Profiting from Unprofitable Companies

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berntson
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Profiting from Unprofitable Companies

Post by berntson »

Here's a puzzle: Are small value stocks expensive or are they cheap? Vanguard's small value fund has a trailing price to earnings of 23. The total market has a trailing price to earnings of 20. So it looks like small value stocks are expensive. But wait! Vanguard small has a price to book of 2 and the total market a price to book of 2.7. So small value stocks look cheap (or at least fairly priced). What gives?

Here's an interesting fact: Firms with negative earnings have historically had higher returns than firms with positive earnings. Fama and French show this in their original cross-sectional returns paper from 1992. Among firms with positive earnings, a higher earnings yield (i.e. lower price-to-earnings ratio) predicts higher returns. Given this, you might expect firms with a negative earnings yield (i.e. with negative earnings) to have the lowest expected returns. In fact, they have had higher expected returns than stocks with positive earnings.

Upshot for investors: Comparisons of average price-to-earnings ratios between funds can be misleading. Small value funds tend to have more firms with negative earnings than the market as a whole (you can especially see this if you look at the top holdings of funds like PXSV and BOSVX). So when calculating price-to-earnings ratios (the way Vanguard does), such companies will raise the price-to-earnings ratio. This will suggest to many that such funds have lower expected returns. But in fact, small unprofitable companies have historically had higher returns. So their presence in a small value fund raises expected returns rather than lowering them (as a naive price-to-earnings calculation might suggest).
stlutz
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Re: Profiting from Unprofitable Companies

Post by stlutz »

Of course, if you define value by price/earnings, then these companies get lumped into the small growth category, the dreaded "black hole" of investing! (Cue ominious music).
In fact, they have had higher expected returns
I never get this. A backtest shows that group A outpeformed group B in terms of actual returns, and the massive leap is then made to say that this outcome was expected ahead of time simply because it occurred. Who expected it prior to the time period covered by the backtest?
LongerPrimer
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Re: Profiting from Unprofitable Companies

Post by LongerPrimer »

Zillow and Trulia did pretty good today 24July. Both lose money.
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JoMoney
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Re: Profiting from Unprofitable Companies

Post by JoMoney »

Broadly speaking without regard to "Growth" or "Value" style, small-caps look more expensive than large-caps (ref: the hundreds of other threads). Oddly, even The Federal Reserve has started making comments about it
Federal Reserve Chairwoman, Janet Yellen, Jul-15,2014 wrote: http://blogs.wsj.com/economics/2014/07/ ... testimony/
"stock market valuations for small firms, social media and biotechnology firms “appear to be stretched.” Meantime risk spreads on corporate bonds have reached all-time lows, a sign of over-valuation."
If I recall though, when The Fed complained about stock valuations being irrationally exuberant in 1996 the larger-cap stocks continued their momentum to bubble up for another 4 years. So much for market timing.

With regard to the "Growth" and "Value" styles though, they are diametrically opposed and the metrics of one style should make the other look more unfavorable.
"Factors" like Quality, Profitability, and Momentum are going to look better in Growth styles. People looking for small market-cap, low price to book, high dividends, and trading on mean-reversion will look better in Value styles. One style "factor" or another is likely to beat the other over some period of time, but you have to guess (if you want to speculate) going forward.

Sometimes I wonder if the presentation of these various conflicting "factors" is done as an excuse to style-drift, seeing as how many of the "factor" funds discussed around here have sold their story around the idea that they were somehow "passive" index like portfolios. Given the vagaries of the market over time, I would think it might be prudent to shift styles if you were trying to "beat the market" and thought you could time the inflection points.
" If you are smart enough to know, please be my guest and act accordingly. Good luck! "
We have 30 years of out of sample real-world performance of DFA's attempt at a fund using a single strategy that looked good over the historical back-testing, but the out-performance certainly wasn't persistent:
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nisiprius
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Re: Profiting from Unprofitable Companies

Post by nisiprius »

JoMoney wrote:...We have 30 years of out of sample real-world performance of DFA's attempt at a fund using a single strategy that looked good over the historical back-testing, but the out-performance certainly wasn't persistent...
Yes, precisely. I sure think that's a fair way to present it.

Despite protests of the form "that's not what we recommend now" or "DFA never said it would persist" or "we give that same general name to a new strategy, adjusted because we know more now and we know that you have to throw out small growth and public utilities, and the new strategy would have been persistent over the past thirty years" or "don't look at that fund in isolation, a mix of 10% of that fund with 90% of other stuff would have done 30 basis points better over this specific date range..."
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Re: Profiting from Unprofitable Companies

Post by Beliavsky »

berntson wrote:Here's an interesting fact: Firms with negative earnings have historically had higher returns than firms with positive earnings. Fama and French show this in their original cross-sectional returns paper from 1992. Among firms with positive earnings, a higher earnings yield (i.e. lower price-to-earnings ratio) predicts higher returns. Given this, you might expect firms with a negative earnings yield (i.e. with negative earnings) to have the lowest expected returns. In fact, they have had higher expected returns than stocks with positive earnings.
Firms with negative earnings are probably much more volatile and higher-beta than other firms. The stock price of an unprofitable firm that cannot be turned around can go to zero. Even if firms with negative earnings have historically earned higher returns, it may not be a good idea to overweight them.

