The term ‘value investing’ is probably one of the most misused and misunderstood phrases in finance. The term is thrown about today with little regard to what it stands for, notably conducting detailed fundamental analysis on a security trading at a deep discount to intrinsic value. Value investing is also increasingly being adopted by quantitative investment strategies sometimes called Quantitative value strategies, which use ratios of common fundamental metrics such as book value and earnings to market price. However, the hallmark of such strategies is that they do not involve a comprehensive effort to determine the intrinsic value of the underlying securities before investing.
If research by U-Wen Kok, Jason Ribando and Richard Sloan is to be believed, this attention to detail is costing investors money and supporting fraudulent companies.
Quantitative Value Strategies Are Misleading Investors
In a new research paper titled ‘Facts about Formulaic Value Investing’ this trio look at how quantitative value strategies perform for investors and they determine two essential facts about such strategies.
“We found little compelling evidence that a strategy of buying US equities that seem underpriced in light of simple fundamental-to-price ratios provides superior investment performance. The evidence does indicate that small-cap stocks that seem expensive given such ratios have underperformed. Such stocks, however, are relatively capacity constrained, illiquid, and costly to borrow, so the opportunity to exploit these lower returns in practice is unclear.”
“Instead of identifying underpriced securities, simple ratios of accounting fundamentals to price identify securities for which the accounting numbers used in the ratios are temporarily inflated.”
This second point is more intriguing than the first because it has implications outside of the quantitative value fund market.
Specifically, the researchers find that the book-to-market ratio systematically identifies securities with overstated book values. For the most part, these book values are subsequently written down. A similar trend is seen with the trailing price to earnings ratio. Historic screens identify securities with temporarily high earnings that subsequently decline. Using a forward price to earnings ratio does not remedy this discrepancy. According to the study, the forward price to earnings ratio only systematically identifies securities for which sell side analysts offer relatively more optimistic forecasts of future earnings.
These findings should serve as a warning not just to those investors who believe they can replicate the success of value investing by employing a quantitative strategy, but also to those value investors who believe they can skip detailed analysis in favor of less rigorous ratio screening.