Get the help of the External Finance Ratio in your portfolio

//Get the help of the External Finance Ratio in your portfolio

 

As you know we continuously do research and read about how we can give you even better investment ideas.

 

New – External Finance Ratio

In this blog post I want to tell you about a ratio we have also added to the Quant Value newsletter’s investment model called the External Finance Ratio (EFR).

 

We got the idea from the excellent book by Richard Tortoriello called Quantitative Strategies for Achieving Alpha: The Standard and Poor’s Approach to Testing Your Investment Choices (click the book name to go to the Amazon page).

 

The ratio calculates if a company was able to finance its asset investments from cash the business generated or if it needed external financing (bank debt or to sell shares) to meet its investment requirements.

 

How it is calculated

The ratios calculated it follows: (Gross change in total assets for the year – net cash generated from operations) / Total assets at the end of the year.

Thus if the ratio is positive (>0) it means that the company was not able to finance its assets growth internally whereas if the ratio was negative (<0) it means that the company was able to finance its assets growth through the cash the business generated.

 

Back tested results

As you know we don’t just add a new ratio to the newsletter’s investment model without first testing it to see if it can help you achieve higher investment return.

 

First test

We tested the EFR ratio in two ways.

Firstly we divided the EFR ratio into five quintiles (five equal groups) with companies with the highest need for external financing (largest positive EFR) in quintile five and those with the lowest need for external financing (largest negative EFR) in quintile one.

 

Over the 12 year period we tested the ratio these were the results:

Date Q1 Q2 Q3 Q4 Q5
06.07.01 -4,8% -2,8% -9,4% -19,8% -37,9%
06.07.02 -4,5% -6,1% -8,9% -7,2% -16,0%
06.07.03 43,5% 34,4% 34,8% 31,3% 32,3%
06.07.04 24,4% 25,0% 28,1% 28,4% 24,1%
06.07.05 25,6% 22,5% 37,9% 27,5% 27,8%
06.07.06 31,6% 35,7% 38,5% 32,5% 26,0%
06.07.07 -24,8% -20,7% -23,9% -25,9% -29,7%
06.07.08 -21,7% -18,8% -24,9% -30,7% -36,6%
06.07.09 22,9% 23,1% 21,5% 19,9% 13,9%
06.07.10 24,9% 24,9% 18,1% 16,3% 12,3%
06.07.11 -12,3% -11,3% -14,4% -14,0% -19,4%
06.07.12 14,4% 20,2% 17,7% 15,5% 11,9%
CAGR 7,9% 8,9% 7,2% 3,6% -2,9%

Q = Quintiles

CAGR = Compound annual growth rate

 

What it means

As you can see, apart from Quintile 1 (Q1), the compound annual growth rates of the quintiles are linear.

This means that EFR has the ability to increase your investment returns if you look for companies with no need for external financing (have a negative EFR).

The fact that quintiles one to three have similar returns means that if you avoid to 40% of companies with the highest EFR ratios you would capture the most of the value this ratio can add to your returns.

 

Second test

Secondly we did a simpler test dividing all the companies only into two groups, one group that needed external financing (positive EFR’s) and another group that did not (negative EFR’s).

Again here is a table with the yearly returns:

Date Low EFR High EFR
06.07.01 -4,1% -18,2%
02.07.06 5,3% -10,7%
06.07.03 37,8% 31,9%
06.07.04 25,6% 26,6%
06.07.05 24,7% 30,9%
06.07.06 33,1% 32,8%
06.07.07 -23,5% -25,7%
06.07.08 -20,0% -29,7%
06.07.09 22,5% 18,4%
06.07.10 22,5% 13,5%
06.07.11 -11,9% -16,3%
06.07.12 17,3% 14,7%
CAGR 8,1% 3,1%

Low EFR = Companies that did not need external financing

High EFR = Companies that needed external financing

CAGR = Compound annual growth rate

 

As you can see the companies that did not need external financing returned +8.1% yearly, substantially outperforming those that needed either bank financing or had to issue new equity  which returned only +3.1% annually.

 

Get it to work for you

To get the external financing ratio to help your portfolio returns simply click the link below:

http://www.quant-value.com/price/

 

By | 2017-05-21T07:19:02+00:00 March 1st, 2013|