I wonder if it is useful to distinguish between two classes of unprofitable firms. One type of firm, call it "value" or "fallen angel", has been profitable in the past but has recently lost money. It may actually be cheap according to PE10 or P/B. Another type of firm, for example a biotech, may never have made money but has invested in projects that management hopes will be profitable in the future. Then the question is how "value" and "growth" unprofitable firms have done. I suspect that the outperformance of unprofitable firms (if it exists) is concentrated in the value firms that have been profitable in the past.
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Re: Profiting from Unprofitable Companies

Post by longinvest »

JoMoney wrote: We have 30 years of out of sample real-world performance of DFA's attempt at a fund using a single strategy that looked good over the historical back-testing, but the out-performance certainly wasn't persistent:
Image
Jo, does the growth graph account for the DFA advisor fee?
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Re: Profiting from Unprofitable Companies

Post by richard »

longinvest wrote:Jo, does the growth graph account for the DFA advisor fee?
It's a standard morningstar chart. It accounts for the funds' expense ratios, but not amounts paid to advisors.
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Re: Profiting from Unprofitable Companies

Post by richard »

nisiprius wrote:
JoMoney wrote:...We have 30 years of out of sample real-world performance of DFA's attempt at a fund using a single strategy that looked good over the historical back-testing, but the out-performance certainly wasn't persistent...
Yes, precisely. I sure think that's a fair way to present it.

Despite protests of the form "that's not what we recommend now" or "DFA never said it would persist" or "we give that same general name to a new strategy, adjusted because we know more now and we know that you have to throw out small growth and public utilities, and the new strategy would have been persistent over the past thirty years" or "don't look at that fund in isolation, a mix of 10% of that fund with 90% of other stuff would have done 30 basis points better over this specific date range..."
Speaking of which, the new strategy popular with many DFA types is the profitability factor. Google novy-marx profitability (or novy-marx profitability dfa) for more info.

BTW, this is directed generally, not at nisi who already knows this.
Last edited by richard on Fri Jul 25, 2014 8:04 am, edited 1 time in total.
longinvest
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Re: Profiting from Unprofitable Companies

Post by longinvest »

richard wrote:
longinvest wrote:Jo, does the growth graph account for the DFA advisor fee?
It's a standard morningstar chart. It accounts for the funds' expense ratios, but not amounts paid to advisors.
So, the growth graph overestimates the returns obtained by a DFSCX investor. DFA funds are only available through selected advisors, for a fee. VFINX, on the other hand, is available without any advisor fee.

That makes for an unfair comparison!

(It would also be interesting to compare the after-tax returns for taxable investors).
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berntson
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Re: Profiting from Unprofitable Companies

Post by berntson »

Thanks everyone! It might be worth emphasizing that Fama and French don't think of this as some sort of new factor. They show that the strange earnings phenomena can be subsumed under size and book-to-market. Basically, the small effect explains why unprofitable companies outperform (unprofitable companies are smaller companies) and the book-to-market effect explains why companies with high earnings yield do better than companies with low earnings yield (companies with high earnings yield tend to have high book-to-market and companies with low earnings yield tend to have low book-to-market).

I'm interested in this because I own BRSIX and PXSV, two small funds with a large number of unprofitable companies. I'm now convinced that comparing price-to-earnings for these funds to price-to-earnings for larger funds (with less invested in small unprofitable companies) may be more complicated than many think.
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Re: Profiting from Unprofitable Companies

Post by Jeff Albertson »

I haven't seen any discussion of 'liquidity.' From John Authers:
And then there were four. Followers of the dialogue between financial academics and investors will know there is agreement on three factors that cause stocks to outperform the market in the long term.

They are size (small stocks beat large one in the long run); value (cheaper stocks beat expensive ones); and momentum (winners tend to keep winning while laggards tend to keep lagging behind).

