Does value screening still work?

Over the years there have been many studies into how different investment strategies affect your potential returns over the long term.  Often these studies involve the selection of companies based on almost childishly simple criteria which ultimately turn out to uncover some hidden truth about market efficiency and the value premium.  Since I use these simple screens to make the bulk of my investment decisions, it seems prudent to check that these simple formula still work when applied to the market as a whole.

Below is a graph of the returns of all companies* in the main and AIM markets in the UK over the last year, where the company had returns for the last 10 years (as I will be sorting by ROE10 shortly).  Sorted by the size of the returns the returns for over five hundred companies looks like this:

1 year returns by returns

As you can see some did well and some did badly.  The average return was 23.7% so this subset of companies strongly outperformed the FTSE 100 and similar indices, but that’s not the point of this exercise.

According to much research (not cited here), sorting by P/B (price/book ratio) is likely to show some sort of trend where low P/B stocks outperform the average and definitely outperform high P/B stocks.  Sorting (descending) by the estimated P/B from one year ago** produces this:

1 year returns by pb

The trend line does seem to indicate what the literature would have us believe – that on average lower P/B stocks have had better returns in the last year.  Breaking the results into five equal groups, the average returns of each group were:

Group 1 2 3 4 5
Returns % 18.9 22.4 25.9 24.0 27.2

Before getting too excited though, remember that low P/B companies tend to be smaller and less liquid, i.e. with a wider spread.  I think that the extra returns will be enough to outweigh the spread costs, but spread size is an important factor in low P/B and small cap investing.  Something to cover at length another day perhaps along with dividends.

Another point is the spread of returns.  In each group some companies did fantastically while others did terribly.  Unless you can spot the difference beforehand you need to be sufficiently diversified, otherwise you could end up with a massively under performing portfolio no matter which group you pick from.

The next well known and highly tested metric is market cap.  When sorted by market cap (descending) from one year ago*** the returns look like this:

1 yr returns by cap

And the quintiles again:

Group 1 2 3 4 5
Returns % 20.4 20.1 26.8 23.8 27.5

So market cap is still a very useful tool in the selection of outperforming companies.  However, the large spread issues are even greater here as by definition the smaller outperforming companies in group five are small and likely to have greater spreads, especially on the AIM index where most of these shares live.

Just from looking at the plot it seems that the variation of returns from each company is much less for big companies (on the left) than for small.  An efficient market proponent would probably say that’s part of the reason for the small cap premium, the variability of returns is that much greater.

The final metric is ROE10 (ROE averaged of the last 10 years), which on its own is most definitely not a value metric as it says nothing about price.  I’ve included it here though as it’s a GARP metric which is closely related to value investing, but more importantly I’ve started using it recently to sift for winners.  It can be combined with the size and P/B metrics to aid and perhaps enhance them.  Sorting by ROE10 (ascending) gives the following results:

1 yr returns by ROE10


Group 1 2 3 4 5
Returns % 15.0 22.4 26.7 28.2 26.2

From this it seems that investing in high return companies turns out to have been more than worthwhile, regardless of the price paid for the shares, which is what growth investors have been saying all along.  Note also that the spread of returns in the top performers (right of the plot) seems to be far less than that of top performing small cap or low P/B stocks.  Interesting.

Now onto some combinations.  If I multiply size and P/B it gives:



Group 1 2 3 4 5
Returns % 21.8 14.9 26.3 24.3 31.2

Which if we look at group five, the smallest lowest P/B stocks, we get the highest returns so far, 31.2%.  Of course this is just a spreadsheet based on data with things like survivorship bias and other reliability issues, but it’s still nice to see that combining size and P/B gives the expected outcome of higher returns.  Note though that group one is a bit of an anomaly (large cap high P/B stocks) with very few losses; perhaps this is the UK large company premium which has been found in a couple of studies.

Finally if I combine P/B and ROE10 I get this:



Group 1 2 3 4 5
Returns % 15.0 18.7 25.9 27.4 31.6

In this case you have to ignore the first 115 or so companies (the first group pretty much) as they are all negative ROE10 companies where the results are messed up by the negative value.  However, I wouldn’t recommend investing in them anyway as a negative ROE10 is not a good thing.  The remaining four groups show a nice progression of returns up to a high of 31.6%.  What’s also nice about this group is that you get the high returns without always being in micro cap stocks.  The estimated average market cap of group five a year ago was 2.5 billion and less than half the companies are on the AIM index, which helps keep trading costs down via a smaller bid/ask spread.

In summary, value screening still seems to work; or at least it did last year.  Adding ROE or perhaps any measure of earnings into the mix probably does have some benefits.  Of course there are many more screens, as many as investors can dream up; but whether you use this approach, the Magic Formula, low p/e or some other system, screening definitely still has something to offer the rational investor.

* Data from Sharelockholmes.  5 companies from over 550 were removed as outliers returning over 400% in the last year.  Although keeping them in would have favoured the P/B ratio’s predictive ability, by the other measures they were random and skewed the data so I took them out.  Of course in the real world you can’t do that, so perhaps that’s a good reason to pick low P/B stocks, to increase the chances of picking up a mega-mover.

