Factor investing: should financial firms be excluded when screening for value?

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Lauretta
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Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Tue Oct 10, 2017 1:36 pm

I have read a working paper (not available on the web unfortunately) by AlphaArchitect in which they back-tested different value metrics (FCF/TEV, EBIT/TEV, P/E, B/M) to see which works better, and they excluded financials in their tests. I read a piece by a value manager in Europe who also thinks financials should be excluded when using these metrics to find cheap stocks.
So I am now puzzled since the Vanuguard ETF VVAL(which supposedly uses some quantitative screening methods) is actually overweight in financials. (It's an ETF available to European investors - I'm not sure about the Vanguard Value ETF(s) in the US).
Should financials be present or excluded when selecting value stocks using quantitative methods, and why?
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by lack_ey » Tue Oct 10, 2017 2:18 pm

It's mostly a matter of convention.

The traditional academic literature on the value factor does the book-to-market sort—or other metrics—over the market minus financials and utilities. So no financials included on either side (high or low value). The thinking is that particularly with financials these by their nature should typically be highly leveraged. Many are heavily in the business of borrowing money to lend out and make more money. As such they would tend to fall in the value side if included. Because of established convention, it's common for new research to keep with this standard.

In practice, this exclusion doesn't actually tend to change the results and conclusions that much. I suppose ideally you look at the results with and without.

It's common for actual money managers, investable indexes, and index funds to take the broader definition and not exclude financials. After all, it doesn't matter all that much, this way the indexes can partition the market without leaving holes, and people don't have to deal with confused investors wondering where their financials went.

Actually, a lot of practitioners would suggest that you use value screens to pick stocks within sectors, in addition to or perhaps instead of sorting across the whole market or a large subset of it. There may be a benefit there in addition to using value to weight between sectors. As you've noticed, an effective consequence of the typical value sort over the whole market would be sector overweights, like the allocation to financials you found in VVAL.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Tue Oct 10, 2017 2:37 pm

lack_ey wrote:
Tue Oct 10, 2017 2:18 pm
It's mostly a matter of convention.

The traditional academic literature on the value factor does the book-to-market sort—or other metrics—over the market minus financials and utilities. So no financials included on either side (high or low value). The thinking is that particularly with financials these by their nature should typically be highly leveraged. Many are heavily in the business of borrowing money to lend out and make more money. As such they would tend to fall in the value side if included. Because of established convention, it's common for new research to keep with this standard.

In practice, this exclusion doesn't actually tend to change the results and conclusions that much. I suppose ideally you look at the results with and without.

It's common for actual money managers, investable indexes, and index funds to take the broader definition and not exclude financials. After all, it doesn't matter all that much, this way the indexes can partition the market without leaving holes, and people don't have to deal with confused investors wondering where their financials went.

Actually, a lot of practitioners would suggest that you use value screens to pick stocks within sectors, in addition to or perhaps instead of sorting across the whole market or a large subset of it. There may be a benefit there in addition to using value to weight between sectors. As you've noticed, an effective consequence of the typical value sort over the whole market would be sector overweights, like the allocation to financials you found in VVAL.

Thanks for your answer - much appreciated, as always. And yes, the paper I read also excluded utilities, just like you've mentioned above.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by patrick013 » Tue Oct 10, 2017 2:49 pm

Lauretta wrote:
Tue Oct 10, 2017 1:36 pm
Should financials be present or excluded when selecting value stocks using quantitative methods, and why?
Perhaps the index screening has selected banks and financials with very strong
forward estimates. Bank failures have been market problems for centuries.
If they are excluded that's one reason.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nisiprius » Tue Oct 10, 2017 4:00 pm

lack_ey wrote:
Tue Oct 10, 2017 2:18 pm
...The traditional academic literature on the value factor does the book-to-market sort—or other metrics—over the market minus financials and utilities...
I've just looked at Kenneth R. French's website, the page entitled Description of Fama/French Factors, and I do not see either of the words "financials" or "utilities" on that page.

What appears to be a copy of Fama, Eugene F. and Kenneth R. French (1993), Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33 (1993) 3-56, does not contain the word "utility" or "utilities," and the only appearance of the word "financial" or "financials" is in the journal title itself. Their description of how they create the value category is:
Kenneth R. French wrote:We also break NYSE, Amex, and NASDAQ stocks into three book-to- market equity groups based on the breakpoints for the bottom 30% (Lo\c), middle 40% (LCfediurn).and top 30% (High) of the ranked values of BE’.\fE for NYSE stocks. We define book common equity, BE. as the COMPUSTAT book value of stockholders’ equity, plus balance-sheet deferred taxes and investment tax credit (if available), minus the book value of preferred stock. Depending on availability, we use the redemption, liquidation, or par value (in that order) to estimate the value of preferred stock. Book-to-market equity, BE,‘,CfE. is then book common equity for the fiscal year ending in calendar year t - 1, divided by market equity at the end of December oft - 1. We do not use negative-BE firms, which are rare before 1980, when calculating the breakpoints for BE) .bfE or when forming the size-BE$.LfE portfolios. Also. only firms with ordinary common equity (as classified by CRSP) are included in the tests. This means that ADRs, REITs, and units of beneficial interest are excluded.
In other words, they mention exclusions of ADRs, REITs, and units of beneficial interest. I'm not exactly sure what ADRs or units of beneficial interest are. But there is no mention of excluding either financials or utilities.