Now it appears there is a fourth: liquidity. The less liquid a stock is, the better it will perform in the long run, compared with more liquid stocks.
The financial academic community has given this notion its imprimatur. This week, the Graham & Dodd prize (named for the academics who founded value investing) for the best 2013 article in the Financial Analysts Journal went to Yale’s Roger Ibbotson, one of the best-known finance researchers, for what may become a seminal article laying out why liquidity should join size, value and momentum.
http://www.ft.com/intl/cms/s/0/3c62469c ... ition=intl
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Re: Profiting from Unprofitable Companies

Post by garlandwhizzer »

I agree with Nisi and Jo Money that factor investing with small and value for example goes through long periods of outperformance alternating with underperformance. For the past 14 years small and value have substantially outperformed. Rather than being a positive going forward, this fact makes it more likely that in the next 14 years the outperforming factors will be others--profitability, quality, and momentum for example--all of which are more closely associated with growth than value. Likewise after small's great run since 2000, the valuation of small has gotten stretched relative to large and large may well outperform for a considerable time going forward just as it has YTD. Bogle's telltale chart makes these points well.

Factors alternate between long multi-year periods of outperformance and underperformance and one risk of factor dominated portfolios is that you get tired of persistent underperformance and sell out at the wrong time. It may well be entirely rational for investors even knowing the positive history of factor out-performance to choose a TSM portfolio exclusively because it doesn't make bets on which factors will dominate in the future but rather includes all of them. TSM trades a smoother less volatile ride for the expectation of a higher return. Whether that higher return materializes or not over a decade depends a lot on timing which in turn depends a lot on luck. Factors do not provide a free lunch.

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Re: Profiting from Unprofitable Companies

Post by larryswedroe »

garland
the outperformance of the factors is generally not from the entire "asset class" outperforming, but from small subset that does so well that it migrates out of the asset class and may not be there in the next period.
So just because you have long period of outperformance doesn 't mean it cannot continue.,
In fact by definition there should always be a premium. It's risk showing up for value type companies that leads to underperformance generally, especially financial crises.
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JoMoney
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Re: Profiting from Unprofitable Companies

Post by JoMoney »

larryswedroe wrote:... In fact by definition there should always be a premium. ...
This is part of my issue with the idea that the market is efficiently pricing "risk premiums". If an anomaly existed at some point, and the market is efficient, then the conclusion is that the anomaly must somehow represent a "risk premium" and people can theoretically build their passive portfolio matching it to their risk/reward preference. But this doesn't work empirically in the stock market. All of these "factors" just represent the same styles active managers have used for decades. That's why the style boxes exist - to allow comparing performance of one fund to another that used the similar style "factors". When we compare actual funds that used these "factors" across time the performance waxes and wanes across some mean performance of the overall market. All of the styles have periods of out-performance and under performance. Exposure to a particular style/factor does help describe why a fund performed a certain way during some period dependent time frame, but that doesn't mean it was because of some persistent premium, nor does it predict future performance (at times past performance seems negatively correlated to future performance - but unpredictably so).

The market is very competitive. I simply do not believe there is money being left on the table where a passive investor can decide to pick one style and believe it will persistently outperform the opposing style. While I do believe there are experts who can (and do) beat the average in their narrow category of expertise, that's an active subset using their informational advantage to decide when the area looks favorable (and taking the risk that they aren't as talented as they think they are). A passive or average investor without any expertise in the area they're focusing on shouldn't expect anything but average performance minus expenses. But wanting and trying to be a skilled above average performer is considerably different then achieving it... by definition, most will not beat the "average"... it's not Lake Wobegon
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Profiting from Unprofitable Companies

Post by garlandwhizzer »

I would respectfully like to ask Larry a question regarding factor investing. Jo Money's graph shows that from 1983 to 2014, period of 31 years, that VFINX, Vanguard's S&P 500 fund, had equal returns with DFSCX, the DFA Microcap Fund. DFA has perhaps the best reputation among financial corporations for capturing factor outperformance. Currently the average market cap of VFINX is 68.3 billion or so and for DFSCX the average market cap is 784 million. That is to say that the S&P 500 fund has a market cap weight at present 87 times greater than DFSCX and likely has had massively less exposure to the small cap premium for the entire 31 years. Talk about capturing the size factor, it should have happened over a 31 year time span with DFA calling the shots. Yet, in spite of the fact that VFINX is 87 times larger in cap weight and also that it tends to be slightly tilted to growth rather than value, it performed equally with DFA Microcap Fund which is not only vastly smaller in cap weight but also tends to have a modest slant toward value. It therefore appears to me that the size factor, at least isolated by itself, may disappear completely for 3 decades or more in terms of returns to investors with real life funds. So is size really a factor that investors can count on? Furthermore a question arises about value. How much of a value slant must a portfolio have in order for the value premium to appear? The slight growth/value slants of these two funds did not produce any positive results for the value premium over 31 years.

