Death of a Value Factor? The Arbitrage of Price to Book

The trending value strategy buys the top 25 stocks by their 6 month price momentum among the top decile of stocks ranked by value composite 2 (VC2), a combination of price-to-earnings ratio, price-to-sales ratio, price to book ratio, earnings before interest tax depreciation and amortization to enterprise value ratio (EBITDA/EV), price-to-cash flow ratio, and shareholder yield.

Price to book was touted by Ben Graham, the father of value investing, in his book The Intelligent Investor (“By far the best book on investing ever written.” – Warren Buffet) as a cornerstone of his rules for investing. Eugene Fama and Ken French published their famous three-factor model in 1992, which identified price to book as one of three factors that can explain the performance of a portfolio. They created a growth portfolio, comprised of stocks with the highest (top 30%) price to book ratios, and a value portfolio comprised of the lowest (bottom 30%) price to book ratios.

Since its publication, low price-to-book ratio has become the cornerstone of value indices, including the Russell 1000 Value (see page 25), the MSCI US Prime Market Value Index, and others, which are now tracked by hundreds of billions of dollars of value ETFs and mutual funds.

Any factor that is widely identified risks the chance of arbitrage. Essentially, as investors become aware of an anomaly (low price-to-book stocks performing well, in this case) and start tilting their portfolios toward that anomaly, it tends to be eroded away. Below is the recent performance of the top decile of stocks ranked by the various value factors of VC2.

Nominal Return %, Top Decile of Various Value Factors (Jan 1999 - July 2016)
Nominal Return %, Top Decile of Various Value Factors (Jan 1999 – July 2016)

The first thing that stands out is how well each factor has performed against the S&P 500 over the last 16 years (it has be too good to be true, right?). The second thing that stands out is that price to book has been eroded as a value factor. It’s reasonable to believe that the erosion is due at least in part to its identification and wide use as a value factor.

This erosion, in addition to historical long periods of underperformance, is reason for concern for the trending value strategy. It’s reasonable to expect better performance if price-to-book was removed from VC2.

Nominal Return %, Trending Value with and without Price-to-Book (Jan 2010 – July 2016)

Removing price-to-book from VC2 does improve performance, though the trending value strategy has been pretty flat for the last 2 years, as stock prices continue to rise and the bull market continues.

In addition to dropping price-to-book from his value composite of evaluating stocks, it appears from his mutual funds’ fact sheets that James O’Shaughnessy has replaced price-to-cash flow ratio with free cash flow to enterprise value.

Nominal Return %, Top Decile of Various Value Factors (Jan 1999 - July 2016)
Nominal Return %, Top Decile of Various Value Factors (Jan 1999 – July 2016)

Free cash flow to enterprise value has been pretty much on par with price-to-sales and price-to-cash flow for the past 16 years, with price-to-cash flow actually outperforming free cash flow to enterprise value from about 2010 to 2015. But O’Shaughnessy has access to much larger datasets than I have available through Portfolio123, which may indicate larger advantages outside of the past 16 years. Additionally, free cash flow to enterprise value seems to have advantages over other traditional value factors, at least in theory.

Mimicking O’Shaughnessy by dropping price to book and replacing price to cash flow with free cash flow to enterprise value, value composite 4 (VC4) is born (VC3 was already named by O’Shaughnessy, as briefly mentioned here).

Nominal Return %, Trending Value (VC2, VC2 – PB, & VC4) (Jan 2010 – July 2016)

The trending value strategy that uses VC4 finishes a touch ahead of the benchmark for this time period, and has exhibited a much flatter trend over the last ~2 years than trending value using VC2 or VC2 without price-to-book.

How these perform moving forward remains to be seen, and I’ll continue to track both. But O’Shaughnessy himself altering the value composite from the one he published in 2011 is pretty strong evidence that he has acknowledged the arbitrage of price-to-book.

If you’d like to test price to book or hundreds of other factors for yourself, start here.

Consumer Staples Strategy – July 2016 Signals

The current stock signals for the consumer staples strategy introduced here are below. They are also published here. I used Portfolio123 to generate this screen.

HLF, Herbalife Ltd
NPD, China Nepstar Chain Drugstore Ltd
SENEA, Seneca Foods Corp.
CCE, Coca-Cola European Partners Plc
MED, Medifast Inc.
ADM, Archer-Daniels-Midland Co
GMCR^16, Keurig Green Mountain Inc
IMKTA, Ingles Markets Inc
MHG, Marine Harvest ASA
UVV, Universal Corp
USNA, USANA Health Sciences Inc
PM, Philip Morris International Inc
KMB, Kimberly-Clark Corp
AVP, Avon Products Inc.
NUS, Nu Skin Enterprises Inc.
ABEV, Ambev SA
GIS, General Mills Inc.
VGR, Vector Group Ltd
EPC, Edgewell Personal Care Co
PEP, PepsiCo Inc
CHD, Church & Dwight Co. Inc.
BTI, British American Tobacco PLC
WFM, Whole Foods Market Inc
FDP, Fresh Del Monte Produce Inc.
BG, Bunge Ltd

What Wilt Chamberlain Can Teach Us About Investing (The Irrational Investor Part 2)

On March 2, 1962 Wilt Chamberlain set an NBA record by scoring 100 points in a game. He scored 28 points in free throws alone, another NBA record, going 28 for 32 (87.5%) from the line. While 100 points in a game is no small task, Wilt averaged 50.4 points per game and had already scored 78 points in a game that season.

What was more impressive in that game was his free throw percentage. Why? Wilt Chamberlain’s career average from the free throw line was 50.4%. So how did he shoot 87.5% that night? By shooting his free throws underhanded. So why didn’t he permanently adopt the underhanded free throw permanently? Because, in his words, it made him “feel silly, like a sissy.” 

Malcolm Gladwell explored this and Wilt’s inexplicable aversion to shooting underhanded in a recent podcast. (A Q&A with Gladwell that touches on the same issue with other NBA players is here). Ira Glass explores this topic, including other examples of people “choosing wrong”, despite evidence suggesting a better outcome if they choose otherwise, in a recent episode of This American Life.

Gladwell ties Wilt’s choice to rebuff the underhanded free throw to Mark Granovetter’s threshold theory. In short, people with low thresholds are much more likely to follow the crowd, despite the advantages of not doing so. People with high thresholds are much more likely to ignore the social context of a behavior.

So how can this help you be a better investor? By being aware of our innate irrationality, we can avoid the herd mentality that led to the dotcom bubble. Awareness of this phenomenon can help you resist the latest trendy stock or strategy and to not lose sight of the underlying fundamentals of an asset. 

Knowing that your brain is working against you will hopefully prevent you from selling low and buying high, like so many millions of investors still seem to do.