate book to price as a proxy for these competing themes.
Applied Finance Quantitative Review – Q3 2020
Our Q3 Quantitative Review includes an array of market insights to help understand what is driving the market and how to explain it to others. Topics include Top 5 Market Cap Companies, comparisons of high yield vs. no yield, and “Low Risk” & “High Risk” stocks as well as a Covid-19 consumer update.
Small Cap Growth: Most Expensive Valuation Since Tech Bubble
The 2020 Covid-19 crisis has caused a spectacular shift in relative Valuations in the value/growth categories within the small-cap Russell 2000. In fact, this is the largest spike in relative Valuation that we’ve seen since the Tech Bubble.
Time to Reconsider Large Cap Value & Growth Allocations
In the current market, we see a difference in Valuation between value and growth names. Value stocks appear to be around their long-term normal range from a relative attractiveness standpoint. Growth companies however, appear to have become overvalued.
Growth Stocks Approaching Valuation Levels Last Observed During Tech Bubble
While we rarely make huge market calls and remain reluctant to do so at this point, its worth noting that growth stocks are trading at below -1.5 StdDev from historical normal levels signaling a significant move outside of normal range. This is especially noteworthy, as the growth relationship in the Russell 1000 is now at levels last observed in the peak of the tech bubble.
The False Bargain of Passive Investing
Today the irony continues, as the intellectual foundations in financial economics that underpinned Bogle’s incredible success are much less robust than they appeared in the early 70’s, yet the push for passive investing is stronger and more fervent than ever. For proactive, process-oriented, intelligent advisors this will create a great opportunity to distinguish yourself from the growing herd of “commodity” advisors who preach little more than fee minimization, rather than alpha generation or negative alpha avoidance.