U-Wen Kok, Jason Ribando and Richard Sloan are the authors of the paper “Facts About Formulaic Value Investing,” which will appear in an upcoming issue of the Financial Analysts Journal.
The authors begin by noting: “The term ‘value investing’ is increasingly being adopted by quantitative investment strategies that use ratios of common fundamental metrics (e.g., book value, earnings) to market price. A hallmark of such strategies is that they do not involve a comprehensive effort to determine the intrinsic value of the underlying securities.”
Kok, Ribando and Sloan find the following:
- The book-to-market ratio systematically identifies securities with overstated book values that are subsequently written down.
- The trailing earnings-to-price ratio systematically identifies securities with temporarily high earnings that subsequently decline.
- The forward earnings-to-price ratio systematically identifies securities for which sell-side analysts offer relatively more optimistic forecasts of future earnings.
The authors conclude that quantitative investment strategies based on such ratios are not good substitutes for value-investing strategies that use a comprehensive approach in identifying underpriced securities.
They cite the Dimensional Fund Advisors (DFA) US Large Cap Value Portfolio (DFLVX) as an early example of such simple formulaic quant (quantitative analysis) strategies: “Begun in 1993, the fund described its investment strategy as follows: The portfolio seeks to capture return premiums associated with high book-to-market ratios by investing in the US Large Cap Value Series of the DFA Investment Trust Company, which in turn invests on a market cap weighted basis in companies that are approximately $500 million or larger in market cap and have book-to-market ratios in the upper 30% of publicly traded companies.”
Clarifying Formulaic Value Strategies
Essentially, the authors are making the case that formulaic value strategies as employed by firms such as DFA should not be confused with value strategies that employ a comprehensive approach to determine the intrinsic value of the underlying securities—an approach used by the legendary value investors Benjamin Graham and David Dodd.
Wes Gray, author of what I consider to be two must-read books, “Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors” and “Quantitative Momentum: A Practitioner's Guide to Building a Momentum-Based Stock Selection System,” provides an in-depth analysis and critique of Kok, Ribando and Sloan’s paper.
Among the issues raised by Gray is that “Facts About Formulaic Value Investing” doesn’t address the real question of whether man (fundamental analysis based on human judgments) or machine (formulaic quantitative strategies) is the superior approach. It only raises the question of whether there may be better approaches than a simple BtM screen.