[ This article is based on Chapter 3 of Equity Management by Jacobs and Levy ]
It is not easy to tell who is the real deal when they about investing in equities and who is merely making up a story on a good investment strategy ?
The really smart quants have a decent answer : Disentanglement.
When we say that a low P/E strategy produces returns which are above average compared to the rest of the markets, this concept of P/E is entangled with many other value measures. If lower P/E stocks also tend to be smaller companies, then it may well be said that the outperformance was attributed to smaller companies rather than the low P/E strategy itself.
Do deal with this problem, the quants will employ a mathematical process to disentangle P/E from the effect of small companies. One possible approach would be to divide companies into buckets of differing market capitalisation and then choose the low P/E stocks from each bucket to see how they perform rather than just buying the lowest P/E stocks from the market.
The results of disentanglement enables us to answer who is the real deal when they talk about equity investing.
Based on market data, only a few strategies work after disentanglement.
a) Low P/E : Generally speaking investing in low P/E stocks tend to work.
b) Small size : Smaller sized companies tend to do well.
c) Sales/Price : Higher sales to price seems to work as well.
d) Analyst Estimates tend to be useful within one month from publication.
e) Residual Reversal
Residual reversal deserves some additional mention. To employ this strategy, look at stocks over the past month and buy the stock which has declined the most and sell the counters which gained the most. It seems that this strategy is fairly effective as well but I have yet to back test this on Bloomberg. Executing this strategy seems cheap and easy as you only need a copy of Share Investor magazine to get the job done.
The above information gives hints to investors who wish to build starting screen to pick the best stock to buy in the market.
What does this mean for yield investors like myself who find that our favourite strategy show little promise after the process of disentanglement ? The first thing to note is that such studies are done in the US where dividends taxation is high compared to capital gains tax.
Beyond this, yield strategies may still outperform because they also employ low P/E stock counters. If a company has a payout ratio within 100% and yields 8%, you are effectively capping your P/E to less than 12.5.
At the end of the day, intermediate income investors need to get off their high horse and see dividend payments as part of lifestyle design rather than a direct attempt to outsmart the markets. They are, in effect, making the extra returns from low P/E counters.