The Combination Metric Backtest and Comparison of Value Deciles (1951 to 2013)

By Greenbackd

The combo value metric is the final frontier in value investment. The dark side of the moon. The manned mission to Mars. Like off-label Spam, most combination models are curious, indelicate compounds of parts unknown. Ovine? Bovine? Porcine? We just don’t know.

To illustrate the benefits of combination, in this post I shine a light on a compound model of known parts–the simple fundamental metrics the subject of backtests on this site over the last four weeks: the price-to-earnings (PE) ratio, the price-to-book value (PB) ratio, the price-to-cashflow (PCF) ratio, and the dividend yield.

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Set out below are the results of Fama and French backtests of the equal weight portfolios of each metric’s value decile using data from 1951 to 2013. As at December 2013, there were 2,406 firms in the sample. The value decile contained the 283 stocks with the lowest ratio of price to earnings, cashflow, book value or dividends. Stocks with negative earnings, cashflow, book value or dividends were excluded. Portfolios are formed on June 30 and rebalanced annually.

Value Deciles Annual and Compound Returns (Portfolio Constituents Equally Weighted)


The PE, PB and PCF ratios deliver comparably excellent returns over the full period examined. The dividend yield meanders around not doing much, and few outstanding years are located therein. Studies have shown that the dividend yield is most most useful in conjunction with other measures of shareholder yield including net buybacks and net debt reduction. Including all of shareholder yield’s components leads to a return comparable to the return of PE, PB or PCF. Absent those measures, the dividend yield is an incomplete metric, and underperforms. For that reason, I have excluded it from the combination.

Composite and Component Value Deciles Annual and Compound Returns (Portfolio Constituents Equally Weighted)


Value Deciles

The composite, which selects portfolios by equally weighting the PE, PB and PCF ratios, delivers a performance over the full period that beats out PE and PB, and slightly underperforms PCF on a compound basis.The composite ratio generates an average annual return that beats out PCF, and PE, but slightly underperforms PB. This is important to note because it demonstrates the advantage of a composite measure over any single measure–even the best single measure periodically underperformed the composite.

Rolling 10-year CAGRs for Composite and Component Value Deciles

This chart shows the rolling 10-year CAGRs to each of the measures. All are highly correlated, but they diverge materially from time-to-time.

Value Deciles

The following chart takes the rolling 10-year data from this chart and compares it to the performance of the composite.

Rolling 10-year CAGRs for Components Relative to Composite


Value Deciles

This chart best illustrates the advantage of using a composite. While the PCF ratio delivered the better return over the full period, it underperformed the combo in 58 percent of rolling 10-year periods. PB was a notable laggard at the beginning of the data, and slightly underperformed over the full period, but the composite was the better bet only 36 percent of the time. PE outperformed strongly at the beginning of the data, but didn’t show thereafter, and so the combo was the better metric 75 percent of rolling ten-year periods.

The attraction of the combo is that it delivers returns comparable to the very best metric at any point in time. While PCF delivered better returns over the full period, most of the outperformance occurred at the beginning of the data, and it lagged thereafter. In contrast, PB underperformed at the start, and then outperformed thereafter. While the combo didn’t ever have its day in the sun as leader, it was the most reliable, never lagging far from the front-runner. Given that we can’t know which metric will be the best at any time, it makes sense to employ all of them if it doesn’t hurt returns too much.

As we’ve seen over the last few weeks, over the long run, and with some regularity, cheap stocks tend to outperform more expensive stocks. The PB, PE and PCF ratios are all very useful metrics for sorting cheap stocks from expensive stocks, but we can’t know which will be the better bet at any given point in time. The combo spreads the risk of underperformance relative to any single metric, and, in doing so, generates reliable investment performance over the full period without lagging far behind the front-runner at point.

My firm, Eyquem, offers low cost, fee-only managed accounts that implement a systematic deep value investment strategy. Please contact me by email at or call me by telephone on (646) 535 8629 to learn more.

Hat tip to Jim O’Shaughnessy whose What Works on Wall Street first discussed the combination metric, and his AAII article “What Works”: Key New Findings on Stock Selection for the idea for the relative performance chart.

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