Market darling vs. ugly ducklings

[skc]

In this thread I want to just forward test a simple theory...

On the market there are expensive stocks and there are cheap stocks. "Expensive" stocks enjoy high PE multiple, high growth expectations and lower dividends. Conversely, "cheap" stocks generally have lower PE multiple, low or negative growth expectations and (potentially) higher historical dividends.

Many investors are wired to look for cheap stocks, hoping for a rise in value. But I wonder if a basket of expensive stocks would indeed outperform a basket of cheap stocks over a 2-5 year timeframe. If it does, it means that the market actually priced the stocks correctly (i.e. stocks were expensive or cheap for a reason).

So I have picked 20 stocks that appeared expensive and 20 stocks that appeared cheap... it's nothing more than a superficial scan of PE and my shallow understanding of the stock. I will try to include some deliberated diversification amongst different sectors. I will also avoided resources, as changes in commodity price would over-ride any meaningful findings from this exercise.

I will put up the 2 lists tomorrow... but in the mean time if you like to nominate some stocks for either list, please feel free to contribute (I don't guarantee it will be included).

 

[DeepState]

In this thread I want to just forward test a simple theory...

On the market there are expensive stocks and there are cheap stocks. "Expensive" stocks enjoy high PE multiple, high growth expectations and lower dividends. Conversely, "cheap" stocks generally have lower PE multiple, low or negative growth expectations and (potentially) higher historical dividends.

Many investors are wired to look for cheap stocks, hoping for a rise in value. But I wonder if a basket of expensive stocks would indeed outperform a basket of cheap stocks over a 2-5 year timeframe. If it does, it means that the market actually priced the stocks correctly (i.e. stocks were expensive or cheap for a reason).

So I have picked 20 stocks that appeared expensive and 20 stocks that appeared cheap... it's nothing more than a superficial scan of PE and my shallow understanding of the stock. I will try to include some deliberated diversification amongst different sectors. I will also avoided resources, as changes in commodity price would over-ride any meaningful findings from this exercise.

I will put up the 2 lists tomorrow...

Over time, low PE / PB / PCF has outperformed the mirror. That does not mean it will do so in any 3-5 year window when the scenario you have outlined could, did and very likely will occur again.

What do you mean by 'correct' price? Do you care about risk adjustment? Maybe they rise more because that is the compensation required for taking on such stocks (actually, the opposite argument holds as low PB/E/CF tend to be more distressed, fall more in the initial market corrections etc.).

What matters in this discussion is cheap relative to intrinsic value. A stock can be cheap whether the PE is high or low. It just so happens that, for various reasons, low PB tends to align to cheap more so than for high PE on average through time. It will not always be the case and that relationship can be violated for years at a stretch. I am leaving aside anything to do with momentum as you have not mentioned past price movement.

 

[So_Cynical]

I will put up the 2 lists tomorrow... but in the mean time if you like to nominate some stocks for either list, please feel free to contribute (I don't guarantee it will be included).

One of each.

Expensive: CPU - P/E 23.9

Cheap: MXI - P/E 5.3

 

[KnowThePast]

In this thread I want to just forward test a simple theory...

On the market there are expensive stocks and there are cheap stocks. "Expensive" stocks enjoy high PE multiple, high growth expectations and lower dividends. Conversely, "cheap" stocks generally have lower PE multiple, low or negative growth expectations and (potentially) higher historical dividends.

Many investors are wired to look for cheap stocks, hoping for a rise in value. But I wonder if a basket of expensive stocks would indeed outperform a basket of cheap stocks over a 2-5 year timeframe. If it does, it means that the market actually priced the stocks correctly (i.e. stocks were expensive or cheap for a reason).

So I have picked 20 stocks that appeared expensive and 20 stocks that appeared cheap... it's nothing more than a superficial scan of PE and my shallow understanding of the stock. I will try to include some deliberated diversification amongst different sectors. I will also avoided resources, as changes in commodity price would over-ride any meaningful findings from this exercise.

I will put up the 2 lists tomorrow... but in the mean time if you like to nominate some stocks for either list, please feel free to contribute (I don't guarantee it will be included).

Hi skc,

This was precisely the question that prompted me to write my software.