P.S. And the 2014 Fama-French five-factor model is described here, A Five-Factor Asset Pricing Model, press "Download This Paper" or "Open PDF in Browser." Where in that paper does it say anything about special treatment of financials or utilities?
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Valuethinker » Tue Oct 10, 2017 4:19 pm

nisiprius wrote:
Tue Oct 10, 2017 4:00 pm
lack_ey wrote:
Tue Oct 10, 2017 2:18 pm
...The traditional academic literature on the value factor does the book-to-market sort—or other metrics—over the market minus financials and utilities...
Exactly what traditional academic literature is that? I've just looked at Kenneth R. French's website, the page entitled Description of Fama/French Factors, and I do not see either of the words "financials" or "utilities" on that page.

What appears to be a copy of Fama, Eugene F. and Kenneth R. French (1993), Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33 (1993) 3-56, does not contain the word "utility" or "utilities," and the only appearance of the word "financial" or "financials" is in the journal title itself. Their description of how they create the value category is:
Kenneth R. French wrote:We also break NYSE, Amex, and NASDAQ stocks into three book-to- market equity groups based on the breakpoints for the bottom 30% (Lo\c), middle 40% (LCfediurn).and top 30% (High) of the ranked values of BE’.\fE for NYSE stocks. We define book common equity, BE. as the COMPUSTAT book value of stockholders’ equity, plus balance-sheet deferred taxes and investment tax credit (if available), minus the book value of preferred stock. Depending on availability, we use the redemption, liquidation, or par value (in that order) to estimate the value of preferred stock. Book-to-market equity, BE,‘,CfE. is then book common equity for the fiscal year ending in calendar year t - 1, divided by market equity at the end of December oft - 1. We do not use negative-BE firms, which are rare before 1980, when calculating the breakpoints for BE) .bfE or when forming the size-BE$.LfE portfolios. Also. only firms with ordinary common equity (as classified by CRSP) are included in the tests. This means that ADRs, REITs, and units of beneficial interest are excluded.
In other words, they mention exclusions of ADRs, REITs, and units of beneficial interest. I'm not exactly sure what ADRs or units of beneficial interst are. But there is no mention of excluding either financials or utilities.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Tue Oct 10, 2017 5:03 pm

Lauretta wrote:
Tue Oct 10, 2017 1:36 pm
I have read a working paper (not available on the web unfortunately) by AlphaArchitect in which they back-tested different value metrics (FCF/TEV, EBIT/TEV, P/E, B/M) to see which works better, and they excluded financials in their tests. I read a piece by a value manager in Europe who also thinks financials should be excluded when using these metrics to find cheap stocks.
So I am now puzzled since the Vanuguard ETF VVAL(which supposedly uses some quantitative screening methods) is actually overweight in financials. (It's an ETF available to European investors - I'm not sure about the Vanguard Value ETF(s) in the US).
Should financials be present or excluded when selecting value stocks using quantitative methods, and why?
I don't believe that financial stocks should be excluded from the Value screens. Indeed, these have been a fertile area of investment for me. These have been a favorite of Value oriented investors like Buffett, Lynch, Davis, and others because they tend to have lower P/E ratios compared to their growth rates than other industries. The Davis family including Shelby and son Chris made their fortune in the money management business in part because of their success with financial stocks.

I have owned different financial stocks over the years and only got burned once, AIG got caught up in the 2008-2009 financial crisis, my share count got greatly reduced after the Uncle Sam bailout. I made good money from Fannie Mae and sold that before it cratered, in part because I knew that Warren Buffett had sold Freddie Mac. I owned banks, insurance companies, and even a bond insurer.

The Value funds got pummeled hard in the 2008-2009 bear market because many of them were loaded up with financial stocks which appeared cheap but had unforeseen risks.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Tue Oct 10, 2017 5:24 pm

nedsaid wrote:
Tue Oct 10, 2017 5:03 pm
Lauretta wrote:
Tue Oct 10, 2017 1:36 pm
I have read a working paper (not available on the web unfortunately) by AlphaArchitect in which they back-tested different value metrics (FCF/TEV, EBIT/TEV, P/E, B/M) to see which works better, and they excluded financials in their tests. I read a piece by a value manager in Europe who also thinks financials should be excluded when using these metrics to find cheap stocks.
So I am now puzzled since the Vanuguard ETF VVAL(which supposedly uses some quantitative screening methods) is actually overweight in financials. (It's an ETF available to European investors - I'm not sure about the Vanguard Value ETF(s) in the US).
Should financials be present or excluded when selecting value stocks using quantitative methods, and why?
I don't believe that financial stocks should be excluded from the Value screens. Indeed, these have been a fertile area of investment for me. These have been a favorite of Value oriented investors like Buffett, Lynch, Davis, and others because they tend to have lower P/E ratios compared to their growth rates than other industries. The Davis family including Shelby and son Chris made their fortune in the money management business in part because of their success with financial stocks.

I have owned different financial stocks over the years and only got burned once, AIG got caught up in the 2008-2009 financial crisis, my share count got greatly reduced after the Uncle Sam bailout. I made good money from Fannie Mae and sold that before it cratered, in part because I knew that Warren Buffett had sold Freddie Mac. I owned banks, insurance companies, and even a bond insurer.

