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.

Trending Value: Breaking Down a Proven Quantitative Investing Strategy

$10,000 invested into the trending value strategy in 1963 became over $69M in 2009. The strategy was published in 2011 and has continued to work since.

What I’m about to introduce to you is not black magic. And I say that because if you’re a realist like me, anytime someone comes to you with something that sounds too good to be true, it’s almost always too good to be true (or a pyramid scheme). Update: see my post attempting to answer the skeptics.

But this strategy is rigorously backtested and rooted in common sense. It isn’t about finding correlations between obscure financial metrics and stock performance to formulate a otherwise seemingly random strategy.

Every metric in this strategy is commonly used by millions of investors every day; but when they are combined in a specific way, the results can be extraordinary.

Nominal Return, Trending Value vs All Stocks (1964-2009)
Nominal Return, Trending Value vs All Stocks (1964-2009)
The trending value strategy was developed by James O’Shaughnessy and detailed in his book What Works on Wall Street as one of the best performing strategies, using a combination of value and growth metrics, terms you’ve probably heard of or seen marketed in ETFs or mutual funds.

Value investing is a well-known investment strategy that aims to select stocks that the market has undervalued – that is, the stock’s price is lower than what its fundamentals suggest it is actually worth.

O’Shaughnessy begins by backtesting strategies using one value metric at a time. For example, a strategy that is only invested in the stocks in the top decile (lowest 10%) of price-to-earnings ratios (P/E) and rebalanced every year. And likewise using price-to-book ratio (P/B), price-to-sales ratio (P/S), and price-to-cash flow ratio (P/CF). He also looks at enterprise value to EBITDA (earnings before interest, taxs, depreciation and amortization) ratio (EV/EBITDA), which was the single best performing value factor he backtested. (For each of these 5 factors, low values are better).

Another factor he looked at was shareholder yield (SHY), which is buybacks (how many stocks are repurchased by the company (i.e., decrease in number of outstanding shares)) plus dividends divided by market capitalization. (For shareholder yield, higher is better). The results for the top decile of these factors (lowest (or highest for SHY) 10%, rebalanced annually) are below (with all stocks for comparison).

Performance of the Top Deciles of Various Value Factors of the Trending Value Strategy (1964-2009)
Performance of the Top Deciles of Various Value Factors of the Trending Value Strategy (1964-2009)

By themselves, all of these factors beat the overall stock market. But combining the factors, coming up with a composite score and investing in the top decile of composite scores, yields even better results. To develop the composite scores, a ranking for each factor is given to each stock in the universe of stocks. So the stock with the lowest P/E gets a score of 100, the stock with the lowest SHY gets a 1, and so on (this can be done with the PERCENTRANK function in Excel (or 1 – PERCENTRANK for SHY, since higher numbers are better), or much more seamlessly using a more powerful tool like Portfolio123).

The ranks for each factor of a stock are added up for its composite score. O’Shaughnessy looked at 3 different value composite scores: value composite 1 (VC1) used the factors described above except SHY, value composite 2 (VC2) add SHY to VC1, and value composite 3 replaces SHY with just buyback yield. The returns for top decile of each of these composite scores is below (rebalanced annually).

Performance of Value Composites VC1, VC2, and VC3 (1964-2009)
Performance of Value Composites VC1, VC2, and VC3 (1964-2009)

Each value composite is a significant improvement over any individual factor. Composites are more powerful than just screening for the best values of the individual factors because a stock that may be deficient in one metric but excellent in the others would get eliminated from consideration by screening (e.g., a stock in the top decile of VC2 may not necessarily be in the top decile for all of the individual factors).

To implement the trending value strategy, you simply invest in the top 25 stocks sorted by 6-month % price change (the “trending” part of the name) among the top decile of stocks ranked by VC2 (O’Shaughnessy chose VC2 over VC3 because of its slightly higher Sharpe ratio, a measure of risk-adjusted return).

The universe of stocks is limited to those with a market capitalization of more than $200M (in 2009 $) to avoid liquidity problems with trading smaller stocks. It’s a buy and hold strategy that is rebalanced annually with the following exceptions. If a company fails to verify its financial numbers, is charged with fraud by the Federal government, restates its numbers so that it would not have been in the top 25, receives a buyout offer and the stock price moves within 95% of the buyout price, or if the price drops more than 50% from when you bought it and is in the bottom 10% of all stocks in price performance for the last 12 months, the stock is replaced in the portfolio.

So what’s the catch? There are a few:

  1. The Data: While most of the metrics described are freely available from any number of online sources, some (e.g., buyback yield) aren’t as easy to come by, and I still haven’t found a free way to obtain all of the data for all of the stocks at once.
  2. Psychology: While the trending value strategy has never underperformed the market for any rolling 5-, 7-, or 10-year periods between 1964 and 2009, it has underperformed the market for rolling 1-year periods 15% of the time, and 3-year period 1% of the time. If you hit a few years with less-than-stellar performance, are you going to stick it out and trust the strategy, or are you going to jump ship to bonds (as many people did in 2009, missing out on the huge subsequent rebound) or another trendy strategy that seems to be performing better at the time?
  3. Commissions (for small-time investors): At $10/trade and 25 trades per year, you need a portfolio of $100,000 to keep your commissions to a reasonable 0.25%.
You can learn how to implement the trending value strategy here, so number 1 is solved. Number 2 is on you. And number 3 is covered here.