About the correction
The past few weeks we have had a market pull back which we have been expecting for a while.
Contrary to how it feels, pullbacks like this are healthy.
Markets can’t go higher in a straight line, and we have, more or less, had a straight line since March 2009, when they turned around after the financial crisis.
Nothing to fear
So, this pullback is long overdue, but it is nothing for you to fear.
We own great companies, follow a time tested investment strategy and, most importantly, have a risk-management system in place (trailing stop-loss system).
Great opportunities ahead
The pullback also means we have got a lot of great investment opportunities ahead to take advantages of as investors exit the markets because of irrational fears.
The best thing to do
The best thing you can do is take a deep breath, turn off the sensational television’s news, and spend time doing things you love doing, for me its playing golf.
A new indicator for the newsletter
This month I want to tell you about a new composite valuation measure we have developed and which, following all our testing, is now the main indicator I use to select ideas for the newsletter.
You know I am a big supporter of combining several different valuation measures to find undervalued companies. This helps you find companies that are undervalued from different points of view – for example based on earnings and cash flow.
The first such indicator we looked at is called Value Composite One and was developed by James O’Shaughnessy in the latest edition of his book, What Works on Wall Street.
But it has a problem
But the Value Composite One indicator has a problem: it includes the Price to Book ratio.
I do not have anything against using the Price to Book ratio to find undervalued companies (it works best after a large correction), but it also underperforms the market for long periods of time.
You can read more about problems with the Price to Book ratio here: Be careful of this time tested value ratio.
Because of this problem, we decided to develop our own composite valuation indicator, which we called Qi Value. Not only does it exclude the Price to Book ratio, but it also includes all the best valuation ratios we have researched and tested.
Qi Value ranks companies using four valuation ratios and thus helps you to select the most undervalued companies from different points of view with the following valuation ratios.
This is calculated as earnings before interest, taxes, depreciation and amortisation (EBITDA) / enterprise value.
This is calculated as operating income or earnings before interest and taxes (EBIT) / enterprise value. (Read more about earnings yield here: A simple ratio beats the world’s best value funds)
FCF (free cash flow) yield is calculated as free cash flow / enterprise value. Free cash flow is equal to cash from operations – capital expenditure.
Liquidity (Q.i) is calculated as adjusted profits / yearly trading value.
It thus gives you an indication of how high a company’s yearly traded value per share is compared to its profits. A high value therefore means low traded value compared to profits, and thus a larger chance of the company’s shares being mispriced.
It can thus help you to identify companies with large controlling shareholders or a stable base of shareholders where traded value is low and there is therefore less analyst interest, because they cannot make money in the trading of the company’s shares.
Does it work? Yes, 478% vs index 23%
This all sounds very interesting, but you may be asking yourself, does it work?
We of course tested the Qi Value indicator thoroughly to make sure it works before using it to select investment ideas for the newsletter and our own portfolios.
We tested the Qi Value indicator worldwide (22,000 companies in all the developed markets) against six other valuation ratios as well as the market index over the 14 year period from May 2001 to February 2015.
The following table summarises the results.
14 year back test summarised
Average return = Average yearly return
CAGR = (Compound Annual Growth Rate)
We tested the Qi Value indicator against the following ratios:
- Earnings yield (EY)
- Price to free cash flow (P/FCF)
- Price to earnings (PE)
- Earnings before interest, taxes, depreciation and amortisation yield (EBITDA yield)
- Price to sales (PS)
- Price to book (BP)
Qi Value is a lot better
As you can see from the above table Qi Value performed better than all the other ratios.
Apart from that the QI Value had:
- The highest total return of 477.6%
- The highest compound annual growth rate of 14.9% per year over the 14 year period
- The lowest standard deviation of 18.1% which means Qi Value returns were not as volatile as the other ratios.
- The highest Sharpe ratio (higher is better) which means the Qi Value indicator would have given you higher risk adjusted returns. Here is the Sharpe ratio definition.
As you can see the Qi Value is a valuable indicator and will definitely add to the quality of investment ideas you get in the newsletter.
Wishing you profitable investing