February 14, 2014
One of the most-cited value investing studies says stocks with low price-to-book ratios outperform stocks with high price-to-book ratios. Investment firm GMO’s Ben Inker says the study’s findings still hold, but work better when a one-year lag is used.
In “The Cross-Section of Expected Stock Returns” (The Journal of Finance, June 1992), Eugene Fama and Kenneth French published data showing an inverse relationship between returns and valuations. Average monthly returns ranged from 0.30% for the decile composed of stocks with the highest price-to-book (P/B) ratios to 1.83% for the decile composed of the lowest P/B ratio stocks. Fama and French calculated average returns for the period of July 1963 through December 1990 for their study.
Inker updated the data and shared his findings in the February 2014 GMO Quarterly Letter. He concluded: “If we just look at traditional value for stock selection—good old price/book as enshrined by Fama and French—the cheapest 10% of the market has outperformed the broad market by 2.5% per year since 1965. Sounds fine, but since the original Fama/French paper was published in 1992, the group has actually underperformed by 1.6% per year. The same group lagged one year outperformed by 3.5% per year since 1965, and since 1992 has outperformed by 2% per year. You can see similar patterns in sectors as well. In most cases lagged value either works better than portfolios based on current data or works almost as well.”
What Inker is referring to is buying the stocks whose P/B ratios ranked in the bottom decile one year ago (stocks whose valuations were lower than 90% of all other stocks last year), instead of buying those stocks that now appear in the bottom decile. His rationale for doing so is based on momentum. A stock becomes very cheap because of selling pressure (downward momentum), and the selling pressure may continue for a while. By using lagged valuation data, an investor allows time for the downward momentum to end.
I created a basic stock screen based on Inkers suggestion to see what would come up. Using the % Rank-Price/Book-1 year ago criterion in our Stock Investor Pro program, I identified the stocks whose P/B ratios ranked in the bottom 10% in February 2013. Then, to help eliminate those stocks that are cheap for a reason or are otherwise not attractive to me, I created a second screen filtering last years cheapest stocks. Specifically, I excluded any stocks that were not currently exchange-listed, are headquartered in China, have a share price below $4 or a market capitalization below $30 million, and were not profitable over the past 12 months.
Since I still had a pretty lengthy list (63 stocks), I decided to get a bit pickier. I required the stocks to have a 26-week relative strength rank of 60% or higher, a sign they have better-than-average price performance, and to be headquartered in the U.S. This narrowed the list to the 25 companies shown in Table 1 below.
Keep the simplicity of the screens used in mind when looking at the list. A closer analysis may reveal traits that make the stocks either more or less attractive investment candidates.
[International Shipholding Corp. (ISH) and Willis Lease Finance Corp. (WLFC) are in our Model Shadow Stock Portfolio and I own them as well.]
|Company||Ticker||P/B||P/B 1-Yr Ago||26-wk Rel Str. Rank|
|American Independence Corp.||AMIC||0.83||0.42||83.00%|
|Bank of America Corp.||BAC||0.82||0.55||72.00%|
|Century Casinos Inc.||CNTY||1.33||0.6||94.00%|
|CNO Financial Group Inc.||CNO||0.79||0.5||72.00%|
|Continental Materials Corp.||CUO||0.63||0.58||84.00%|
|E TRADE Financial Corp.||ETFC||1.2||0.62||86.00%|
|Equal Energy Ltd.||EQU||1.14||0.49||77.00%|
|Genworth Financial Inc||GNW||0.53||0.25||77.00%|
|Green Plains Renewable Energy||GPRE||1.32||0.59||84.00%|
|Hartford Financial Services||HIG||0.82||0.46||64.00%|
|HMN Financial Inc.||HMNF||1.03||0.61||88.00%|
|International Shipholding Corp.||ISH||0.57||0.5||64.00%|
|Jefferson Bancshares Inc.||JFBI||0.91||0.61||85.00%|
|The L.S. Starrett Company||SCX||0.89||0.59||90.00%|
|Lincoln National Corp.||LNC||0.97||0.54||69.00%|
|Monster Worldwide Inc.||MWW||0.95||0.61||91.00%|
|Oppenheimer Holdings Inc.||OPY||0.64||0.51||78.00%|
|Parke Bancorp Inc.||PKBK||0.99||0.6||84.00%|
|Protective Life Corp.||PL||1.06||0.56||67.00%|
|Spirit Realty Capital Inc.||SRC||1.11||0.48||73.00%|
|Summit Financial Group Inc.||SMMF||0.67||0.52||66.00%|
|WashingtonFirst Bankshares Inc.||WFBI||1.02||0.51||75.00%|
|Willis Lease Finance Corp.||WLFC||0.7||0.62||77.00%|
Charles Rotblut, CFA is a Vice President with the American Association of Individual
Investors and editor of the AAII Journal.
View original at: AAII Investor Update E-Newsletter
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