- Two new quant studies support the primacy of price to book as a value metric.
- The Vera Yuan study at GuruFocus shows a decisive advantage for PB over five other metrics peak-to-peak and trough-to-trough since 2000, both in financials and non-financials.
- The Tobias Carlisle study at Greenbackd shows overwhelming advantage of lowest PB decile versus highest PB decile since 1926.
- This research tends to validate Buffett's focus on book value and suggests avoiding glamour stocks with high PB.
- It also provides perspective on the results of strict value managers in recent turbulent years including anomalous bad performance in 2007-2008.
Two new quant studies have added to the strong case for the primacy of book value as the value investor's leading metric and tool. The slicing and dicing of value metrics may never yield a definitive and final method, but all serious students of value investing need to pay attention to these two pieces.
It began with Ben Graham, of course, who in 1934 introduced the basic idea that quantitative measures of value rather than stories or future projections should be the central approach of individual investors. To me the truly shocking followup was Graham disciple David Dreman's Contrarian Investment Strategy (1979), which basically argued buying the cheapest decile of stocks as measured by P/E without necessarily referring to the individual companies. This approach was validated but greatly modified and complicated by James O'Shaugnessy's What Works on Wall Street (2005), which looked at a variety of value metrics, sliced the equity universe by cap size, and added a momentum element. My own key takeaway from O'Shaughnessy's work was his advocacy of price-to-sales as a key metric with more stability than earnings. Another offshoot of the buy-a-basket-and-ignore-the-companies approach is Joel Greenblatt's "magic formula," combining lowest enterprise value to EBITDA and highest ROIC. In my view, each of these approaches "works," to a significant degree if one has the discipline to stick to them, and each contributes to the dialogue about value.
The two new studies make the case for Warren Buffett's favorite metric, at least for his own Berkshire Hathaway (BRK.B, BRK.A): book value. Both are by in-house analysts associated with in-house funds based on value investing, and thus may have an axe to grind. Their work nevertheless has a solid ring to it.
The Yuan Study
Vera Yuan is an in-house analyst at GuruFocus, and her paper looks at R Squared as price indicator from 2000 through 2012. She further breaks the data down into peak-to-peak (2000-2007, 2007-2012, and the cumulative 2000-2012) and trough-to-trough (2002-2008). She examines R Squared by eight metrics: earnings, revenues, FCF, EBITDA, Operating Income, Pre-tax Income, Book Value, and Tangible Book Value. She divides the stock universe into financial companies and non-financial companies.
Her findings: among financial companies, Book Value and Tangible Book Value provide greater R Squared than any other metric for all time periods. Among non-financial companies, somewhat surprisingly, Book Value is still the overall leader, although it trailed earnings and operating earnings VERY narrowly from 2000 to 2007 and EBITDA and operating earnings also very narrowly from 2007 to 2012.
Low starting PB is the clear winner. To be sure, she examined companies with higher initial PB and higher PB growth rates and found that initial low PB overpowers higher growth rates.
The Carlisle Study
Tobias Carlyle of Greenbackd (and Eyquem) studied the stock universe from 1926 to 2013 comparing 459 companies of the value (low PB) decile to 404 companies of the glamour (high PB) decile.
Once again the results are decisive. The value decile provided an AAR of 27.3% and a CAGR for capital growth of 20.3%. The glamor decile provided a 10.4% AAR and a CAGR of 6.3%. Anyone who has ever looked at graphs of compounding returns will grasp immediately the ginormous scale of outperformance.
To give a sense of how the difference unfolds over shorter periods, Carlisle included a year-by-year comparison over the turbulent recent years from 1999 to 2013. Glamor did better than value in four years, 1999, 2007, 2008, and 2010. Value won handily for the overall period. So you don't have to live 87 years or leave it to your great-grandchildren in order to reap the rewards.
1. Screening for value by price-to-book works. If you have the patience and discipline (I don't quite have it), it probably beats both indexing and anecdotal stock-by-stock analysis.
2. Buffett's belief in book value as a measure for Berkshire Hathaway is well grounded. It is also a solid primary measure for all bank, insurance, and money management companies.
3. Avoid pricey glamor stocks (I do manage to comply with this one, always have, often looking silly for a while, but being happy in the end).
4. Value investing (low PB) and being smart made you look like an idiot in 1999, but not for too long.
5. Value (low PB) was great in the first great market crackup (2000-2003); it was horrible in the second crackup (2007-2009). Value managers, even good ones, got a lot of egg on their faces. I myself did well in the first crackup, but suffered damage in the second. The reasons seem clear after reading these papers. Solid value principles kept value managers deeply in financials in the second period, an emphasis that killed them. However, value bounced back promptly and with great vigor.
6. PB probably works better than other measures because it is summative and accurate -- reflecting bad years and one-time write-downs equally -- and because it is a smoother series than earnings.
I wrote this piece primarily to call these pieces of research to the attention of students of value investing. I heartily encourage taking the trouble to read them yourselves. Like many value approaches, the rigorous application may test your capacity for patience and discipline, but even if you do not adhere to this approach entirely, it should add to your overall sense of what works and doesn't work in the markets.