We employ a multi-factor valuation model that emphasizes four categories of variables: value, management, momentum, and sentiment.
Value — We examine price-driven measures using the balance sheet, cash flow and income statements. We consider the balance sheet because asset-rich companies resist market declines and are prime takeover targets. On the income statement, earnings yield (the reciprocal of P/E) is among the more robust measures of a stock’s fundamental valuation for U.S. stocks, as the more earnings for every dollar invested, the more attractive the security. On the international front, cash-flow yield (the reciprocal of P/CF) is prized as greater cash earnings indicates higher quality; dividend yield is also influential.
However, value alone is an insufficient investment signal. A company may deserve a low multiple if there’s no prospect for growth or evidence of successful management. Our valuation model considers the relative success of management as important as assets, profits, cash flow, and dividends.
Management — Our so-called management factor quantifies management’s operating efficiency and profitability by measuring the basic underlying performance of a going concern. We use a composite of variables to provide a profile of management savvy:
- Return on assets (ROA) is among the best measures of overall corporate performance, reflecting the extent to which all tangible corporate resources are utilized.
- Measures of growth and profitability indicate how efficiently a firm uses its assets and can be tailored to fit industry-specific characteristics.
- Share repurchase (or issuance) and dividend growth indicate a capital structure decision with implications for a firm’s cost of capital and long-term valuation.
- Measures of quality — barometers of corporate fitness — distinguish between companies whose earnings, while similar in quantity, may differ significantly in composition. Quality lends itself well to industry-specific distinctions — within REITs, occupancy levels come into play, while banks lean on loans.
Consistent with the goal of all security analysis, we combine these measures and financial ratios to improve our success in discriminating future corporate performance.
Momentum — We rely on momentum to assess Wall Street opinions in real time. We define and measure momentum in three dimensions:
- Relative price strength reflects the market’s up-to-the-minute take on a company’s performance. It is our quantitative equivalent of the maxim “Don’t fight the tape.” We evaluate various region-based metrics, such as a company’s idiosyncratic price behavior, its sub-industry momentum, and the price momentum of its customer and competitor ecosystem.
- Revisions to estimated earnings, dividends, and assets are fundamentals-based indicators of a stock’s potential trajectory.
- Stable price patterns — over the preceding year — are prized.
Momentum helps anticipate future leaders and laggards.
Sentiment — We scrutinize the actions of informed participants — the “smart money,” if you will — to decipher their investment views and derive alpha indications from their purchasing and selling behavior.
- Insider trading is a tangible reflection of the expectations of those “in the know” regarding company prospects. Purchases, in particular, reflect where insiders think their company is headed.
- Short “holders” forewarn of declining future returns. Their aggregate short position indicates a level of aversion to a particular stock.
- Institutional investors as a whole are the largest market participants, so it is not surprising that their actions influence stock prices. The greater the institutional ownership, the better the forecast for returns.
- Stock options offer investors two advantages: the benefit of leverage and the ability to express their views efficiently. Analyzing a stock’s options-market volume alongside its options’ implied volatility spread enables us to tap into an economically intuitive and robust source of insights.
Since quantitative evidence of sentiment isn’t available worldwide, its inclusion is limited to markets with robust data.
Contextualization — Profile Matters
Each measure varies in influence, determined by a company’s profile, investors, and market. Its profile includes region, industry, size, growth characteristics, beta, volatility, and institutional ownership. For example, gross profits relative to enterprise value is a better indicator of value for software companies than for producers of household durable products; sentiment measures tend to be more powerful among small-cap issues than large-cap; and price-relative strength is a better predictor of future stock prices among higher-growth stocks.
We add yet another layer of understanding by considering the significance of a stock’s global or regional emphasis.
In the end, we derive an all-in excess expected return for each company. All-in means we boil our multi-factor valuation down to a single number; excess suggests above (or below) the level of the market; expected indicates forward-looking. Each stock’s summary measure of attractiveness carries across all of our strategies.