The Value funds got pummeled hard in the 2008-2009 bear market because many of them were loaded up with financial stocks which appeared cheap but had unforeseen risks.
Thanks for the feedback. I remember reading about Fannie Mae also in a book by Peter Lynch.
In Europe there's a very small active fund (AUM=20M-mostly the manager's own money as far as I understood) investing in US small and microcaps, which has more than 50% invested in financials. It has recently managed to beat the Russell 2000 - whilst the manager is apparently running a café at the same time(!)...
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by lack_ey » Tue Oct 10, 2017 6:06 pm

nisiprius wrote:
Tue Oct 10, 2017 4:00 pm
lack_ey wrote:
Tue Oct 10, 2017 2:18 pm
...The traditional academic literature on the value factor does the book-to-market sort—or other metrics—over the market minus financials and utilities...
I've just looked at Kenneth R. French's website, the page entitled Description of Fama/French Factors, and I do not see either of the words "financials" or "utilities" on that page.

What appears to be a copy of Fama, Eugene F. and Kenneth R. French (1993), Common risk factors in the returns on stocks and bonds, Journal of Financial Economics 33 (1993) 3-56, does not contain the word "utility" or "utilities," and the only appearance of the word "financial" or "financials" is in the journal title itself. Their description of how they create the value category is:
Kenneth R. French wrote:We also break NYSE, Amex, and NASDAQ stocks into three book-to- market equity groups based on the breakpoints for the bottom 30% (Lo\c), middle 40% (LCfediurn).and top 30% (High) of the ranked values of BE’.\fE for NYSE stocks. We define book common equity, BE. as the COMPUSTAT book value of stockholders’ equity, plus balance-sheet deferred taxes and investment tax credit (if available), minus the book value of preferred stock. Depending on availability, we use the redemption, liquidation, or par value (in that order) to estimate the value of preferred stock. Book-to-market equity, BE,‘,CfE. is then book common equity for the fiscal year ending in calendar year t - 1, divided by market equity at the end of December oft - 1. We do not use negative-BE firms, which are rare before 1980, when calculating the breakpoints for BE) .bfE or when forming the size-BE$.LfE portfolios. Also. only firms with ordinary common equity (as classified by CRSP) are included in the tests. This means that ADRs, REITs, and units of beneficial interest are excluded.
In other words, they mention exclusions of ADRs, REITs, and units of beneficial interest. I'm not exactly sure what ADRs or units of beneficial interest are. But there is no mention of excluding either financials or utilities.

P.S. And the 2014 Fama-French five-factor model is described here, A Five-Factor Asset Pricing Model, press "Download This Paper" or "Open PDF in Browser." Where in that paper does it say anything about special treatment of financials or utilities?
Check for example their "The Cross-Section of Expected Stock Returns" (1992) where the beginning of the data section (1-A) says "We use all nonfinancial firms..."

A number of papers like "Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?" several years later have lines like " We exclude utilities from the tests to avoid the criticism that their dividend decisions are a byproduct of regulation. We also exclude financial firms."

A lot of times financials are excluded but not utilities (I don't think I've seen the reverse). Sometimes both. Sometimes neither.

If you look around at alphaarchitect (Wes Grey), you see this rationale is given explicitly.
https://alphaarchitect.com/2013/11/25/w ... e-studies/

It's not just Wes Grey. For example, the well-cited "Value and Momentum Everywhere" (2013) by Asness and co. at AQR exludes "ADRs, REITs, financials [emphasis added], closed-end funds, foreign shares, and stocks with share prices less than $1 at the beginning of each month" and less-liquid stocks. Though that's from a former Fama student.

Maybe they're not excluded in the more recent Fama-French papers, and aren't in a lot of papers. I guess it's a bit less prevalent than I thought, but it's certainly a thing.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by stlutz » Tue Oct 10, 2017 6:30 pm

The underlying reason for the exclusion is not something nefarious but simply because the financial statements of banks, other financial firms, utilities, and "industrial" (i.e. everyone else) companies simply look different from one another. And key for the academic researchers using Compustat is that different items are available in that database depending upon what type of company it is.

Obviously one can compare P/Es between a bank and a technology company. But once you start introducing concepts like "Cost of Goods Sold", "Tangible Book Value", "Capital Expenditures", or "Interest Income", suddenly you can only do your calculation for some firms. If you are going to compare the performance of metric X vs. metric Y, you need to calculate them using the same population of companies else your results are inconsistent.

In historical backtesting, valuation metrics hold up both across the market and within industries (i.e. low PE banks outperform as do low PE consumer staples companies). Backtesting has issues that create questions about the results, particularly that done by academics. But excluding financials and utilities is a feature and not a bug in my view.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Tue Oct 10, 2017 7:39 pm

stlutz wrote:
Tue Oct 10, 2017 6:30 pm
The underlying reason for the exclusion is not something nefarious but simply because the financial statements of banks, other financial firms, utilities, and "industrial" (i.e. everyone else) companies simply look different from one another. And key for the academic researchers using Compustat is that different items are available in that database depending upon what type of company it is.

Obviously one can compare P/Es between a bank and a technology company. But once you start introducing concepts like "Cost of Goods Sold", "Tangible Book Value", "Capital Expenditures", or "Interest Income", suddenly you can only do your calculation for some firms. If you are going to compare the performance of metric X vs. metric Y, you need to calculate them using the same population of companies else your results are inconsistent.