Low PB/PE/PS portfolios have outperformed their high value counterparts in pretty much every 5 year period, in pretty much all world markes, including emerging ones.

RY mentioned risk and volatility, but surprisingly, these portfolios have also often proved to be better in that respect as well.

My own backtesting in Australia market agrees with this research.

"Contrarian Investment Strategies" by David Dreman is a little outdated, but still accurate. It has a field day trying to destroy any credibility of MPT by comparing the results of various (mainly Low PE and PB) strategies.

High value stocks can be a good and invstment, and be under-priced even at high valuation. My data tells me that you will need more parameters that just a Value ratio to filter out successful ones.

A few months ago I would have recommended my portfolio for a version of Low Value test, but I am slowly moving away in a different direction.

 

[odds-on]

Hi skc,

I nominate NWH and NVT.

Cheers

 

[The Falcon]

These days when any punter can run value screens, and I would suggest the competition for bargains is fiercer I wonder how that changes to risk-reward dynamics.

This is an interesting exercise and I will follow with interest.

 

[systematic]

Go for it, of course...but for mine; I'm happy enough that value has been satisfactorily shown to beat glamour - all over the world and over all sorts of time periods.

I'd only make the comment re: KnowThePast's view that value beats glamour in pretty much every 5 year period...is not necessarily incorrect (depends on your definition of "pretty much every") - it just makes the journey (of value investing) sound a little easier than it is. Not that I think you meant it that way, KnowThePast!

skc, you said, "Many investors are wired to look for cheap stocks..." I'm not sure what you mean by "many" - but it certainly is not "most". I don't think you meant it that way...but just wanted to make the observation.

 

[Logique]

I can't believe how far a stock like Iluka ILU has fallen. At some point stocks like this and BHP have to start getting attractive.

Not that I'm saying we're at that point yet, but certainly ones to keep an eye on.

 

[Triathlete]

I can't believe how far a stock like Iluka ILU has fallen. At some point stocks like this and BHP have to start getting attractive.

Not that I'm saying we're at that point yet, but certainly ones to keep an eye on.

I have been following ILU and believe it has further to fall $5.50 or lower...not sure if this chart helps any.

 

[KnowThePast]

Hi Systematic,

I'd only make the comment re: KnowThePast's view that value beats glamour in pretty much every 5 year period...is not necessarily incorrect (depends on your definition of "pretty much every") - it just makes the journey (of value investing) sound a little easier than it is. Not that I think you meant it that way, KnowThePast!

skc, you said, "Many investors are wired to look for cheap stocks..." I'm not sure what you mean by "many" - but it certainly is not "most". I don't think you meant it that way...but just wanted to make the observation.

Yes, definitely not that easy for a number of reasons. It is certainly not what the majority does.

Although I also agree with skc that majority believe they are buying value. It's just that value tends to be something with high multiple that they believe is worth even more.

The kind of value I am talking about lives in the sewers of the stock market, hardly anyone wants to touch them.

Another important thing to remember is that there are hardly any studies done on this in Australia. Most of the research is based on American and European markets, which we believe also applies here. While the general theme of value beating glamour applies here, there are some differences to be aware of.

 

[skc]

Over time, low PE / PB / PCF has outperformed the mirror. That does not mean it will do so in any 3-5 year window when the scenario you have outlined could, did and very likely will occur again.

Another important thing to remember is that there are hardly any studies done on this in Australia. Most of the research is based on American and European markets, which we believe also applies here. While the general theme of value beating glamour applies here, there are some differences to be aware of.

This is why I wanted to do this exercise.

Low PB/PE/PS portfolios have outperformed their high value counterparts in pretty much every 5 year period, in pretty much all world markes, including emerging ones.

My own backtesting in Australia market agrees with this research.

I will be delighted if you could share some of your methodology and findings. It'd be much more useful than my snapshot which will prove nothing.

What do you mean by 'correct' price? Do you care about risk adjustment?

Correct = the stock deserves a high multiple, over the following 3-5 year period. No I don't care about risk adjustments in this simple exercise.

A few months ago I would have recommended my portfolio for a version of Low Value test, but I am slowly moving away in a different direction.

