In search of super returns in stocks

Market mispricings may be spotted by identifying stocks with high Return On Equity but low Price To Book ratio

By Teh Hooi Ling

Sunday, Aug 15, 2010
The Business Times

Key article highlights:

• One way to value a company is to use the abnormal earnings formula - discount its future stream of abnormal earnings (earnings above the cost of its capital) to its present value; and add that number to the current book value of the capital.
• By scaling the formula with book value on both sides, we get Price-To-Book (PTB) value on the left-hand side, and abnormal return on equity (ROE).
• This suggests that a company's PTB ratio is a function of three factors: its future abnormal ROE (ROE less the cost of equity), the growth in its book equity, and its cost of equity.
• Hence, there is a strong relationship between PTB ratios and ROEs.
• Companies with high ROE should trade at higher PTB ratio compared with those with lower ROE.

The Screening

• ROEs and PTBs on Jan 1 of each year of all the companies listed on the Singapore Exchange from 1990 until 2007 were downloaded.
• Stocks were ranked by dividing their ROEs with their PTBs and split equally into 10 groups.
• The first group, or the first decile, is the top 10 per cent of stocks with the highest ROEs relative to their PTB ratios.
• The 10th decile comprises those with the lowest ROEs and highest PTB ratios.
• Then there's a group of loss-making companies.

The Back-Testing

• An investor performs the screening and invests $100 in the top four stocks with the highest ROE/PTB on Jan 1, 1990.
• On Jan 1, 1991, he repeats the same screening again; divested the initial four stocks and reinvested the proceeds into a new batch of stocks with the highest ROE/PTB.
• And he consistently did that for the past 17 years.

The Result

• There is a very clear relationship between stock returns and ROE/PTB.
• The top 10 per cent of companies with the highest ROE/PTB turned $100 into $34,048 in 17 years, a compounded return of 41 per cent a year.
• The next 10 per cent managed to grow the pot to $4,710, a decent 25 per cent a year.
• The third decile, managed $958 for a return of 14 per cent a year.
• And as we move to stocks with lower and lower ROE/PTBs, the return shrinks correspondingly.
• The fifth decile grew only 3.8 per cent a year and the 10th decile - the 10 per cent of the market with the lowest ROE/PTB - shrank the $100 to just $25.
• The test calculations did not take into consideration transaction costs.
• This screening process takes into consideration the underlying earnings capacity of a company in relation to how the market is valuing the company.
• Those with high ROE but low PTB are clear cases of mispricing.
• As the testing entailed a one-year holding period each year, decay factors (e.g. barriers to entry in their industries, change in production or delivery technologies, and quality of management) were insignificant.

The Conclusion

• If you find a stock with high ROE but relatively low PTB, then you may potentially have on your hands an undiscovered gem.

My view - the ROE/PTB measure might just be a simple value metric to uncover undiscovered multi-bagger stocks.

Accounting games companies play

In The Edge Financial Daily Today 2012
Written by Goola Warden of The Edge Singapore
Thursday, 14 June 2012

Key article highlights:

• It is possible for investors to identify the "accounting games" companies play by reconciling their revenues and earnings with their cash flow statement and balance sheet.
• Reported revenue and earnings albeit easily manipulated, impacts figures on balance sheets.
• Legitimate sales and real earnings booked results in increased cash on the balance sheet; unreal revenues and earnings however, inflates the accounts receivable figure.
• An annual 10% revenue growth accompanied with 20% to 30% accounts receivable growth poses a big problem because the company will never get the cash.
• This manipulation technique is likely to be used by companies whose business have a significant time lag between signing contracts and actual delivery of the product or service.
• Companies with an unexpected surge in sales towards the end of a financial year should be looked out for.
• 'Bill and hold' sales allowed Sunbeam to meet revenue and earnings expectations but was essentially fraudulent as their inventory of barbeque grills stockpiled.
• Investors should read every line of a company's financial statements, check all the footnotes and try to understand the company's policy for recognising revenues, earnings, depreciation and accruals.
• Artificially lowering reported expenses to achieve revenue boost results in telltale balance sheets.
• America Online's floppy disks to get signups, an advertising expense that should have been in the income statement, ended up as deferred customer acquisition cost on the balance sheet.
• Inventory consistently growing faster than sales could be a sign that the cost of goods sold on the income statement is understated thereby boosting reported earnings.
• Investors ought to have a healthy skepticism of any move by a company to revalue assets on its balance sheet, especially commodity and agricultural companies.
• Bre-X, a mining company, kept increasing the estimates of the size of its supposedly Indonesian gold deposit. Eventually, it met with a share collapse when earlier ore samples from its mine had been found salted with gold dust.
• Ordinarily, cash should be coming from the operation of the business and going to investments for the future and repaying debt, that is, investing cash and financing cash flow.
• Cash flow classification tricks, however, overstates the operating cash flow instead of the investing or financing cash flow (e.g. classifying tax expense as capital expenditure).
• WorldCom's payment for use of third-party satellites expense was classified as an asset under property, plant and equipment on the balance sheet (instead of an expense in the income statement) and cash outflow as a result of investing activities (instead of operating cash outflow in the cash flow statement) resulted in overstated earnings, overstated operating cash flow and an increase in assets.

