As factor investing makes it way into more Canadian pension portfolios, a team of researchers has published a new paper that questions whether or not one factor in particular isn’t doing what it’s supposed to.
In “Facts About Formulaic Value Investing”, authors U-Wen Kok. Jason Ribando, and Richard Sloan suggest that automation is failing to identify and deliver what Benjamin Graham and David Dodd dubbed the “intrinsic value” of securities. Rather, there is ample evidence that formulaic value investing approaches don’t actually deliver superior performance and, worse, the actually identify the companies value investors want to avoid – those with inflated accounting numbers.
Specifically, the authors find no evidence to show that buying U.S. equities which appear underpriced based on simply fundamental-to-price ratios actually leads to better investment performance. And while U.S. small cap stocks could be an exception, these securities just don’t have the capacity, liquidity and cost benefits to make them a viable option.
Rather than finding underpriced securities, simple ratios actually tend to draw investor to companies where the accounting numbers are temporarily inflated. These are broken down as follows:
• “The book-to-market ratio systematically identifies securities with overstated book values that are subsequently written down.
• The trailing-earnings-to-price ratio systematically identifies securities with temporarily high earnings that subsequently decline.
• The forward-earnings-to-price ratio systematically identifies securities for which sell-side analysts offer relatively more optimistic forecasts of future earnings.”
Food for thought considering how many pension funds are turning to passive strategies as a way to control costs and better understand the risks in their portfolio. Based on this research, it’s worth looking under the hood at how these ratios identify securities.
Download the paper and take a look for yourself.