The Power of Low Valuations

July 31, 2015 — 1 Comment

Quiz!

When a diversified stock portfolio has low valuations, as measured by Price/Book, which of the following is most likely?

  1. Investors are pessimistic about the investment, which could lead to poor performance.
  2. Investors are pessimistic about the investment, which could lead to unusually high performance.
  3. Investors are optimistic about the investment, which could lead to poor performance.
  4. Investors are optimistic about the investment, which could lead to unusually high performance.

Look for the answer below and read this month’s article for a discussion.

Article

Extended-Term Component, one of two stock portfolios offered by Quality Asset Management, exhibits high volatility along with high average returns. In recent years, the portfolio went through a slow period. At this point, it would be nice to have some indication of where we stand. There is one measure that is very helpful – the Price/Book (P/B), or price of the companies relative to their book value, or liquidation value. When breaking the timeline of returns to up and down periods, we observe a strong relationship between the returns in the upcoming period and the Price/Book at the start of the period (see charts below). Specifically, down periods started with a Price/Book of 1.38 to 2.04, while up periods started with a Price/Book of 0.69 to 0.75.

There is nice logic to this behavior. A Price/Book below 1, indicates that people are paying for the company less than its value by the books – a very low price. This is usually the result of very negative sentiment. Once the pessimism wanes, people go back to wanting to pay a premium for the companies relative to their book values. This leads to gains beyond the growth in the book values of the companies, explaining the dramatic gains of 84% to 580%, that were experienced in past up periods.

Up Periods for Extended-Term Component
Period Begin Period End Starting P/B Annualized Gain Total Gain
02-1999 12-1999 0.69 105% 84%
03-2003 10-2007 0.75 52% 580%
11-2008 04-2011 0.71 62% 214%
Down Periods for Extended-Term Component
Period Begin Period End Starting P/B Annualized Gain Total Gain
12-1999 03-2003 1.45 -14% -39%
10-2007 11-2008 2.04 -66% -68%
04-2011 07-2015 1.38 -8% -31%

Today, the P/B is equivalent to 0.79 (after adjusting for the profitability bias), close to the range that started the big up periods in the past. While the future can bring lower valuations or longer down periods, the data is strong enough to give some optimism for an up period in upcoming months or years. If we experience declines from this point, I would expect the gains to be greater.

Quiz Answer:

When a diversified stock portfolio has low valuations, as measured by Price/Book, which of the following is most likely?

  1. Investors are pessimistic about the investment, which could lead to poor performance.
  2. Investors are pessimistic about the investment, which could lead to unusually high performance. [The Correct Answer]
  3. Investors are optimistic about the investment, which could lead to poor performance.
  4. Investors are optimistic about the investment, which could lead to unusually high performance.

Explanation: A low Price/Book means that the price of the investment is low relative to the company’s book value. Investors are usually willing to pay a low price because they are pessimistic about the investment. Once the sentiment improves, investors are willing to pay more than the book value. This leads to unusually high performance, because the price goes up by compounding the price gains relative to the book value with the growth in the book value.

Disclosures Including Backtested Performance Data

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Gil Hanoch

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One response to The Power of Low Valuations

  1. Nice article, Thank You Gil.

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