Beyond The P/E Ratio
Low book value and small-size firms significantly have outperformed high book value and large-size firms, nothing new here. These factors have not been adjusted for liquidity, but the chart above will suffice for this discussion.
This historical out performance brings up some important questions. Will these well known factors outperform over the next 100 years now that everyone knows about this tendency? Are basic, unadjusted value ratios still as useful a predictor of excess returns in the era of computer data bases and hedge funds that have brought increased liquidity to the small-cap space? With more and more firm assets based on intellectual property as opposed to hard assets, I would suspect that the book value measure has become less meaningful for some firms, while increased activity in small-caps and better information technology may correct these pricing anomalies.
This is not to say that searching for value is futile, it just requires more skill, creativity, and know-how, going beyond the P/E ratio and other oversimplified valuation metrics and slowly waiting for the few outstanding opportunities that present themselves. Understanding the context of a particular situation will be more important than ever, and preferably these opportunities will join both value and growth at the hip, without the need to pay a premium for future expectations, getting the upside potential (future reinvestments in new projects or the expansion of current projects at the firm) for little to nothing.
So what metrics can be used as a starting point in idea generation? Joel Greenblatt’s book The Little Book That Beats The Market starts to get at what I think I’m talking about, and his metrics weigh cheapness (high pre-tax earnings yield) against quality (high ROIC). Greenblatt’s metrics are also more rigorous and meaningful than P/E and ROE type metrics, adjusting for firms with different tax rates and capital structures. However, even this should just be a starting point in a good analysis. The screen doesn’t look for sustainable competitive advantage or earnings quality, so you get some duds that come up from time to time like Crox (CROX).
Buffett similarly looks for great companies selling at reasonable prices, but goes beyond this by incorporating competitive advantage and a deep understanding of the business. I believe Buffett is on to something when he says he tries to think like the owner of an entire business. Buffett’s philosophy has also incorporated Phil Fisher’s methods, and deep understanding of a company through scuttlebutt is invaluable as well to both take advantage of situations as well as to help avoid disaster.
Another area to consider in conjunction with Greenblatt’s metrics and Buffet’s general philosophy are hidden assets and misalignments between management and shareholders that erode the value of control, neither of which can be simply captured with basic financial ratios, but rather need to be examined carefully in order to capitalize on these types of opportunities. Hidden assets consist of the usual suspects: real estate, raw materials, and business units. I would add to this earnings quality, another area which requires intelligent consideration to adjust earnings to economic reality- not rocket science but something which requires considerable accounting knowledge. Finally, complex situations (such as special situations and complex companies that are financial puzzles) that other market participants are slow to fully understand will continue to be profitable.
Which ever way you look at things, it has never been tougher to be an active manager. Mechanical methods of finding value become less useful once they are well known. Looking ahead, the managers who will tend to outperform will likely look for value where others will not or are not sophisticated enough to do so.