I initially wanted to use your current portfolio as the "cheap" basket... but some of them were simply too small and illiquid. That portfolio also overweight mining services a bit too much and I wanted more diversification.

Expensive: CPU - P/E 23.9. Cheap: MXI - P/E 5.3

I nominate NWH and NVT.

Thanks. Precisely the sort of stocks I am thinking about.

 

[shouldaindex]

Darlings:
Healthscope, NetComm, Medibank, Sydney Airport, Domino's, Regis Health, Corporate Travel, Freedom Foods, Capitol Health, REA Group, Nearmap, Vocus, Seek, TPG, Ramsay Healthcare, OzForex, CoverMore, Carsales, 1300 Smiles, G8 Education, GreenCross, Aristocrat Leisure, Resmed, Qube.

Ducklings:
Hills, AGL, Regional Express, JB Hi-Fi, Energy Action, The Reject Shop, CountPlus, UGL, Cardno, DWS, Myer, APN, Vision Eye, Carbcharge, PAS Group, LogiCamms, Mermaid Marine, STW Communications, Seven West Media, Chandler McLeod, Skilled, MetCash, Santos.

I should add, I've done comparisons of groups and the result is usually determined by the absolute top end 1 or 2 stocks.

For instance (just a general prototype of what I'd expect over the long term): 40% lose more than half their value, 20% more lose value, 20% make gains but underperform the index, 10% outperform the index, and the best 10% go gangbusters.

 

[systematic]

Hi Systematic,

Yes, definitely not that easy for a number of reasons. It is certainly not what the majority does.

Although I also agree with skc that majority believe they are buying value. It's just that value tends to be something with high multiple that they believe is worth even more.

The kind of value I am talking about lives in the sewers of the stock market, hardly anyone wants to touch them.

Another important thing to remember is that there are hardly any studies done on this in Australia. Most of the research is based on American and European markets, which we believe also applies here. While the general theme of value beating glamour applies here, there are some differences to be aware of.

...That's a good point - the majority (especially fundamentals based investors) probably do believe they are buying value. I've never thought of it like that. Far from (my) reality. For example, for a brief period I'd look at what Roger Montgomery was calling a good value stock (on his freely available videos etc)...only to find that I hardly ever (if ever at all) had any of his picks in my rankings as a value stock. And; that's a value fund manager. Unless my value rankings are up the creek, of course.

Mmmm...I don't want to disagree entirely with your last paragraph...but there have been some good ones done on the Aussie market - not all to be found on SSRN though.

 

[KnowThePast]

...That's a good point - the majority (especially fundamentals based investors) probably do believe they are buying value. I've never thought of it like that. Far from (my) reality. For example, for a brief period I'd look at what Roger Montgomery was calling a good value stock (on his freely available videos etc)...only to find that I hardly ever (if ever at all) had any of his picks in my rankings as a value stock. And; that's a value fund manager. Unless my value rankings are up the creek, of course.

Mmmm...I don't want to disagree entirely with your last paragraph...but there have been some good ones done on the Aussie market - not all to be found on SSRN though.

Could you please point me in their direction?

I've read a couple, but none were anywhere near as extensive as what you can find for the US ones.

 

[KnowThePast]

This is why I wanted to do this exercise.

I will be delighted if you could share some of your methodology and findings. It'd be much more useful than my snapshot which will prove nothing.

Hi skc,

I am way too selfish to post much of it on a public forum, but I'll offer some thoughts.

In my thread, I've previously detailed my analysis of Low PB stocks here (post #200 & #201):
https://www.aussiestockforums.com/forums/showthread.php?t=26890&page=10

This is roughly the process I follow when I test other strategies. It is never a clear cut test, which gives an answer. I look at it from many different angles with various additional criteria to see if it still holds up. Position sizing, hold period, averaging, brokerage, dividends, interest rates, stop losses, etc. can make a massive difference to a strategy, unless you stay fully invested and re-balance once a year.

Knowing which strategy you run, and what kind of shape it is likely to take, plays a part in these portfolio management decisions. Stop losses, position sizing, holding period etc. are very much dependant on what kind of strategy you run.

