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.

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2 Replies to “Death of a Value Factor? The Arbitrage of Price to Book”

  1. Hi, I have a question concerning stocks that fell. So I used trending value strategy and one of my stocks fell 20 % the other one 36 %. However, both stocks seem to be very volatile one and taking into consideration their 6 month performance is not that bad.

    Seadrill Partners LLC Reg.
    Century Aluminum Co. Registered Shares

    these are the stocks

    How do these strategies handle these cases?

  2. Good question. With the more aggressive (and volatile strategies) larger stop losses are required to account for the increased volatility. For the trending value strategy, O'Shaughnessy's backtest dumped a stock if it dropped 50% AND was in the bottom 10% of stocks ranked by 12 month price change. However, I haven't found that to be very effective in my backtests.

    Using an entry-based stop loss of 30% improves the performance of the trending value strategy. And a significant improvement to the strategy can be made by using a composite of the 3, 6, and 9-month momentum instead of just the 6 month to rank the stocks. I'm working on a post about this, along with adding a volatility factor to the momentum composite ranking (this is what O'Shaughnessy's mutual funds use).

    A 15% entry-based stop loss has worked well for the consumer staples strategy (a less volatile strategy).

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