Can this one simple ratio help you outperform the world’s best value funds?

//Can this one simple ratio help you outperform the world’s best value funds?

 

dearfellowinvestor_s

 

.

Can a simple quantitative value strategy (using even one simple ratio) outperform the best value investment funds?

 

Value investing works

If you have studied value investing for any length of time I’m sure you are also convinced that, over long periods of time, value investing is the only investment strategy you can use that will let you substantially outperform the market.

What to compare value investing returns to?

As you know value investing can be implemented in a number of ways. For example some value investors look at price to book ratios, others to price to earnings others free cash flow.

With all these different ways you can practice value investing how do you know if you (or your value fund manager) is doing as well as you could, even if you are outperforming the market?

 

An easy test

The easiest way to test this is to compare the top value investment funds in the United States to a few simple quantitative strategies that also use value investing.

You can easily find a lot of really good quantitative value investing strategies in the best-known books in this field (click book title for Amazon page):

What Works on Wall Street by James O’Shaughnessy  and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Westley Gray and Tobias Carlisle.

 

What strategy to use

Based on these great books and research from the research paper I wrote with a friend called Quantitative Value Investing In Europe: What Works for Achieving Alpha.

Quantitative Value Investing In Europe: What Works for Achieving Alpha

I chose a few, easy to implement, qualitative value investing strategies.

.

.

How to do it

From the Morningstar.com website I got the ten-year returns of the best US based value investing funds that invest only in the USA as well as globally.

Back-test universe

For the quantitative value investing strategies I looked for companies with a market value of more than $1 billion and with median liquidity of € 0.25 million per day.

For the US only funds we ran the model only selecting companies with a primary listing in the USA.

For global value investment funds we looked at companies in Western Europe, the UK, Switzerland and Scandinavia.

Return adjustments -1.5%

From the return generated by the qualitative value investment strategies we deducted 1% for dealing costs for buying and selling (this is very conservative as most investment funds can deal buy and sell investments for a lot less than this, most likely under 0.5%).

We also made provision for bid ask spreads deducting 0.5% from the yearly returns.

Survivorship bias eliminated

When implementing the quantitative value strategies we included companies in the investment universe that have gone bankrupt or re-organised in the past 10 years.

This is done to ensure that the strategies do not only select from companies that have survived the past 10 years.

Should a company have gone bankrupt or delisted returns were calculated using the last stock exchange price of the company before it was delisted.

How the strategy was implemented

Each year we selected 50 companies for each strategy that comply with the above guidelines. After one year all the investments were sold and this amount (including dividends) was re-invested in a further 50 ideas.

 .

.

The quantitative value investing strategies

The quantitative value investment strategies we tested were:

  1. Cheapest Earnings Yield (earnings before interest and taxes (EBIT) / enterprise value)
  2. Cheapest Earnings Yield combined with best six months share price momentum
  3. Lowest Value Composite One* value companies
  4. Lowest Value Composite One* value companies combined with best six months share price momentum

*You can read more about the Value Composite One value here: Value Composite One defined   http://www.quant-value.com/value-composite-one-added-to-the-investment-model/

As you can see these are all relatively simple strategies you can easily implement using a simple stock screener.

 .

Value funds vs Quantitative value

So how did the value funds perform against the quantitative value strategies?

 

Investments in US companies only

All funds and quantitative value strategies sorted by average returns

QvFF_US_All_avg_sorted

4.8% better

As you can see the best quantitative value strategy outperformed the best US fund with 4.8% per year for 10 years.

Even the worse performing quantitative value strategy on average did 2.4% (per year for 10 years) better than the best performing US value fund.

Call me conservative but this is substantial!

All funds and quantitative value strategies sorted by cumulative 10 year returns

If you assume that you invested $100 in each of the funds and quantitative value strategies this is the amount you would have had at the end of the 10 years.

QvFF_US_All_cumulative_sorted

100% more after 10 years

The difference in total return over 10 years between the best fund and best quantitative value strategy was also substantial.