In historical backtesting, valuation metrics hold up both across the market and within industries (i.e. low PE banks outperform as do low PE consumer staples companies). Backtesting has issues that create questions about the results, particularly that done by academics. But excluding financials and utilities is a feature and not a bug in my view.
Good point about comparability. US Bancorp is considered to be a financially strong bank, its balance sheet is 10% equity and 90% liabilities. But that is just looking at what the accountants say that US Bank is worth about $48 billion but the market values it at $90 billion. US Bank has a trailing P/E of about 16. Trailing P/E is based on historical earnings.

JP Morgan has a balance sheet of about 10% equity and 90% liabilities. JP Morgan has a book value (accountants) $254 billion of but a market capitalization of $339 billion. JP Morgan has a trailing P/E of 14.

Coke's balance sheet is 26% equity and 74% liabilities, a lot of debt but Coke has a lot of cash flow. The accountants say that Coke is worth $23 billion but the market says it is worth $194 billion. Coke has a trailing P/E of 48.

Microsoft's balance sheet is 30% equity and 70% liabilities. The accountants say Microsoft is worth $72 billion but the market cap is $588 billion. Microsoft trades at a trailing P/E of 28.

Exxon's balance sheet is 53% equity and 47% liabilities. The accountants say that Exxon is worth
$174 billion but the market cap is $348 billion. Exxon trades at a trailing P/E of 30.

So you can see that banks are comparably more leveraged, probably one reason they tend to have lower P/E ratios than the rest of the market. I calculated this taking into account the accounting equation of assets = liabilities + capital. I take shareholders equity (capital) and divide it by assets. You can also see that US Bank trades at not quite 2 times book value whereas Coke trades at over 8 times book and Microsoft also trades at about 7 times book. Exxon trades at about 2 times book value. JP Morgan is comparably cheap trading at Price to book of 1.35.

On the other hand, banks and other financial institutions are pretty highly regulated.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by patrick013 » Tue Oct 10, 2017 8:06 pm

nedsaid wrote:
Tue Oct 10, 2017 7:39 pm
Good point about comparability. US Bancorp is considered to be a financially strong bank, its balance sheet is 10% equity and 90% liabilities. But that is just looking at what the accountants say that US Bank is worth about $48 billion but the market values it at $90 billion. US Bank has a trailing P/E of about 16. Trailing P/E is based on historical earnings.
Nothing wrong with those figures. $48 billion is best described in one sentence
as liquidation value. Adjustment could be made for appraised or replacement
cost of some hard assets but in a discontinuing operation maybe not realizable.
Probably as high a PE as it's worth in it's industry considering risks. If 10% of
it's loan customers started defaulting every year could linked assets be sold to
breakeven on those loans ? Maybe, maybe not.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Tue Oct 10, 2017 8:07 pm

Lauretta wrote:
Tue Oct 10, 2017 5:24 pm
nedsaid wrote:
Tue Oct 10, 2017 5:03 pm
Lauretta wrote:
Tue Oct 10, 2017 1:36 pm
I have read a working paper (not available on the web unfortunately) by AlphaArchitect in which they back-tested different value metrics (FCF/TEV, EBIT/TEV, P/E, B/M) to see which works better, and they excluded financials in their tests. I read a piece by a value manager in Europe who also thinks financials should be excluded when using these metrics to find cheap stocks.
So I am now puzzled since the Vanuguard ETF VVAL(which supposedly uses some quantitative screening methods) is actually overweight in financials. (It's an ETF available to European investors - I'm not sure about the Vanguard Value ETF(s) in the US).
Should financials be present or excluded when selecting value stocks using quantitative methods, and why?
I don't believe that financial stocks should be excluded from the Value screens. Indeed, these have been a fertile area of investment for me. These have been a favorite of Value oriented investors like Buffett, Lynch, Davis, and others because they tend to have lower P/E ratios compared to their growth rates than other industries. The Davis family including Shelby and son Chris made their fortune in the money management business in part because of their success with financial stocks.

I have owned different financial stocks over the years and only got burned once, AIG got caught up in the 2008-2009 financial crisis, my share count got greatly reduced after the Uncle Sam bailout. I made good money from Fannie Mae and sold that before it cratered, in part because I knew that Warren Buffett had sold Freddie Mac. I owned banks, insurance companies, and even a bond insurer.

The Value funds got pummeled hard in the 2008-2009 bear market because many of them were loaded up with financial stocks which appeared cheap but had unforeseen risks.
Thanks for the feedback. I remember reading about Fannie Mae also in a book by Peter Lynch.
In Europe there's a very small active fund (AUM=20M-mostly the manager's own money as far as I understood) investing in US small and microcaps, which has more than 50% invested in financials. It has recently managed to beat the Russell 2000 - whilst the manager is apparently running a café at the same time(!)...
Lauretta, keep in mind there is more risk in financial stocks than what is generally perceived by investors. That is one reason they are priced cheaper. Think of AIG and its debacle with credit default swaps, in effect insuring bonds. The largest Savings and Loan in the United States, Washington Mutual, went under during the 2008-2009 financial crisis as did investment bank Lehman Brothers. Also think of the trillions of derivatives that are out there doing heaven knows what. Also see my analysis above comparing US Bank, JP Morgan, Coke, Microsoft, and Exxon-Mobil. These are all stocks I own individually myself. It gives you some insight as to how banks are priced.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Tue Oct 10, 2017 8:11 pm