My view - an investor is essentially risking his money when buying any company's shares. While there is potential capital growth and cash flow from dividends, adequate pre-investment due diligence and post-investment monitoring must be conducted. Periodic review of financial statements can serve as a means to uncover any irregularities on the company's operating state of affairs.

Time to re-assess price-to-book stock picks?

Including dividend yield in the decision appears to capture the cream of the crop

by Teh Hooi Ling, Senior correspondent

Saturday, Feb 4, 2012 

The Business Times Weekend

SHOW ME THE MONEY

Key article highlights:

• Strategy of buying baskets of stocks with varying ratios of dividend (D) yield to price-to-book (PTB) ratio was tested.
• The test data included list of stocks trading on Singapore Exchange every year on March 31 starting from 1990, dividend yield, price-to-book ratio and last traded stock price on Jan 17, 2012.
• Stocks were ranked based on dividend yield over price-to-book ratio (i.e. D/PTB ratio) and divided into 10 groups of equal numbers.
• Decile 1 comprised stocks with lowest dividend yield but highest PTB ratios; and Decile 10 comprised stocks with highest dividend yield but lowest PTB ratios.
• Quality of assets and corporate debt levels were not screened.
• There were 10 groups of stocks each year with their returns tracked annually.
• For each group, the median price appreciation was taken as the return and median dividend yield added to compute the total return respectively.
• The groups of stocks will be different each year depending on their D/PTB ratio as at Mar 31.
• 10 investors started 1990 with $100 were assumed with Investor 1 always investing in Decile 1 portfolio and Investor 10 in Decile 10.
• Each group's total return at the end of each year was reinvested in the following year's corresponding decile for 22 years.
• The result: Buying stocks with the highest dividend yield, but lowest PTB ratio appeared to be a winning strategy.
• The D/PTB strategy turned $100 into $1,575 for Decile 10, representing a compounded annual return of 13.3 per cent.
• Conversely, $100 diminished to just $16 for Decile 1, representing a decline of 7.9 per cent yearly.
• Meanwhile, the Straits Times Index's (STI) capital appreciation over the same period was 3 per cent annually excluding dividends.
• The D/PTB ratio strategy was then compared with the strategy of simply buying stocks with the lowest PTB ratios.
• PTB as a predictor of a company’s future stock performance was first highlighted by US finance professors Eugene Fama and Kenneth French in 1992.
• Their breakdown study showed convincing that the lower the company's ratio of PTB value, the higher its subsequent stock performance tended to be.
• Fama and French found that no other measure had nearly as much predictive power – not earnings growth, price/earnings, or volatility.
• The D/PTB test methodology was repeated by grouping stocks based on their PTB where Decile 1 comprised stocks with the highest PTB and Decile 10 with the lowest PTB.
• The result: Buying stocks with the lowest PTB outperformed the rest of the baskets of stocks but paled in comparison with that of buying stocks with the highest D/PTB ratios.
• The PTB strategy grew $100 into $365 for Decile 10, representing a compounded annual growth of 6.1 per cent.
• When a 3 per cent annual dividend yield was assumed for the STI constituent stocks, the PTB Decile 10 return was comparable to that of the STI's.
• Comparing the two strategies, portfolios of high D/PTB stocks fall less than the general market during downturns because the dividends provided a floor for the stocks' prices.
• Additionally, the performance of the highest D/PTB porfolio towered over the rest and appeared to have captured the market's absolute cream of the crop.
• Based on the two strategies' test results, screening stocks based on both dividends and PTB would yield a better outcome than selecting stocks just on PTB.

Dividend yield and PTB ratio form part of my assessment criteria when i screen stocks.  With the D/PTB ratio, it seems i now have a far more powerful screening metric to facilitate my investment decision making.