Value Composite One added to the newsletter investment model

//Value Composite One added to the newsletter investment model

 

I would like to introduce you to new factor we have added to the investment model we use to select investment ideas for the Quant Value newsletter.

 

How we learned about it

It’s called the Value Composite One (VC1) and came to our attention when we read the latest edition of James O’Shaughnessy’s book What Works on Wall Street: The Classic Guide to the Best-Performing Investment Strategies of All Time (click for Amazon page).

 

What is inside

The VC1 factor 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 it is calculated

To calculate the VC1 factor we 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% in the database, it receives a rank of 1 (lower is more undervalued) and if a company has a PE ratio in the highest 1% (it is overvalued) 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 highest (most expensive) score get a score of 100.

 

12 year back test in Europe

As with all the strategies we use in the investment model we 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.

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.

Here is a table with the yearly returns:

Date No. companies1 Return
06.07.01 513 2,44%
06.07.02 494 -0,59%
06.07.03 475 41,47%
06.07.04 513 35,56%
06.07.05 551 43,91%
06.07.06 627 43,01%
06.07.07 722 -21,35%
06.07.08 665 -25,16%
06.07.09 570 35,43%
06.07.10 589 21,73%
06.07.11 599 -17,28%
06.07.12 532 18,95%
CAGR2 12,36%

1 Number of companies in portfolio

2 Compound annual growth rate

 

A lot better than the index

This compares very favourably to the 4,86% per year or 73% in total all companies in the database returned over the same period.

 

Best factor changes over time

The reason why a combination of value factors (like the VC1) is a good idea for you to use is that the individual valuation ratios that give you the best return changes over time.

For example in the first edition of O’Shaughnessy’s book Price to Sales was the best ratio he tested while in the latest version EBITDA to EV was the best ratio.

A valuation factor that uses a few valuation measures overcomes this problem by giving you a list of companies that are undervalued based on a few valuation measures and thus more consistent returns.

 

Smaller portfolios may be even better

As you can see the number of companies selected each year is quite large (up to 722 companies fat too much for us to invest in).

If you combine the VC1 with another factor like the top 20% of companies in terms of the 6 month Price Index 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 you in 2012.

 

We also tested 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 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.

Again here is a table with the yearly returns:

Date No. companies1 Return
06.07.01 520 -39,12%
06.07.02 500 -14,67%
06.07.03 489 32,41%
06.07.04 539 17,44%
06.07.05 560 23,38%
06.07.06 640 23,52%
06.07.07 740 -29,17%
06.07.08 680 -31,17%
06.07.09 580 6,14%
06.07.10 600 10,66%
06.07.11 620 -18,77%
06.07.12 558 3,50%
CAGR2 -4,43%

1 Number of companies in portfolio

2 Compound annual growth rate

 

You already get the benefit

As you can see the VC1 factor is a very important tool that can help you get returns a lot higher than the market.

Its quite complicated to calculate but as we have the database and programming for it already included in the investment model of the Quant Value newsletter you get all the benefits of it when you subscribe to the quant value newsletter.

Details of how inexpensive and easy it is to subscribe can be found here: Quant Value newsletter subscription information.

By | 2017-05-21T07:19:02+00:00 February 4th, 2013|