In an earlier post, I examined the performance of different value metrics. My conclusion was simple: cheap stocks beat expensive stocks.
Most value investors don’t simply look for cheap alone. They try to find companies that are both cheap and good. Good is typically defined as companies that can earn high returns on their capital.
Finding these companies is a worthwhile pursuit but it is difficult to pull off systematically because companies earning high returns on capital are going to attract significant competition. I think it is far more difficult to do this than most value investors appreciate. Mean reversion, fueled by competition, inevitably pulls these returns down. Finding the rare birds that don’t succumb to this is hard. These companies usually have a “moat“, which is hard to identify. Needless to say, this kind of investing requires a touch of genius that I don’t have. When investing, I operate under the assumption that every company succumbs to mean reversion.
With that said, finding these rare opportunities certainly pays off over the long run. You can park money in a company like Coca-Cola or Nike and earn high returns over long stretches of time, while reducing taxes and transaction costs.
The Magic Formula
Joel Greenblatt sought out a systematic quantitative method to find companies that are simultaneously cheap and earn high returns on capital. The result was The Little Book that Beats the Market. In the book, Greenblatt demonstrated that simultaneously buying cheap companies that earn high returns on invested capital will outperform. He calls this the magic formula and generously maintains a free screener here.
Tobias Carlisle took this a step further in Deep Value and discovered that the quality metric of high returns on invested capital actually reduces returns from the magic formula. He explains in Deep Value how mean reversion tends to bring these returns down. Cheap alone is better than cheap plus good. In other words, it takes qualitative insight to determine which companies have a moat that will allow them to sustain high returns on capital. Tobias maintains a free large cap screen for this here.
I would recommend reading both The Little Book That Beats the Market and Deep Value.
Backtesting Quality Metrics
I decided to test the returns for myself and try to see which “quality” metric works best when combined with a value factor. The test I ran is limited to Russell 3000 components. My definitions of cheapness were:
- EBITDA/Enterprise Value is higher than 20%
- Price to free cash flow is less than 15
- Price to sales is less than 1
- Earnings Yield is over 10% (i.e., P/E is less than 10)
- Price to book less than 1
- Price to tangible book less than 1
In addition to examining metrics that define high returns on capital, I also included metrics for financial quality, such as the debt to equity ratio and the Piotroski F-Score. Below is a summary of all of the quality metrics that I tested.
Return on Equity – This is the oldest and most simple method of corporate quality. It is simply the company’s net income divided by equity (assets – liabilities). For the purposes of the test, I define high ROE as over 20%.
Return on Invested Capital – Joel Greenblatt’s preferred measure of quality. This is earnings before interest and taxes divided by invested capital. Invested capital is defined as working capital plus net fixed assets. For the purposes of the test, I define high ROIC as over 15%.
Gross Profits/Assets – Robert Novy-Marx created a very simplistic measure of quality, gross profits/assets. He found that this method works extremely well, because it uses profits further up of the income statement where it is more difficult for a firm to manipulate the numbers. You can read his paper on the subject here. For the purposes of the test, I define good gross profitability as over 30%.
Debt/Equity – This is another simplistic measure of financial quality. It is simply total debt divided by equity (assets-liabilities). For the purposes of the test, I define a good debt/equity ratio as under 50%.
F-Score – This is a more complex measure of financial quality designed by Joseph Piotroski, who is currently a professor at Stanford. Piotroski designed a 9 point scale of financial quality in a paper written back in 2000. Piotroski backtested combining this measure of financial quality with price to book and found that the results greatly exceeded the market. Each component adds to the score. A perfect F-Score would be a 9. It’s too bad F-Scores don’t go up to eleven. The components of the F-Score are defined below.
- A net decline in long-term debt for the current year.
- A net increase in the current ratio in the current year. The current ratio is current assets/current liabilities. It measures the liquidity of the company’s balance sheet to meet short-term obligations.
- A positive increase in gross margins in the current year.
- Faster asset turnover in the current year.
- The total number of shares outstanding is flat or decreasing. In other words, the company isn’t issuing new equity and diluting the current pool of shares.
- Return on assets is positive.
- Operating cash flow is positive.
- Return on assets for the current year is higher than the previous year.
- Operating Cash Flow/Total Assets is higher than return on assets.
The results of the backtest are below. The results are in the Russell 3000 universe with annual rebalancing beginning in 1999.
The High Return Metrics – ROE, ROIC, GP/Assets
Measures for returns on capital – ROE, ROIC and GP/Assets – actually detract from the performance of EBITDA/Enterprise Value. They add performance to the other valuation metrics slightly, with Gross Profits/Assets being the best.
The middling performance of high return quality metrics is due to mean reversion, or the propensity for high return businesses to eventually succumb to the pressures of competition.
With that said, if you are trying to identify high return businesses, the best metric to use appears to be Gross Profits/Assets.
Financial Quality (The Debt/Equity Ratio and the F-Score)
In contrast, measures of financial quality, such as the debt/equity ratio and the F-Score, supercharge all of the valuation metrics that are examined here. Why is this?
Cheap stocks are only cheap because they are in some kind of trouble. There is an “ick” factor. Any time you run a value screen, you will scratch your head and think “Do I really want to invest in this garbage?”
This is why financial quality metrics are more useful than business quality metrics. If a company has a good balance sheet and is financially healthy then it has time to resolve its problems. Managers have time to implement a new strategy that can turn things around. Even without a new strategy, time will help the financially healthy company. For instance, if the company is in a crowded, competitive industry, the financially healthy company can weather the storm while the highly leveraged firms will go out of business first. Less firms means less competition. Less competition means that future returns in the industry will improve.
This is also why the high return metrics add a little to the other valuation metrics but detract from the EBITDA yield. Unlike the other valuation metrics tested here, the EBITDA yield is the only one here that uses Enterprise Value in the calculation. Enterprise Value brings balance sheet health into the valuation ratio. For EBITDA/Enterprise Value to result in a high yield, the company must have little debt and a lot of cash on hand. In other words, valuation metrics that use Enterprise Value will identify companies that are both cheap and have safe balance sheets.
RadioShack vs. Best Buy
This reminds me of an article I read over at the Motley Fool. The author explains why Radio Shack fell apart and Best Buy was able to turn around.
Radio Shack had numerous problems, including asking for your phone number when you buy batteries.
Best Buy’s problem is that it basically became a showroom for Amazon. The referenced article explain how Best Buy successfully turned things around by cutting costs, emulating the Apple Store, expanding the Geek Squad and improving their website.
I have a more simplistic explanation for why Best Buy was able to recover and Radio Shack fell apart. Radio Shack had a lot of debt and Best Buy didn’t. Radio Shack’s debt to equity ratio was over 670%. Best Buy’s debt to equity ratio was 41% a few years ago and is 29% today.
Best Buy’s balance sheet gave them an edge: time. They had time to work through their problems and try to find a solution. If Best Buy had Radio Shack’s debt levels, the CEO would have never been able to pursue the turnaround strategy. All troubled companies are trying to turn things around, but only those with financial strength will have the time to do so.
Screening for High F-Scores and EBITDA Yield
One of the most robust combinations tested was the F Score and the EBITDA Yield, with a 17.69% rate of return since 1999. I ran a screen for companies with an EBITDA yield over 20% and an F-Score of 8 or higher. This combination of criteria is very stringent. It only returned 5 results out of the entire Russell 3000. Best Buy actually comes up in this screen, implying that it is still a financially healthy bargain. Output from the screen is below.
I am not going to buy positions in these companies, but wanted to share the results of what I found. Hopefully this will give you some useful leads that are worthy of further research.
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.