patrick013 wrote:
Tue Oct 10, 2017 8:06 pm
nedsaid wrote:
Tue Oct 10, 2017 7:39 pm
Good point about comparability. US Bancorp is considered to be a financially strong bank, its balance sheet is 10% equity and 90% liabilities. But that is just looking at what the accountants say that US Bank is worth about $48 billion but the market values it at $90 billion. US Bank has a trailing P/E of about 16. Trailing P/E is based on historical earnings.
Nothing wrong with those figures. $48 billion is best described in one sentence
as liquidation value. Adjustment could be made for appraised or replacement
cost of some hard assets but in a discontinuing operation maybe not realizable.
Probably as high a PE as it's worth in it's industry considering risks. If 10% of
it's loan customers started defaulting every year could linked assets be sold to
breakeven on those loans ? Maybe, maybe not.
Business have an additional "going concern" value. It is sort of like Newton's laws of motion. What
is in motion tends to stay in motion. They have established brands, loyal customers, competitive
advantages. These and other things like intellectual property are difficult for accountants to measure which is why you see a big difference between what in theory is liquidation value and the value put on a company by the stock market. In other words, a business is worth more than the sum total of its assets but intangible things like quality of management and workforce are hard to put a price on.

Generally Accepted Accounting Standards (GAAP) is supposed to account for impairment of assets, so if those 10% of loans start defaulting, the accountants are supposed to write them down to their impaired value.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by patrick013 » Tue Oct 10, 2017 8:27 pm

nedsaid wrote:
Tue Oct 10, 2017 8:11 pm
These and other things like intellectual property are difficult for accountants to measure which is why you see a big difference between what in theory is liquidation value and the value put on a company by the stock market. In other words, a business is worth more than the sum total of its assets but intangible things like quality of management and workforce are hard to put a price on.
I'm not a follower of banks but in this case there's just a financial return over
expected defaults. I see no patents, research, or brand value. Just market
price over fully diluted EPS or production value. It's a bank collecting margins
primarily on loans as most banks do. Been an accountant for too many years
BTW. But, yeah, low quality loans could be a sign of management and vice-versa
but not so much as a brand-centric product but rather an average run bank in the
loan market.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by alex_686 » Tue Oct 10, 2017 8:30 pm

nedsaid wrote:
Tue Oct 10, 2017 8:11 pm
Business have an additional "going concern" value. It is sort of like Newton's laws of motion. What
is in motion tends to stay in motion. They have established brands, loyal customers, competitive
advantages. These and other things like intellectual property are difficult for accountants to measure which is why you see a big difference between what in theory is liquidation value and the value put on a company by the stock market. In other words, a business is worth more than the sum total of its assets but intangible things like quality of management and workforce are hard to put a price on.
This is all true but I want to extend a bit. Different business work different ways. Coca Cola and Apple need little in the way of physical plant to work, so their book value. Industrialist tend to have lots of physical plant to work with so they have a higher book value. There is a smooth continuum. Except for banks and utilities. They are off in their own little cluster. For a bank every loan they hold is part of their book value. It's like trying to figure out the average age in a kindergarten class and including the teacher. You are going to have a bunch of 4 and 5 year old and 1 50 year old. Nonsense results. For the maths to work you need to treat the outlier group differently.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by jalbert » Tue Oct 10, 2017 10:17 pm

I think DFA screens out REITs and utilities, but includes financials. I think Vanguard value indices just apply a value metric to the entire market (within the cap limits of the particular index). S&P Small-cap indices (value or otherwise) have profitability and liquidity screens, but do not exclude financials (or REITs or utilities).

You can look at the portfolios of VBR, IJS, and DFSVX on Morningstar.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Wed Oct 11, 2017 3:55 am

nedsaid wrote:
Tue Oct 10, 2017 7:39 pm
stlutz wrote:
Tue Oct 10, 2017 6:30 pm
The underlying reason for the exclusion is not something nefarious but simply because the financial statements of banks, other financial firms, utilities, and "industrial" (i.e. everyone else) companies simply look different from one another. And key for the academic researchers using Compustat is that different items are available in that database depending upon what type of company it is.

Obviously one can compare P/Es between a bank and a technology company. But once you start introducing concepts like "Cost of Goods Sold", "Tangible Book Value", "Capital Expenditures", or "Interest Income", suddenly you can only do your calculation for some firms. If you are going to compare the performance of metric X vs. metric Y, you need to calculate them using the same population of companies else your results are inconsistent.

In historical backtesting, valuation metrics hold up both across the market and within industries (i.e. low PE banks outperform as do low PE consumer staples companies). Backtesting has issues that create questions about the results, particularly that done by academics. But excluding financials and utilities is a feature and not a bug in my view.
Good point about comparability. US Bancorp is considered to be a financially strong bank, its balance sheet is 10% equity and 90% liabilities. But that is just looking at what the accountants say that US Bank is worth about $48 billion but the market values it at $90 billion. US Bank has a trailing P/E of about 16. Trailing P/E is based on historical earnings.

JP Morgan has a balance sheet of about 10% equity and 90% liabilities. JP Morgan has a book value (accountants) $254 billion of but a market capitalization of $339 billion. JP Morgan has a trailing P/E of 14.

Coke's balance sheet is 26% equity and 74% liabilities, a lot of debt but Coke has a lot of cash flow. The accountants say that Coke is worth $23 billion but the market says it is worth $194 billion. Coke has a trailing P/E of 48.

