Value investing II

How to measure value?

There are many ways to measure value –

P/E

EV/EBIT or EV/EBITDA

P/B

replacement value multiples

However you measure it, value is designed to capture the idea that you’re “getting a deal.” P/E and EV/EBIT(DA) type measures reflect this by showing you how quickly you can earn your initial investment back …. A P/E of 20 means that each year you get 5% of your initial investment. A P/E of 3 you therefore mean that each year you get back 33% of your investment. Seems like a steal of a deal, right? 3 years and then it’s gravy. Unfortunately, most of the time, there is a reason that a P/E is 3 … specifically, markets anticipate that earnings are going to fall. If you look at companies with a 2-3 P/E – there are 7 of them below – you can see that in some cases (UAL, MTG, BPT), earnings have been falling. In another case, SDLP, there has been an unusually high earnings number in the recent quarter. For CBB, ARC and ESI, earnings are volatile. The one thing we don’t see for these 2-3 P/E companies is a consistently increasing earnings stream ….if so, it would be valued much higher.P/B is similar, but different. P/B and replacement value multiples, or multiples against reserves for commodity firms capture the deal you are getting on value – in this case, a low multiple may capture some hidden impairment of the assets of the firm. Perhaps the value reserves or machines are being marked to on the books is too high.

Ticker Company earnrecent earn1qago earn5qago
UAL United Continental 313,000,003.08 822,999,996.18 507,999,989.66
MTG MGIC Investment 69,191,000.28 102,418,001.99 133,075,997.27
CBB Cincinnati Bell 32,600,000.43 80,300,000.50 -18,299,999.74
SDLP Seadrill Partners 189,600,001.44 35,400,000.55 33,099,999.69
BPT BP Prudhoe Bay 15,043,999.77 31,508,000.06 43,378,000.73
ARC ARC Document Solutions 3,183,999.96 80,335,999.25 -2,327,000.01
ESI ITT Educational Services 10,446,999.86 1,688,000.00 14,917,000.10

 

Skimming through the list of companies with 10-20% Price to book ratios (the company trades at 10-20% of book equity), there are 13: half are oil and gas and hal fare financials … again situations where it’s easily possible for book value to be way too high (given the recent fall in the price of oil, oil and gas equipment may easily be worthless; and financial assets such as bad loans can also easily be worthless).

 

So there are good reasons why P/E and P/B type ratios can be low – on average, they seem unjustifiably so, as these firms, on average, outperform, but if you own these firms, be prepared for decreasing earnings, writedown of assets and other things that accompany low multiples.

Change the rules

As in most endeavors in life, quantitative investing requires learning from mistakes. An example I recently encountered involved one of my fairly complex short screens. The idea behind the screen was similar discussed here…. Shorting …. and a Happy New Year, but the execution was infinitely more complicated.

Anyway, this screen was spitting out 5 or so stocks each month when I did my rebalance. Last month, it returned only 2 stocks … I was not too concerned: there’s always variation in the number of stocks returned month to month. However, I decided to increase the allocations to each of these names since there were only two names … and then, one of the names (KPTI)  had a +60% month. With an oversized allocation and the large positive return, it certain made its presence felt in my overall portfolio return. Sigh.

No worries – it was an up March 2016, and my longs rallied to yield an overall profit .. BUT …. I was somewhat shaken. I did a bit of analysis on the short screen I was using and found something interesting. like KPTI, a large chunk of stocks returned in my short screen were biotech stocks. This made sense since biotech stocks generally look terrible from an earnings standpoint. In fact, these stocks are designed to basically lose money, until they get far enough in a clinical trials to be acquired by a large pharma company.

Enough biotech companies fail that, even accounting for the few that are sold at a massive gain to big pharma, the backtest on my screen was looking great. However, I was taking large risks on individual bets. So …. I did what any human (seemingly rational) investor would do and just excluded biotech from my short screen.

I had to reduce the other restrictions to get back to a reasonable number of stocks in the portfolio at all times … and it definitely reduced the spikes and cliffs. So I implemented it for my April rebalance – 4 non biotech names.

Seems like a win all around, but somehow I doubt this will be my only post on changing the rules. I also somehow feel my next post on this practice of changing rules won’t be as positive about the practice as this one, but we’ll see.