1. Value stocks outperform most years, even on risk adjustment basis.
2. They do not outperform by much, but it is very consistent and statistically significant.
3. There's different measure for value, and not all are equal.
4. for most strategies, out/under performance is especially noticeable at extremes.
5. Most studies and systems concentrate on stocks that are suitable for funds, there's limited data that's useful for retail investors. Unfortunately, these systems are expensive to build, so they are unlikely to become a target market any time soon.
6. a likely number of suitable opportunities is an important factor in position sizing.
7. fishing for data, which RY referred to is a very problem that you need to be extermely aware of when backtesting. There's never a guarantee that a great backtest result will have any relevance in the future. There's no right answer here, it is not an exact science.
8. shouldaindex made a good point, that top 1-2 stocks make the biggest difference. While true, removing these outliers (and from benchmark), still shows outperformance for cheap stocks (just a lot less). Getting some of these outliers in your portfolio will ultimately be the difference between great and slightly above average return.
9. Having a very bad first year makes it almost impossible to catch up.
10. Now, once you establish a strategy that has a positive expectancy and you are reasonably sure that it should continue into the future, you look at whether it is possible to improve the result with human judgement. It seems such an easy thing to do, all you need to do is exclude a few stocks that are hopeless. But in practice, it's a lot more difficult. There will regularly be a hopeless case that becomes a ten bagger after going nowhere but down the first few years. RY, thanks for the thread on Smart Beta. I am sceptical that it is a good idea for most even though in theory, as I said, it seems like an easy and perfectly logical thing to do.

There's a lot more. The main point I am trying to make is that it's not as easy as measuring whether cheap stocks outperform, there's a lot of moving parts.

My portfolio is a good example of some of these points. Being aware of point 9, I've made a decision to allocate capital over a 24 months period, rather than going all in. With a limitation of only 1 purchase per month, I had to cherry pick what I thought was the best opportunity. Backtesting back to my portfolio start date, the reason I am not currently ahead by about 30% is that I didn't buy 2 stocks that became multi baggers over this period. I've paid a very expensive price for my risk management.

Speaking of risk management, I will post up some backtests on the stop losss thread soon, short on time these days.

 

[Logique]

I have been following ILU and believe it has further to fall $5.50 or lowerView attachment 60649...not sure if this chart helps any.

Thanks Triathlete, good work. I don't doubt that you are right. $5.00 looks strong support. It will be well worth a look if it gets to that level.

 

[DeepState]

High P/E vs Low P/E (top 30% in market vs bottom 30%) courtesy of Ken French. Australia. Value weighted. Pls note the axis is logarithmic. You already know which line is which.



Rolling 2 yr annualized returns. The lines cross all the time.



What will be gained from one sample?

 

[Wysiwyg]

High P/E vs Low P/E (top 30% in market vs bottom 30%) courtesy of Ken French. Australia. Value weighted. Pls note the axis is logarithmic. You already know which line is which.

I don't believe the stock universe from 1975 would be the same all the way therefore how accurate are these tests?

 

[KnowThePast]

I don't believe the stock universe from 1975 would be the same all the way therefore how accurate are these tests?

They would most likely rebalance at regular intervals, usually annually.

They could also have a buy/sell trigger.

It certainly wouldn't have been a buy and hold for 40 years strategy.

 

[skc]

High P/E vs Low P/E (top 30% in market vs bottom 30%) courtesy of Ken French. Australia. Value weighted. Pls note the axis is logarithmic. You already know which line is which.

Rolling 2 yr annualized returns. The lines cross all the time.

I can't really tell which line is which in your second chart.

What will be gained from one sample?

I guess part of this exercise was to force a learning on myself that I don't need to look for low PE stocks alone for investment. I am always too quick to dismiss stocks which I deem "high PE, much growth priced in". I wanted to select some stocks that appear "expensive" but still "undervalued". Be contrarian to the contrarian, if that makes any sense.

I know that it isn't going to prove anything statistically.

1. Value stocks outperform most years, even on risk adjustment basis.
2. They do not outperform by much, but it is very consistent and statistically significant...

Thanks KTP. Great amazing effort as always. You've gone through much more than I can hope to do in this thread.

I am very glad that the thread has generated much knoweldgeable discussion. However, I am going to abandon the original idea of the thread... which is simply interesting but not worthy of the time committment required.