History, however, says we can count on the value factor if we get enough of it, and if we are patient and wait long enough. But I have a theoretical question with this as well. Several very knowledgeable market and financial analysts including Bill Bernstein, Jeremy Grantham, Bill Gross, and Cliff Asness suggest that we are in a "new normal" or "new neutral" period where all investment returns going forward are going to be small by historical standards, 2.5% real or less for a 60/40 balanced portfolio. They suggest a long and persistent period of slow economic growth, high governmental and personal debt, a baby boomer retirement funding crisis, essentially zero real bond returns, and very modest real stock market returns starting from today's generous stock valuations. Correct me if I'm wrong, but I don't believe a scenario exactly like that has ever occurred in US economic history. It is not clear whether that scenario will unfold but it is a possibility. If it does occur, it isn't clear to me that value is the place to hide out. Isn't there a place in the portfolio for owning solid financially sound large cap stocks with reliable earning streams, dividends, and wide moats to protect their earnings? Those types of stocks don't seem to me to be too expensive at present relative to small cap value stocks.

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Re: Profiting from Unprofitable Companies

Post by Jebediah »

JoMoney, as usual, tried to mislead by cherry picking the start date of his chart.

Here is what DFSCX since inception vs VFINX looks like (keep in mind it's a log scale):

Image

Growth of 10K
DFSCX: $430K
VFINX: $353K
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JoMoney
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Re: Profiting from Unprofitable Companies

Post by JoMoney »

Jebediah wrote:JoMoney, as usual, tried to mislead by cherry picking the start date of his chart.

Here is what DFSCX since inception vs VFINX looks like (keep in mind it's a log scale):
[..chart..]
Growth of 10K
DFSCX: $430K
VFINX: $353K
Call it what you like, it doesn't change the results for that period, or any other - it's clearly "period dependent", and very little sign of "persistence" in the so called premium. If anything, the period after Banz's paper and funds tracking small-caps became available seem to have been a horrible time to start investing in that style.
People should go and look at it for themselves and decide if it looks like some sort of "persistent premium" is apparent.
I thought using that start date was being generous, showing a period of "return to the mean", some of the periods looked absolutely dreadful. Even with the figures over the period you're showing, the difference is less than 1% compounded over the 32.5 years, some people pay 1% for the privilege of accessing DFA funds.
I could argue using the current date as your end date is "cherry picking", there's plenty of reasons to believe small-cap stock valuations are quite "stretched" at the present.
Here's a real "cherry picked" 18 year period with your start date:
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Re: Profiting from Unprofitable Companies

Post by Jebediah »

JoMoney,

You said:

We have 30 years of out of sample real-world performance of DFA's attempt at a fund using a single strategy that looked good over the historical back-testing, but the out-performance certainly wasn't persistent.

---

I take it from this statement that you are interested in whether DFA was able to implement a strategy in the real world "that looked good over the historical backtesting".

Here is the answer.

DFA US Large Value since inception

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DFA US Small Value since inception

Image



DFA Int'l Developed Large Value since inception

Image



DFA Int'l Developed Small Value since inception

Image



DFA Emerging Value and Small since inception


Image
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JoMoney
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Re: Profiting from Unprofitable Companies

Post by JoMoney »

We could go back and forth posting charts of various time periods all day... I think you're missing the point. The advocates of these strategies claim the "premium" in their favorite style is "persistent", where all I see is various periods of switching back and forth, outperforming in one period - then under-performing in another. Finding periods of "reversion to the mean" (or even periods where one outperformed the other) is quite easy.
Image
Image
Most of those other funds don't have the 30+ years of data that we have with DFSCX, but the longer the period available, the more inconsistent the idea that it's "persistent" looks.
I have no doubts that DFA (or most any other fund company) is capable of building a fund that tracks differently. If people were building tactical allocations that were trying to switch back and forth between whatever style fund was going to outperform in the future that might be a different story. It's the idea that somehow these one particular styles of stocks "persistently" outperform that I take issue with.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham
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Re: Profiting from Unprofitable Companies

Post by Jebediah »

If that's all you see then sorry but your observational capacity is lacking. Have a look at the Fama-French data or the Credit Suisse yearbooks or read Asness's Value and Momentum Everywhere. Or ignore the history if you wish, but the data is what it is. We are beyond the question of whether these premia existed and were persistent in the past. The question is whether to expect them to continue in the future.

I wonder how you choose to interpret a chart such as this...


Image
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JoMoney
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Re: Profiting from Unprofitable Companies

Post by JoMoney »

The question should be whether or not a passive investor or mutual fund is able to exploit these "anomalies" or "premiums" or whatever they want to call them. If history is any guide, the fad for the strategy that back-tested so well will lead to disenchanting real-world results.
I think it's actually pretty funny that we barely have a single 20 year period of DFA's Small Value fund, and the chart shows the premium bottoming out.
Image
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Jebediah
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Re: Profiting from Unprofitable Companies

Post by Jebediah »

Yeah that "bottoming out" of DFSVX has been a real nightmare for its disenchanted investors.

20 years to date: growth of 10K, Sharpe Ratio
DFSVX: $106 K , 0.55
VFINX: $61 K , 0.42
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