Microsoft's balance sheet is 30% equity and 70% liabilities. The accountants say Microsoft is worth $72 billion but the market cap is $588 billion. Microsoft trades at a trailing P/E of 28.

Exxon's balance sheet is 53% equity and 47% liabilities. The accountants say that Exxon is worth
$174 billion but the market cap is $348 billion. Exxon trades at a trailing P/E of 30.

So you can see that banks are comparably more leveraged, probably one reason they tend to have lower P/E ratios than the rest of the market. I calculated this taking into account the accounting equation of assets = liabilities + capital. I take shareholders equity (capital) and divide it by assets. You can also see that US Bank trades at not quite 2 times book value whereas Coke trades at over 8 times book and Microsoft also trades at about 7 times book. Exxon trades at about 2 times book value. JP Morgan is comparably cheap trading at Price to book of 1.35.

On the other hand, banks and other financial institutions are pretty highly regulated.
Thanks nedsaid! This has given me the opportunity to look up some balance sheets - something I am begining to teach mysef to read. Please excuse me if I say something silly - I am a complete beginner in this - I just wanted to confirm one thing: are 'book value' and 'stockholders equity' the same? One uses the former in the B/M ratio and the latter for ROE, but aren't they basically the same quantity? Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Finally, since you are investing in financials, I was wondering whether you had come across Paragon Commercial Corp and FS Bancorp Inc? They make up respectively nearly ~10% and 8% of the small cap fund I mentioned yesterday, which seems to me a very concentrated bet on these two banks!
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by alex_686 » Wed Oct 11, 2017 9:40 am

Lauretta wrote:
Wed Oct 11, 2017 3:55 am
Thanks nedsaid! This has given me the opportunity to look up some balance sheets - something I am begining to teach mysef to read. Please excuse me if I say something silly - I am a complete beginner in this - I just wanted to confirm one thing: are 'book value' and 'stockholders equity' the same? One uses the former in the B/M ratio and the latter for ROE, but aren't they basically the same quantity? Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Very different.

Equity = Assets - Liabilities.

Book value is part of assets but there are other things that fall into assets. I can't think of any good non-technical books on the subject - they run towards accounting text or other technical items. One exception might be Howard Mark Schilit's Financial Shenanigans.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Wed Oct 11, 2017 10:22 am

alex_686 wrote:
Wed Oct 11, 2017 9:40 am
Lauretta wrote:
Wed Oct 11, 2017 3:55 am
Thanks nedsaid! This has given me the opportunity to look up some balance sheets - something I am begining to teach mysef to read. Please excuse me if I say something silly - I am a complete beginner in this - I just wanted to confirm one thing: are 'book value' and 'stockholders equity' the same? One uses the former in the B/M ratio and the latter for ROE, but aren't they basically the same quantity? Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Very different.

Equity = Assets - Liabilities.

Book value is part of assets but there are other things that fall into assets. I can't think of any good non-technical books on the subject - they run towards accounting text or other technical items. One exception might be Howard Mark Schilit's Financial Shenanigans.
Thanks, I really enjoy reading Howard Marks' letters so I'll try that. But according to Investopedia,
Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
So according to this definition, it's the same as how you define Equity, except for the intangible assets bit.
http://www.investopedia.com/terms/b/bookvalue.asp
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by alex_686 » Wed Oct 11, 2017 12:40 pm

Lauretta wrote:
Wed Oct 11, 2017 10:22 am
Thanks, I really enjoy reading Howard Marks' letters so I'll try that. But according to Investopedia,
Book value is also the net asset value of a company, calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
So according to this definition, it's the same as how you define Equity, except for the intangible assets bit.
http://www.investopedia.com/terms/b/bookvalue.asp
One last thought. There is a difference between your equity and the company's equity.

A company's equity's is basically a plug number, Assets-liabilities. Assets are a accounting principle, not a economic principle. Book value is what the company is worth if it had a big garage sale / fire sale and sold itself for scrape.

You equity is tied to the market capitalization of the company. That can be, and should be, worth many times the level of the accounting equity. The sum should be more than just its parts.

But different companies are structured different way. For most companies, assets are "marketed to book". You buy a asset and you deprecate that asset over a fixed life. A building will thus fall in value on the books even if you think it has appreciated. Banks are different. Most of their assets are "marked to market". If you hold government bonds and they have gone up in value (because rates have fallen) they you mark the asset price higher. Because of this banks tend to have very high book values - they can and do mark their assets higher for accounting purposes.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Wed Oct 11, 2017 12:43 pm

patrick013 wrote:
Tue Oct 10, 2017 8:27 pm
nedsaid wrote:
Tue Oct 10, 2017 8:11 pm
These and other things like intellectual property are difficult for accountants to measure which is why you see a big difference between what in theory is liquidation value and the value put on a company by the stock market. In other words, a business is worth more than the sum total of its assets but intangible things like quality of management and workforce are hard to put a price on.
I'm not a follower of banks but in this case there's just a financial return over
expected defaults. I see no patents, research, or brand value. Just market
price over fully diluted EPS or production value. It's a bank collecting margins
primarily on loans as most banks do. Been an accountant for too many years
BTW. But, yeah, low quality loans could be a sign of management and vice-versa
but not so much as a brand-centric product but rather an average run bank in the
loan market.
What I was trying to show in my examples is that companies and industries are different. In the case of
banks, they have more leveraged balance sheets and tend to trade at lower P/E ratios compared to earnings
growth rates. I was also making a point about "enterprise value" or "going concern value" that the accountants can't capture. But yes, stocks trade mostly on a multiple of their earnings. Stocks with higher and steadier growth rates command higher multiples, nirvana is earnings that grow faster than the economy and growth that is steady and predictable.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Wed Oct 11, 2017 1:01 pm