If you followed the best quantitative strategy at the end of 10 years you would have had $368.9 in your pocket (for every $100 at the start), 100% ($100) more compared to the $267.4 you would have if you invested in the best performing value fund.

 

 

Investments in companies worldwide

All funds and quantitative value strategies sorted by average return

QvFF_Global_All_avg_sorted

2.6% better

As you can see the best global quantitative value strategy outperformed the best value fund by 2.6% per year for 10 years.

Even the worse performing quantitative value strategy on average did 1.2% (per year for 10 years) better than the best performing value fund.

 

 

All funds and quantitative value strategies sorted by cumulative return

QvFF_Global_All_cumulative_sorted

Also 100% more after 10 years

The difference in total return over 10 years between the best fund and best quantitative value strategy was also substantial.

If you followed the best global quantitative strategy at the end of 10 years you would have had $373.4 in your pocket (for every $100 at the start), more than 100% ($100) more compared to the $271.5 you would have had if you invested in the best performing value fund.

 

 

Surprising results

The results are really surprising.

Even if you have already spent a lot of time studying quantitative value investment strategies I am sure they also surprised you.

One simple ratio beats best fund

As you can see all the qualitative value strategies we tested outperformed the value investment funds, both for the US a as well as the funds that invest globally.

Even if you invested using a simple one ratio strategy, earnings yield (EBIT to enterprise value), it would have led to you beating the best value funds in the business.

What if you put all the quant strategies and funds (US and global) together you may be thinking.

 

 

All together

If you put the returns on the US and global strategies together (not surprisingly) the quantitative value strategies did better than the value funds.

Ten year average returns 

QvFF_Global&US_average_sorted

3.2% better

As you can see the best global quantitative value strategy outperformed the best value fund by 3.2% per year for 10 years.

With the worse performing quantitative value strategy on average did 0.8% (per year for 10 years) better than the best performing value fund.

 

Cumulative returns over ten years

 QvFF_Global&US_cumulative_sorted

Also 100% more after 10 years

The same as the other cumulative returns above the difference in total return over 10 years between the best fund and best quantitative value strategy was substantial.

If you followed the best quantitative strategy at the end of 10 years you would have had $373.4 in your pocket (for every $100 at the start), more than 100% ($100) more compared to the $271.5 you would have had if you invested in the best performing value fund.

 

 

Why isn’t everyone doing it?

If these quantitative strategies work so well why aren’t more investors following them you may be thinking?

The reason is that it looks a lot easier to do than it is.

As James Montier  writes in in the research report Painting By Numbers: An Ode To Quant:

“The most likely answer is overconfidence. We all think that we know better than simple models.

The key to the quant model’s performance is that it has a known error rate while our error rates are unknown.

The most common response to these findings is to argue that surely a fund manager should be able to use quant as an input, with the flexibility to override the model when required. However, as mentioned above, the evidence suggests that quant models tend to act as a ceiling rather than a floor for our behaviour.

Additionally there is plenty of evidence to suggest that we tend to overweight our own opinions and experiences against statistical evidence.”

 

Other reasons include:

Miss the largest winners

It is easy to avoid the biggest winners because these companies are in the quantitative model for a good reason, they are undervalued and you are most likely to find news on exactly how bad these companies are doing.

It’s not easy buying a company if all the news you can find on it is negative.

It may not always work

In spite of substantial past market beating results investors usually abandon a quantitative strategy when it starts to underperform the market, thinking the strategy is broken.

And this even if the strategy has a substantial back tested history and real world performance of market outperformance.

 

Have you tried it in the real world?

I’m sure you’ll also be wondering if I have tried any of the above mentioned strategies in the real world.

I have and it worked so well that I started a newsletter on the research I have done

The newsletter is called Quant Value which you can find at www.quant-value.com

Here is the full track record

You can find the full track record of the newsletter here: www.quant-value.com/track-record/

Your questions answered

And we have answered questions investors just like you had here: www.quant-value.com/faqs/

Wishing you profitable investing

 

 

Tim_sign3

 

By | 2017-05-21T07:19:02+00:00 May 27th, 2014|