In Brief
A value and momentum screen focused on finding under-valued, out-of-favor companies just at the point when the market is starting to recognise them. According to Lakonishok, investors have judgmental biases and behavioral weaknesses including the tendency to extrapolate the past too far into the future, to wrongly equate a good company with a good investment irrespective of price, to ignore statistical evidence and to develop a "mindset" about a company. As a result, "value stocks become underpriced and glamour stocks become overpriced relative to their fundamentals". He believes these biases and weaknesses can be exploited to achieve superior long term returns.
Background
In a 1994 study Contrarian Investment, Extrapolation and Risk, Lakonishok, Andrei Shleifer, and Robert Vishny examined the performance of value stocks relative to that of “glamour” securities in the United States over a 26-year period. The authors found that value stocks tended to outperform glamour stocks by wide margins. In his view, this is mainly because of investors extrapolating past fundamental performance too far into the future, resulting in many well performing stocks becoming overpriced and many poorly performing stocks becoming underpriced.
Along with fellow academics Andrei Shleifer (Harvard University) and Robert Vishny (now both retired), Josef Lakonishok set up Chicago-based LSV Asset Management, which now manages over $65 billion in assets for both institutional and individual accounts using quantitative models to find value-oriented companies.
Lakonishok looks for potentially undervalued companies by comparing four key ratios. As well as traditional price-to-book value measure, he looks at price to-cash flow, price-earnings, and price-to-sales ratios. If the company's stock price is below the industry average based on any one of these four ratios, it's worth a closer look. However, identifying a group of out-of-favor stocks is just the beginning. The trick is to ascertain which of them are likely to rebound vs. being cheap for a reason, such as being near bankruptcy. He looks for value stocks that are beginning to show some sign of momentum, either in terms of price momentum (relative strength) or in terms of improving analyst sentiment and earnings surprise.
Screen Criteria
Without knowing the details of LSV's investment criteria, an indicative set of Lakonishok-inspired screening metrics might be:
- At least one of Price-to-book, price-to-cash-flow, price-earnings or price-to-sales ratios more favourable than the industry
- 6 Month relative strength above zero
- 3 month relative strength above zero …
