The problem if you use a single valuation ratio (price to earnings ratio for example) to select investment is that it can move “in and out of favor” (depending on market valuation) and can significantly under perform the market over any given period despite its long-term out performance.
The solution ?
A valuation factor that uses a few valuation measures (called a value composite) overcomes this problem by giving you a list of companies that are undervalued based on the combination of a few valuation measures. This will give you more consistent returns as a few valuation measures will ensure that you only invest in companies that are truly undervalued.
James O’Shaughnessy (in the updated version of What works on Wall Street) found that stocks selected based on a value composite outperformed stocks scoring highest on any single value factor 82% of the time in all 10-year rolling periods between 1964 and 2009.
So, a composite that combines several different value factors delivers stronger returns and more consistency than any individual factor !
And based on these convincing results we also incorporate the value composite below in the model we use to select investments for the Quant Value newwsletter.
How is it calculated?
The value composite (VC1) James used is calculated using the following five valuation ratios:
- Price to book value
- Price to sales
- Earnings before interest, taxes, depreciation and amortization (EBITDA) to Enterprise value (EV)
- Price to free cash flow
- Price to earnings
How is VC1 calculated ?
To calculate the VC1 factor you have to assign a percentile ranking (1 to 100) to each of the five valuation ratios for each company.
For example if a company has a price to sales ratio that is in the lowest 1 percent for our database, it receives a rank of 1 (lower is more undervalued) and if a stock has a PE ratio in the highest 1 percent (it is over valued) of the universe it receives a rank of 100.
If a value is missing, we assign a neutral value of 50 for the valuation ratio.
Once all the valuation ratios have been ranked we add up all the values for each company and (using this value) rank all the companies in percentiles (from 1 to 100).
Companies that are the most undervalued get VC1 score of 1 those with the worst (most expensive) score get a score of 100.
Our 12 year back test…
As with all the strategies we use in the newsletter’s investment model we want to make sure it works which means we have back tested the returns you could have made if you used the VC1 indicator as an investment strategy for the 12 years between June 2001 and June 2012.
If you bought cheap companies
Over this period if you bought only non-financial companies (in Europe EU, the UK, Switzerland and the Nordic countries) with the VC1 value of less than 20 you would have earned a respectable 12.36% per year or 283% in total.
This compares very favourably to the 4,86% per year or 73% of all the companies we tested (the market) returned over the same period.
If you bought expensive companies
We also tested what would have happened if you only bought companies with a VC1 value of more than 80 (in other words expensive or overvalued companies).
Over the same 12 year period from June 2001 to June 2012 you would have lost 4.43% per year for a total loss of 40,7% over 12 years.
The returns of both strategies
If you combine the VC1 with another factor like the top 20% of companies in terms of the 6 month Price Index, F-score or shareholder Yield, not only will the number of companies be less but your returns are also very likely to be higher as you saw with the research paper we sent along with your subscription to the newsletter.