alex_686 wrote:
Tue Oct 10, 2017 8:30 pm
nedsaid wrote:
Tue Oct 10, 2017 8:11 pm
Business have an additional "going concern" value. It is sort of like Newton's laws of motion. What
is in motion tends to stay in motion. They have established brands, loyal customers, competitive
advantages. These and other things like intellectual property are difficult for accountants to measure which is why you see a big difference between what in theory is liquidation value and the value put on a company by the stock market. In other words, a business is worth more than the sum total of its assets but intangible things like quality of management and workforce are hard to put a price on.
This is all true but I want to extend a bit. Different business work different ways. Coca Cola and Apple need little in the way of physical plant to work, so their book value. Industrialist tend to have lots of physical plant to work with so they have a higher book value. There is a smooth continuum. Except for banks and utilities. They are off in their own little cluster. For a bank every loan they hold is part of their book value. It's like trying to figure out the average age in a kindergarten class and including the teacher. You are going to have a bunch of 4 and 5 year old and 1 50 year old. Nonsense results. For the maths to work you need to treat the outlier group differently.
Yes, I have made this point many times. I have posted a lot about Microsoft, which from memory has a book value of about $9 a share and last I looked was $75 a share. Most of the value of Microsoft is the value of its franchises like Microsoft Office and WIndows, the value of its intellectual property, its valued employees, and the going concern value of the company itself. In business, there is a certain momentum, what is in motion tends to stay in motion. Book value, in my opinion, isn't too meaningful for a company like Microsoft.

As far as Coke, I guess it depends on whether it owns its bottlers or not. That seems to be an on again, off again proposition. Last I checked, Coke was franchising its bottlers.

So if you really wanted to be a stock analyst, you would want to compare numbers not only against the stock market itself but also against the numbers within its industry. Each industry is different. So yes, a Software company would be much different than an industrial company like General Electric. Some industries, like utilities, are very capital intensive and others are not.

As far as the point whether or not financials should be excluded from Value screens, what I would say is that a skilled Value manager should take into consideration differences between industries. The thing is, successful value oriented managers like the Davis family, Warren Buffett, Peter Lynch, and others have made a mint on financial companies. You could develop a Value screen and apply it across all industries, I just think you can do better than that. You have to compare a stock against the benchmarks for its industry. This might be one criticism of the DFA approach to Value. Too bad Larry Swedroe isn't around to comment on this. Packer16 often shows up in the Value threads and it would be fun to hear from him on this topic.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by patrick013 » Wed Oct 11, 2017 1:09 pm

Lauretta wrote:
Wed Oct 11, 2017 3:55 am
Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Something about financial ratios would be a good start. Within an industry there
are averages. Quick ratio all the way to return on equity. The PE Method is always
used with almost complete disregard for balance sheet ratios. But a company
with extra high debt\equity ratio will have a slightly lower PE and a company with
low cash and working capital will have a lower PE. Ryder Trucking usually has 90%
debt so it rarely has a PE more than the mid teens. So industry averages about
certain financial ratios is important. The Altman Z-Score is worth calculating.

But don't dwell on the fact of differences of accounting balances on a balance
sheet with the equity value of production calc'd by the PE Method for a company in
no danger of becoming bankrupt. The former are historical cost placements
including capitalized costs of some intangibles (cost of developing a patent) while
the latter is a financial market estimate of future production return and value of the
company, all things considered.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by patrick013 » Wed Oct 11, 2017 1:16 pm

nedsaid wrote:
Wed Oct 11, 2017 12:43 pm
I was also making a point about "enterprise value" or "going concern value" that the accountants can't capture.
Not their job anyway, just provide information for decision making. Rating,
ranking, and pricing companies in the market is for buyers and sellers.
Current account balances is all they need to provide, and do provide, so the
analysts can do their thing. :)
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Wed Oct 11, 2017 1:24 pm

Lauretta wrote:
Wed Oct 11, 2017 3:55 am

Thanks nedsaid! This has given me the opportunity to look up some balance sheets - something I am begining to teach mysef to read. Please excuse me if I say something silly - I am a complete beginner in this - I just wanted to confirm one thing: are 'book value' and 'stockholders equity' the same? One uses the former in the B/M ratio and the latter for ROE, but aren't they basically the same quantity? Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Finally, since you are investing in financials, I was wondering whether you had come across Paragon Commercial Corp and FS Bancorp Inc? They make up respectively nearly ~10% and 8% of the small cap fund I mentioned yesterday, which seems to me a very concentrated bet on these two banks!
Book value and stockholders equity on a balance sheet are pretty much the same. Book value is often expressed on a per share basis. For example, Microsoft has a book value of about $9 a share. So all these numbers I am talking about here are provided by the accountants and you can see them on the financial statements.

Book to market and return on equity are two different things.

Book to market = book value of firm/market value of firm. It is a percentage of the book value of a firm compared to its market value. So for Microsoft, you have $9 book value per share/$75 stock price = 0.12 or 12%. Another way of saying this is that market price is 8.33 times book value.

