Wednesday, March 2, 2011

The 'magic formula' still works - but be careful to not follow blindly

Teh Hooi Ling Senior Correspondent
4 September 2010
Business Times Singapore

Updated study shows highest ROE/PTB stocks yield best returns, while stocks with low ROE and high PTB are toxic

IN cyberspace, words or ideas have a life of their own. You see, sometimes my articles get picked up by some investment blogs out there. And AsiaOne, the online portal of Singapore Press Holdings, also puts up some of our articles on their pages. So occasionally, I receive e-mail messages about articles published years ago.

One story on which I get quite a few email messages every once in a while is titled 'In search of super returns in stocks'. The article was first published in July 2007.

Last month, AsiaOne put up that article once more on one of its pages, and I again received a number of readers' email messages, some even saying that the article was 'timely'.

Well, given the popularity of the article, I've decided to update the study to see if that strategy had withstood the 'financial crisis of our generation' and whether it still works post-crisis, in an environment described by many as the 'new normal'.

Just to recap. Basically, what I did for that study was to rank all the stocks listed on the Singapore Exchange based on their ratio of return-on-equity (ROE) to price-to-book (PTB) ratio.

(ROE is net profits divided by shareholders' equity, that is the rate of return of shareholders' equity. PTB is the market cap divided by the shareholders' equity, that is how many times the market is valuing the business vis-a-vis the initial amount pumped in by the shareholders.)

I then split the stocks with positive ratios into 10 equal groups. The first group, or the first decile, would be the first one-tenth of stocks with the highest ROE/PTB ratios. The 10th decile would be those with the lowest ROE/PTB ratios. Then the last group is made up of loss-making companies.

I did the ranking every year based on the companies' data as at the beginning of the year, starting from 1990 until 2006. I then calculated the average return of the stocks in the various groups a year later.

The object of the study is to find out what the returns for an investor would be if he or she were to consistently buy the 10 per cent of stocks in the market which had the highest ROE/PTB, or the lowest such ratio, or any of the other groups of stocks in between.

So $100 each would be invested into the 11 groups of stocks at the beginning of 1990. By the end of that year, the portfolios would be liquidated, and the money would be reinvested into the next 11 groups of stocks the following year. Money from Decile 1 would be reinvested back into the Decile 1 stocks the next year, and so forth. The process continued until 2006. No transaction costs were taken into account.

Super returns

The results of investing in the highest ROE/PTB stocks were phenomenal. It yielded one of the best returns - if not the best - of all the various strategies I've tested all these years.

The investor who invested his $100 into Decile 1 stocks - that is, stocks with the highest ROE relative to their PTB in early 1990 - would have grown that amount to a whopping $34,048 by the end of 2006. That's a compounded return of 41 per cent a year. How many fund managers can actually match that?

The returns get progressively smaller for stocks with lower ROE/PTB. The relationship is very clear - the lower the ROE/PTB, the lower the return.

While the top 10 per cent of companies with the highest ROE/PTB turned $100 into $34,048 in 17 years, the next 10 per cent managed to grow the pot to just $4,710. Still, that's quite a decent 25 per cent a year.

The following 10 per cent, or the third decile, managed $958 for a return of 14 per cent a year between 1990 and 2006. 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.

So has the recent financial crisis messed things up? I updated the portfolios' performance by including data from the last three years.

The year 2007 was a good year for stocks, and particularly the 10 per cent of the market with the highest ROE/PTB. The 36 stocks in there chalked up the highest average return of 118 per cent. The rest managed an average return ranging from 17 per cent to just over 50 per cent.

The following year, 2008, was the eye of the storm where the financial crisis was concerned. There was no escape. All stocks were down. But the consolation was, again, the highest ROE/PTB stocks as a group suffered marginally smaller losses. It plunged by 55 per cent. The range for the rest of the groups was an average loss of 53 per cent to 68 per cent.

Last year was again a good year for stocks. The highest ROE/PTB stocks rebounded by 121 per cent. That's second to Decile 2's 144 per cent return. The range of returns for all the groups was between 40 per cent and 144 per cent.

So, between 1990 and 2009, consistently buying the 10 per cent of stocks with the highest ROE/PTB year after year grew $100 to $74,229. That's a compounded annual return of 39.2 per cent a year. The next 10 per cent of stocks grew to $7,984, for a return of 24.5 per cent. (The power of compounding is amply illustrated here as well. A 15 percentage-point difference a year turned into a factor of 10 in 20 years' time.) The third 10 per cent grew by 12.7 per cent a year to $1,099.

Meanwhile, stocks with the lowest ROE/PTB shrank the initial $100 to just $25. In other words, stocks with low ROE and high PTB are toxic!

What's in the formula

In response to this article, a few readers have written in to point out that if we simplify ROE/PTB, it actually becomes earnings yield, or the inverse of price-earnings ratio.

Reader Darrell Lim gave the example of four companies. All have ROEs of 20 per cent, but each is valued differently by the market. The first at PTB of 0.5 time, and next at one time, the third at 1.5 times and the last company at two times book.

'If I'm expecting a 20 per cent ROE, but my PTB is 0.5, it means that even if the company performs as it should and its ROE for the following year is 20 per cent, I'm actually getting a 40 per cent return on investment - assuming market values tend towards true book values (or higher) in the long run,' he said.

Perhaps that accounts for part of the returns - stocks trading up to their book value.

I also have a number of readers writing in to ask where they can find PTB figures for companies. We can calculate that by taking the share price divided by the net asset value per share of the stock. Or as reader Nigel Tan pointed out to me, the data can be found on the Reuters website ( []? ). Just type in the company's name and select the company you want from the list which pops up.

And for those who are wondering which are the stocks with the highest ROE/PTB now, I've included the top 10 per cent here. Like the back-testing, I didn't filter out any stocks. As such, we have stocks whose earnings were boosted by extraordinary items or companies with some corporate governance issues. So do your home work before rushing in to buy any of the stocks listed here.

The writer is a CFA charterholder

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