Low P/B value investing:

Why it works and how it can work better by considering momentum and reversal?

Course Report for MFIN7015 Behavioural Finance By: Kwok Yap 2008966872 ericykwok@gmail.com

Summer 2011
1

Low P/B value investing works

Fama and French (1998) found consistent value premium in international markets. Interestingly.... I noted in their paper that a low P/B strategy seems to deliver slightly better results (~1%) than other value metrics such as P/E or P/C.
Market
Weighted avg return vs Market vs HB/M 11.00

HB/M
15.60 4.60

HE/P
14.45 3.44 (1.15)

HC/P
14.70 3.70 (0.90)

HD/P
13.65 2.64 (1.95)

Note: Based on 5,614 firms in 13 markets during 1975-1995. Data further processed.
2

Is it just a statistical error?

Is this slight advantage not significant statistically? Possible.
No access to original research data

Or are there some rationales behind it? I think so. Personal experience: 10+ years value investing experience. Low P/B is my favorite value metric, with satisfactory results. P/B have qualitative merits based on accounting, business and economic reasons that make it a better value metric.

Why low P/B strategy works?

1. B less subject to management manipulation than E. 2. E and C affected by business cycle, but not B. 3. Larger B = more physical assets for use.just need better strategy or management. 4. Unhappy shareholders force low P/B managers to change strategy, or themselves. 5. Low P/B industry new investment Competition Profitability Share price Low P/B will trigger a chain of changes that will likely lead to better profitability and higher share prices over time.
4

Change in P/B possibly explains reversal

LOSERS: Low P/B Competition WINNERS WINNERS: High P/B Competition LOSERS new investment Profitability Share price

new investment Profitability Share price

Many shall be restored that now are fallen and many Shall fall that now are in honor.
- Benjamin Graham quoting Horace
5

Value investing + momentum + reversal?

Asness (1997) found no meaningful gains with high-value-highmomentum strategy Reason: the two strategies are inherently conflicting.
Good for value = bad for momentum, vice versa

Suggestion: Value + Momentum: avoid or buy fewer shares of stocks with poor momentum. Value + Reversal: patiently holding losers stock for 3-5 years for reversal. This will minimize average purchase cost and maximize return. Dont catch a falling knife!

How to make low P/B work better?

Piotroski (2000) used historical financial statement to separate winners from losers. Suggestion: Low P/B + Multivariate quantitative framework + Qualitative research Investment Targets Targets + Momentum + Reversal Maximum return!
Profitability metric - ROIC
Qualitative Research: 1) Sustainable profitability level 2) Sustainable growth rate

Low P/B
Other value metrics P/C, P/E Leverage, Liquidity ratios

Momentum & Reversal