The basic premise behind value investing is easy enough to understand: by stocks for less than they’re worth and then sell them after they appreciate. But even if you have the patience to put such a strategy into place, knowing what companies are actually worth in the first place is no small task. A host of value-oriented screens and strategies have cropped over the years to make investors’ lives easier, but according to research from Alpha Architect, complexity doesn’t lead to better results.
“We compare the performance of 13 value investing screens used by practitioners against a simple model based on buying stocks with the lowest enterprise multiple. Our sample of value investing screens underperform the simple lowest enterprise multiple strategy,” write Wesley Gray, Jack Vogel, and Yang Xu of Alpha Architects. “The one exception is the Piotroski F-Score screen, which has similar performance relative to the enterprise multiple strategy.”
EBIDTA/TEV outperforms more complex value screens
To compare the value screens, the group looked at large cap stocks (above the 40th percentile in their respective index) from stocks in the NYSE, AMEX, or NASDAQ between 1963 and 2013, eliminating any company with a negative book value. If one of the screen for produced zero stock recommendations in a given year they would incorporate more mid-caps and try again, but the research doesn’t apply to smaller, illiquid companies. They also used the S&P 500 Equal Weight Total Return Index as a benchmark, which has a bias against large-cap stocks compared to owning the market (ie market-cap weighted returns).
Not only did EBITDA/TEV (Total Enterprise Value) outperform the other value screens, its effectiveness wasn’t arbitraged away over time as EMH adherents say it should have been. That doesn’t mean it’s the best performing strategy in every market cycle, but the rest of the market hasn’t repositioned to squeeze it out either.
“Our basic assessment is that a complex system that adds little value over a simple system should be avoided if the performance is similar. Only when complexity can be shown to improve performance by a substantial amount should we consider transitioning to a complex system,” write Gray, Vogel, and Xu.
Thirteen complex value screens
The 13 value screens that they compared, in addition to the straightforward EBITDA/TEV have varying levels of complexity. The Dogs of the Dow 10 (and 5) buy the 10 (or 5) stocks with the highest dividend yield. The Graham Enterprising Screen, Graham Defensive Utility, Graham Defensive Non-Utility, and Graham Enterprising Investor Revised are all implementations of the rules put forward in Graham’s Intelligent Investor, focusing on low PE multiple, low debt/working capital, positive and growing EPS, and a history of paying dividends.
The Magic Formula excludes financials and utilities, as well as stocks with return on capital below the top quartile, and then buys stocks with the highest earnings yield. The Fundamental Rule of Thumb (FRT) excludes ADRs, real estate, financials, and companies with above average liabilities/total assets, then buys stocks with the highest total of earnings yield plus retained earnings plus dividend yield.
The Cash Rich Firms screen and Price to Free Cash Flow screen have an obvious emphasis, but are more complex than their names imply. While the Weiss Blue Chip Dividend Yield and O’Shaugnessy Value Screen would each need a detailed explanation.
Finally, the Piotroski High F-Score, the only value screen that did about as well as the simply EBIDTA/TEV measure, looks at nine financial signals: four related to profitability, three that check leverage and liquidity, and two related to operational efficiency. This strategy buys stocks in the top 20% based on book-to-market value that score an 8 or 9 out of the 9-point test.