How to Identify the Cheapest Stocks (Part 2 of 4)

This is the next installment in our series covering Turnkey Analyst’s approach to the holy grail of investing – how to identify low risk, high quality, undervalued stocks that generate market beating returns.  In Part 1, we focused on avoiding losses.  In Part 2, we will focus on how best to measure whether a stock is cheap.

It has been well-documented in academia that those investors who buy out-of-favor value stocks will, over time, beat the market and outperform those who choose more widely-held and popular glamour stocks.  Over the years practitioners have explored a range of value strategies aimed at identifying such value stocks, including low price to earnings, book value, dividends and others; indeed, many of these strategies appear to consistently beat the market.  So which one should you choose?

In order to answer this question, we look to the world of horse racing.  And how do they solve the argument for which horse is the fastest at Churchill Downs (site of the Kentucky Derby)?  Simple.  They have a horse race, in which the fastest horse wins.  And so that is exactly what we will do.  We pit a variety of value strategies against one another, and then 1) measure the absolute compound growth of each, and 2) observe the risk profile of each, and its performance, after adjusting for this risk.  In the end we crown a winner.

Now for the horses in our race:

1. E/M – Earnings Yield.  The reciprocal of the classic P/E, the Earnings Yield is simply a firm’s earnings divided by its market capitalization.
2. EBITDA/TEV – Enterprise Yield (EBITDA variation).  Employed extensively in private equity, this is simply a firm’s earnings before interest, depreciation and amortization (EBITDA) divided by its enterprise value.  (For a quick refresher on shareholder yields, enterprise value, and the difference between EBITDA and EBIT, see this post from last year:http://alphaarchitect.com/2011/09/thinking-in-terms-of-shareholder-yields-%e2%80%93-notes-from-the-underground/)
3. EBIT/TEV – Enterprise Yield (EBIT variation).
4. FCF/TEV – Free Cash Flow Yield.  The numerator for this metric is Free Cash Flow, which is net income + depreciation and amortization – working capital changes – capital expenditures.  Once again, enterprise value is in the denominator.
5. GP/TEV – Gross Profits Yield.  Revenue – cost of goods sold in the numerator, and enterprise value in the denominator.  Sometimes simpler can be better.
6. B/M – Book to Market.  A classic.  The book value of a firm’s equity, divided by its market capitalization.

In running our horse race, we measure returns from January 1964 through December 2011, and we limit our analysis to stocks with a market capitalization greater than the smallest 40 percent of NYSE stocks (a financial research convention that ensures there is sufficient liquidity to execute the strategies), which equates to about $1.4 billion. This horse race only includes the top-notch thoroughbreds (liquid stocks) and we leave the lower caliber ponies to another day (illiquid small stocks).

Below are the 1964-2011 compound growth rates for the various price measures that make up our horse race:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

There are two numbers we are particularly focused on in assessing our horse race. The first is the best performing price ratio, which turns out to be Enterprise Yield using EBIT, with a raw compound annual growth rate of 14.55%. The second is the spread between the highest and lowest deciles, the so-called value premium. The bigger the spread, the better job the strategy does at differentiating between stocks that are statistically likely to outperform and those likely to underperform. Looking over our data, we can see that once again Enterprise Yield using EBIT is the winner, generating a 7.45% value premium, which wins this element of the horse race pretty handily.

Next, we review our strategies in terms of how well the return of each compensates us per unit of risk we incur. Two common ways of measuring this are the Sharpe and Sortino ratios, which we will discuss in turn, and then we will also review some drawdown risk metrics.

The Sharpe ratio uses the historical relationship between an asset’s excess return (over the risk-free rate) and its volatility (representing its riskiness). The higher the Sharpe ratio, the more return generated for a given amount of risk. So for example, let’s say XYZ Corp. has a long term return of 10%, with an average standard deviation of 16%, and the risk-free return is 2%. XYP Corp.’s Sharpe ratio would be 0.5 = (10%-2)/16%.

The Sortino ratio also measures risk adjusted returns, but considers downside risk. Because the Sharpe ratio measures both upside and downside volatility, it can theoretically punish a strategy that has done very well when most of that high volatility derives from the upside. So the Sortino reflects only the downside volatility, and also measures excess returns over some chosen acceptable return, in our case 5%.

Drawdown risk measures the largest peak-to-trough drop across the history of a price metric, thus capturing the worst absolute performance observed. Evaluating drawdowns can help in understanding the risk that a loss of capital could occur that would be so significant as to be essentially permanent.

Below are the Sharpe, and Sortino ratios, and historical drawdown risk metrics for each price ratio in our horse race:

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

As you can see from the table above, Enterprise Yield using EBIT appears to offer superior risk-adjusted performance versus our other price metrics. Its Sharpe ratio of 0.58 and Sortino ratio of 0.89 are the highest observed, suggesting this metric offers the best risk/reward ratio, whether one defines risk as overall volatility or downside volatility only. Additionally, this metric controls very well for drawdown risk, with the lowest worst overall (-37.25%) and worst monthly (-18.43%) drawdowns when compared with the other price metrics.

And down the stretch these thoroughbreds come…and the winner is….Enterprise Yield (using EBIT) pulling into the lead!

The Enterprise Yield using EBIT is the best performing price metric in terms of both raw returns as well as on a risk-adjusted basis. The portfolio created from the Enterprise Yield using EBIT generates a horse-race leading CAGR of 14.55%. It also generates the largest spreads between value and glamour stocks, at 7.45%. It also outperforms the other price metrics with respect to return generating efficiency. Both its Sharpe ratio of 0.58, and its Sortino ratio of 0.89 best all comers, demonstrating superior returns versus risk incurred as measured by overall volatility as well as downside only volatility. Finally, maximum drawdowns, both overall and monthly, are also less severe than for other price metrics. It was a great race, and we offer hearty congratulations to our winner, Enterprise Yield using EBIT.

In our next installment in this series, we will discuss how to identify high quality firms.