** P/B 1 year ago is calculated from the current P/B and the last years returns, i.e. assumes that book value and the number of shares was unchanged.  This is a naive assumption but I don’t think it is too unreasonable and hopefully it hasn’t skewed the results.

*** Market cap 1 year ago just relies on the number of shares on average being the same, which is a reasonable assumption I think.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

6 thoughts on “Does value screening still work?”

  1. Hi Richard, yes it's always nice to see that you're not completely wrong.

  2. Very interesting article.I'm reading through Penman's book Financial Statement Analysis and Security Valuation. On page 81, he shows that stocks in the lowest quintile for both PE and PBV return 30.0% pa. The next highest return is 26.4%, which is in the lowest PBV quintile, but the highest PE quintile.For your edumatainment, I recently produced a list of stocks in the highest quintile PE and PBV for companies with a market value over £300m (sourced from Sharelock Holmes).It returned 25 companies, heavily weighted to the insurance and travel/leisure sector. I think it would be tougher than you think to obtain adequate diversification.I have no idea on how to form a view on insurance companies, as they're all impenetrable to me. Looking at the travel/leisure sector, though, I can see such companies as:PUB – Punch Taverns – pub operatorETI – Enterprise Inns – pub operatorMARS – Marstons – yet another pub operator, but it also operates a beweryTCG – Thomas Cook Group – tour operator, nothing to do with alcohol this time.So, you'll get limited diversification in the travel/leisure sector. All of the above companies are not good. PUB reported a loss, and is on a gearing of 213%. ETI has long term liabilities over net income of 150, implying that it would take 150 years (!) to pay off its debt out of net income (although there were exceptionals of 103m). MARS had a ratio of 30, and TCG had a ratio of 78 (but it also had short term liabilities in excess of long term liabilities, so the picture is much worse).I haven't stripped out exceptional charges, which no doubt would make the figures look less frightening than I presented above.But I make my point: by buying in the bargain bucket end of the range, one is getting some extremely dodgy goods. One has to be clear that by buying here, one is taking significant risks. As to how one judges the risk/return payoff, that's difficult to say. It's always difficult to decide if "strategic ignorance" is good or bad. On the one hand, one could argue that you pray that the bad news is more than priced in, and hence and expect better-than-normal returns in aggregate; or else you could argue that by looking under the bonnet, you can avoid some swingeing and entirely preventable losses.One company that I like to keep on my "anti"-watchlist is RCG (RCG Holdings). It has a mkt cap of £61m, a PBV of 0.17, a PE of 0.74 (yes, really!), and a ROE of 18%. It was highlighted to me by a Greenblatt trawl I did some time ago. Now, you might think, great, low PBV and adequate ROE, and it even has low gearing, let me back up the truck. But you'd better sit on your keyster, meester. Check out the discussion board on Interative Investor, and you'll see some gut-wrenching conversations. The stock declines on a weekly basis. The directors have no qualms about diluting shareholders heavily, and it makes VERY dubious aquisitions that don't make any sense.If you check out a few boards that have horror stories to tell (like QED or YELL), I think you'll quickly disabuse yourself of the notion that you can buy any old cheap stuff and get away with it.

  3. Hi Mark, thanks for commenting… I'll make a few remarks:There are a million studies (and now one more thanks to me) that show low PB or low PE etc outperform. The question that always comes up is does it work going forward rather than backward? I think it does (there are enough real value fund managers out there that have done it for decades) but perhaps less dramatically than in the studies due to spread, failure rates, selling winners too early, not buying the real crummy companies that would have then returned 500% etc, i.e. missing the outliers and so on. That's kind of what my site is about, trying to run one of these academic studies in real time and see what it actually returns.Enterprise Inns – interesting you mention this, I've just put 4% of my fund into it.RCG – Going by the numbers I'd buy this at anything below about 50p, but there are two issues for me; 1. It hasn't been listed long enough and 2. It doesn't trade mainly in the UK. Other than that I wouldn't have anything against it, although I did just give it a cursory glance.YELL – I think this would definitely be on my buy list if it had been listed longer (10 years at least). This might be the company that gets me to change that, or at least consider it. The fact that there are horror stories doesn't bother me, it just means that other people bought the stock too high. Of course if it goes to zero then we all loose 100%, but I've had that before too (on my first purchase of all things) so I'm battle hardened to that idea as well, not that it's something I want to revisit.

  4. Hi John,Good luck with your ETI ;)It may interest you to know that Yell was touted by Fidelity Special Situations manager Sanjeev Shah during late 2009, if memory serves. Back then, the price was around 39p. Today, it's around 10p. Ouch. I'm not sure if Sanjeev still holds, but I think it constitutes around 1% of his fund. I may well be wrong, though. So you'd be in good company if you decided to buy. I very much respect Sanjeev, and I'm glad I didn't sell out of the fund when he took over from Anthony Bolton, but I'm wondering if he made a total mistake on Yell.

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