In search of super returns in stocks

Market mispricings may be spotted by identifying stocks with high Return On Equity but low Price To Book ratio

By Teh Hooi Ling

Sunday, Aug 15, 2010
The Business Times

Key article highlights:

• One way to value a company is to use the abnormal earnings formula - discount its future stream of abnormal earnings (earnings above the cost of its capital) to its present value; and add that number to the current book value of the capital.
• By scaling the formula with book value on both sides, we get Price-To-Book (PTB) value on the left-hand side, and abnormal return on equity (ROE).
• This suggests that a company's PTB ratio is a function of three factors: its future abnormal ROE (ROE less the cost of equity), the growth in its book equity, and its cost of equity.
• Hence, there is a strong relationship between PTB ratios and ROEs.
• Companies with high ROE should trade at higher PTB ratio compared with those with lower ROE.

The Screening

• ROEs and PTBs on Jan 1 of each year of all the companies listed on the Singapore Exchange from 1990 until 2007 were downloaded.
• Stocks were ranked by dividing their ROEs with their PTBs and split equally into 10 groups.
• The first group, or the first decile, is the top 10 per cent of stocks with the highest ROEs relative to their PTB ratios.
• The 10th decile comprises those with the lowest ROEs and highest PTB ratios.
• Then there's a group of loss-making companies.

The Back-Testing

• An investor performs the screening and invests $100 in the top four stocks with the highest ROE/PTB on Jan 1, 1990.
• On Jan 1, 1991, he repeats the same screening again; divested the initial four stocks and reinvested the proceeds into a new batch of stocks with the highest ROE/PTB.
• And he consistently did that for the past 17 years.

The Result

• There is a very clear relationship between stock returns and ROE/PTB.
• The top 10 per cent of companies with the highest ROE/PTB turned $100 into $34,048 in 17 years, a compounded return of 41 per cent a year.
• The next 10 per cent managed to grow the pot to $4,710, a decent 25 per cent a year.
• The third decile, managed $958 for a return of 14 per cent a year.
• And as we move to stocks with lower and lower ROE/PTBs, the return shrinks correspondingly.
• The fifth decile grew only 3.8 per cent a year and the 10th decile - the 10 per cent of the market with the lowest ROE/PTB - shrank the $100 to just $25.
• The test calculations did not take into consideration transaction costs.
• This screening process takes into consideration the underlying earnings capacity of a company in relation to how the market is valuing the company.
• Those with high ROE but low PTB are clear cases of mispricing.
• As the testing entailed a one-year holding period each year, decay factors (e.g. barriers to entry in their industries, change in production or delivery technologies, and quality of management) were insignificant.

The Conclusion

• If you find a stock with high ROE but relatively low PTB, then you may potentially have on your hands an undiscovered gem.

My view - the ROE/PTB measure might just be a simple value metric to uncover undiscovered multi-bagger stocks.