Saturday, April 7, 2012

Time to re-assess price-to-book stock picks?

Including dividend yield in the decision appears to capture the cream of the crop

by Teh Hooi Ling, Senior correspondent

Saturday, Feb 4, 2012 
The Business Times Weekend

Key article highlights:
  • Strategy of buying baskets of stocks with varying ratios of dividend (D) yield to price-to-book (PTB) ratio was tested.
  • The test data included list of stocks trading on Singapore Exchange every year on March 31 starting from 1990, dividend yield, price-to-book ratio and last traded stock price on Jan 17, 2012.
  • Stocks were ranked based on dividend yield over price-to-book ratio (i.e. D/PTB ratio) and divided into 10 groups of equal numbers.
  • Decile 1 comprised stocks with lowest dividend yield but highest PTB ratios; and Decile 10 comprised stocks with highest dividend yield but lowest PTB ratios.
  • Quality of assets and corporate debt levels were not screened.
  • There were 10 groups of stocks each year with their returns tracked annually.
  • For each group, the median price appreciation was taken as the return and median dividend yield added to compute the total return respectively.
  • The groups of stocks will be different each year depending on their D/PTB ratio as at Mar 31.
  • 10 investors started 1990 with $100 were assumed with Investor 1 always investing in Decile 1 portfolio and Investor 10 in Decile 10.
  • Each group's total return at the end of each year was reinvested in the following year's corresponding decile for 22 years.
  • The result: Buying stocks with the highest dividend yield, but lowest PTB ratio appeared to be a winning strategy.
  • The D/PTB strategy turned $100 into $1,575 for Decile 10, representing a compounded annual return of 13.3 per cent.
  • Conversely, $100 diminished to just $16 for Decile 1, representing a decline of 7.9 per cent yearly.
  • Meanwhile, the Straits Times Index's (STI) capital appreciation over the same period was 3 per cent annually excluding dividends.
  • The D/PTB ratio strategy was then compared with the strategy of simply buying stocks with the lowest PTB ratios.
  • PTB as a predictor of a company’s future stock performance was first highlighted by US finance professors Eugene Fama and Kenneth French in 1992.
  • Their breakdown study showed convincing that the lower the company's ratio of PTB value, the higher its subsequent stock performance tended to be.
  • Fama and French found that no other measure had nearly as much predictive power – not earnings growth, price/earnings, or volatility.
  • The D/PTB test methodology was repeated by grouping stocks based on their PTB where Decile 1 comprised stocks with the highest PTB and Decile 10 with the lowest PTB.
  • The result: Buying stocks with the lowest PTB outperformed the rest of the baskets of stocks but paled in comparison with that of buying stocks with the highest D/PTB ratios.
  • The PTB strategy grew $100 into $365 for Decile 10, representing a compounded annual growth of 6.1 per cent.
  • When a 3 per cent annual dividend yield was assumed for the STI constituent stocks, the PTB Decile 10 return was comparable to that of the STI's.
  • Comparing the two strategies, portfolios of high D/PTB stocks fall less than the general market during downturns because the dividends provided a floor for the stocks' prices.
  • Additionally, the performance of the highest D/PTB porfolio towered over the rest and appeared to have captured the market's absolute cream of the crop.
  • Based on the two strategies' test results, screening stocks based on both dividends and PTB would yield a better outcome than selecting stocks just on PTB.
Dividend yield and PTB ratio form part of my assessment criteria when i screen stocks.  With the D/PTB ratio, it seems i now have a far more powerful screening metric to facilitate my investment decision making.