Over the past few weeks, I have generated value investing ideas using the Stockopedia screening tools. This week that quest continues with an earnings-based screen.
Most of the mainstream academic finance research has focused on the Price-to-Book metric, which was the focus of my last screen. However, it has been known for some time that using earnings-based metrics may overcome some of the issues that Price-to-Book faces as a measure of value. Most of the published data has come from “quant practitioners,” who use their research to manage money via quantitative strategies. While I am not aiming to generate a purely quantitative screen, understanding the history of this research helps ensure I pick the right screening factors.
Earnings-Based Value Metrics – A Brief History
Perhaps the best-known of the early quant practitioners are David Dremen and James O’Shaughnessy. In 1980, Dremen wrote a book called Contrarian Investment Strategy, which highlighted that a low Price-to-Earnings strategy was the best-documented way to beat the market. In 1998, he followed this up with a book called Contrariarian Investment Strategies: Beating the Market by Going Against the Crowd. He looked at more up-to-date data for Price/Earnings, Price/Cash Flow, Price/Book Value, and Dividend Yield, finding Price/Earnings to still come out on top.
O’Shaughnessy’s book What Works on Wall Street was first published in 1997 and is now in its 4th Edition. O’Shaughnessy conducted a more thorough analysis and included the Sharpe ratio in his findings. The Sharpe ratio takes the excess return that a strategy generates and divides it by the volatility of those returns. The idea is that a higher return doesn’t gain investors anything if it comes at the cost of higher volatility. If the Sharpe ratio of a strategy was the same as the index, investors could simply leverage up the index to get the same result with less effort. Although the idea isn’t without its issues – leveraging the index is not cost-free, and investors don’t mind upside volatility – it makes sense to conclude that a strategy only outperforms another if it has a higher Sharpe ratio.
What Works on Wall Street contains some interesting findings. The first was that in the period studied (1951-2003 in my Third Edition of the book), Price-to-Book-Value and Price-Sales came out with the highest Sharpe ratios. The second was that the outperformance was concentrated in the largest stocks, which goes against the…
