VALUE INVESTING
The Best Indicator Of Value

By Stephen Bland (TMFPyad)
October 15, 2004

Value players use a wide variety of ratios and other criteria such as net cash in the trawl for suitable shares. My pyad approach considers the four filters of P/E, yield, assets and debt but there are many others out there such as Price/Sales, Price/Cash Flow, Return on Equity, Relative Weakness and so on. Which combination you use is entirely a personal choice, whatever floats your particular value boat.

The question is whether some individual filters are better than others, or some combinations better than others.

In his book What Works on Wall Street, author James O'Shaugnessy tested a variety of criteria over a 44 year period up to 1994 by selecting portfolios of 50 shares mechanically then reselecting them annually. He stresses the advantages of very long term investing at which the book is aimed specifically. By implication though this tells us little of the effectiveness of the value features he tested upon very short-term approaches.

He found that with large caps, high yield produced the best absolute returns of all the various value approaches he considered and the highest on a risk adjusted basis too. In fact HY large caps did four times as well as large caps in general. However the figures do lend support to the HY idea in general as an attractive approach to investing in large cap shares over very lengthy periods and I have long believed in this. Enough to feature a non-mechanical high yield portfolio in my Value Investor newsletter each month. One new share is added per issue.

Turning to the whole market as distinct from just large caps, O'Shaugnessy found that Price/Sales was the single leading value ratio. This produced the highest return of all those he examined over the period and it also does well on a risk adjusted basis although it is riskier than the market as a whole. Interesting because it is not a ratio to which I've ever paid much heed even after I first read his book years ago. That is principally because I'm looking at short term investing for my value shares, not 44 years, and his conclusions mean little over the short term. I am not knocking P/S it's just that I am comfortable with my four pyad ratios and don't feel the need to add to them or replace anything.

Also interesting is his finding that high yield across all shares is not a long term winning strategy compared with the market in general, which supports the view that long term HY investing should be confined primarily to large caps for reasons of security.

Taking risk adjusted factors into account, O'Shaugnessy found that the ideal approach was obtained by splitting the portfolio into two halves consisting of his ideal growth strategy together with his ideal value strategy. The former involves those shares selected from across the whole market with a combination of the best persistent eps gains, low P/S and good relative strength. The ideal value strategy is the above mentioned large cap HY style.

The ideal growth strategy on its own did outstandingly well but at a higher risk than the market. The ideal value strategy did outstandingly well, though not as good as the growth one, but with lower risk than the market. Taken together he felt that this pairing offered the perfect combination of growth matched with reasonable risk.

As I said though, apart from very long term strategies like my high yield portfolio where I believe it is instructive, interesting though the book is, I'm not sure it offers much to the short term value investor. What happens very long term to 50 share annually rebased portfolios tells us nothing about what might happen to a couple of individual shares over six months I feel. It's the old idea of statistics being applicable to the trends of large numbers of things but supplying no reliable information about the characteristics of individual items amongst them.

For me though Price/Tangible Book has to be the king of the value ratios, especially where the assets have a decent proportion of property or other valuables like cash or investments amongst them. This one ratio above others, particularly with small caps which is where most deep value shares lie, is the one most likely to out the value in my view. That doesn't mean it is impossible to ever find a share with good value on other features yet trading over book, but it does mean to me that P/TBV is the first and most desirable thing to be considered.

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