Return on Equity = Net Income/Shareholders Equity. So again with Microsoft, you have earnings per share of
$2.70 and book value of $9.00 per share giving you a return on equity of 30%. Pretty much, this is earnings compared to shareholder investment. If you got $30 dollars of earnings for every $100 you invested each year, I would say you have a very good investment.

I can't speak to the two stocks you have asked about, if you have the ticker symbols you could look up the financials at places like Morningstar, Marketwatch, and Yahoo Finance.
Last edited by nedsaid on Wed Oct 11, 2017 1:28 pm, edited 1 time in total.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Wed Oct 11, 2017 1:26 pm

patrick013 wrote:
Wed Oct 11, 2017 1:16 pm
nedsaid wrote:
Wed Oct 11, 2017 12:43 pm
I was also making a point about "enterprise value" or "going concern value" that the accountants can't capture.
Not their job anyway, just provide information for decision making. Rating,
ranking, and pricing companies in the market is for buyers and sellers.
Current account balances is all they need to provide, and do provide, so the
analysts can do their thing. :)
You are right. I am trying to show the limitations of accounting. This also gives insight as to how firms are
valued on Wall Street.
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by nedsaid » Wed Oct 11, 2017 1:42 pm

patrick013 wrote:
Wed Oct 11, 2017 1:09 pm
Lauretta wrote:
Wed Oct 11, 2017 3:55 am
Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Something about financial ratios would be a good start. Within an industry there
are averages. Quick ratio all the way to return on equity. The PE Method is always
used with almost complete disregard for balance sheet ratios. But a company
with extra high debt\equity ratio will have a slightly lower PE and a company with
low cash and working capital will have a lower PE. Ryder Trucking usually has 90%
debt so it rarely has a PE more than the mid teens. So industry averages about
certain financial ratios is important. The Altman Z-Score is worth calculating.

But don't dwell on the fact of differences of accounting balances on a balance
sheet with the equity value of production calc'd by the PE Method for a company in
no danger of becoming bankrupt. The former are historical cost placements
including capitalized costs of some intangibles (cost of developing a patent) while
the latter is a financial market estimate of future production return and value of the
company, all things considered.
A couple of points, Patrick says that high debt tends towards lower P/E ratios, a good example would be utility companies. On the other hand, companies with high levels of cash tend towards higher P/E ratios.

Another point in analyzing financial ratios is liquidity. Current assets or liquid assets are things like cash,
short term investments, inventory, and accounts receivable. Stuff that turns over in less than a year. Current (short term) liabilities are debts that are due in less than a year. A good sign for a company is that it has more current assets than current liabilities. It means the company can pay its bills.

The thing is, a company can have plenty of assets but low liquidity, such a company can get caught in the classic cash squeeze. My understanding is that AIG had plenty of assets to cover its guarantees on bonds that defaulted during the 2008-2009 financial crisis but not enough cash. Some assets are harder to sell in a crunch and thus less liquid. So if you have a big plot of land for further expansion, during a financial panic you may not be able to sell it to raise cash, if you do sell it, it will be at a hugely discounting price. So it goes back to the old saying that cash is king. AIG got a bailout from Uncle Sam. Warren Buffett bailed out Goldman Sachs, General Electric, and to a lesser degree Bank of America.

So this is another wrinkle to analyzing companies. You are on your way to being a stock analyst!
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Wed Oct 11, 2017 2:47 pm

nedsaid wrote:
Wed Oct 11, 2017 1:24 pm
Lauretta wrote:
Wed Oct 11, 2017 3:55 am

Thanks nedsaid! This has given me the opportunity to look up some balance sheets - something I am begining to teach mysef to read. Please excuse me if I say something silly - I am a complete beginner in this - I just wanted to confirm one thing: are 'book value' and 'stockholders equity' the same? One uses the former in the B/M ratio and the latter for ROE, but aren't they basically the same quantity? Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Finally, since you are investing in financials, I was wondering whether you had come across Paragon Commercial Corp and FS Bancorp Inc? They make up respectively nearly ~10% and 8% of the small cap fund I mentioned yesterday, which seems to me a very concentrated bet on these two banks!
Book value and stockholders equity on a balance sheet are pretty much the same. Book value is often expressed on a per share basis. For example, Microsoft has a book value of about $9 a share. So all these numbers I am talking about here are provided by the accountants and you can see them on the financial statements.

Book to market and return on equity are two different things.

Book to market = book value of firm/market value of firm. It is a percentage of the book value of a firm compared to its market value. So for Microsoft, you have $9 book value per share/$75 stock price = 0.12 or 12%. Another way of saying this is that market price is 8.33 times book value.

Return on Equity = Net Income/Shareholders Equity. So again with Microsoft, you have earnings per share of
$2.70 and book value of $9.00 per share giving you a return on equity of 30%. Pretty much, this is earnings compared to shareholder investment. If you got $30 dollars of earnings for every $100 you invested each year, I would say you have a very good investment.

I can't speak to the two stocks you have asked about, if you have the ticker symbols you could look up the financials at places like Morningstar, Marketwatch, and Yahoo Finance.
Thanks again nedsaid; yes of course I understood that B/M and ROE are completely different, its just that book value and shareholders equity seemed the same and they are used respectively in those ratios. So in fact, unless I am mistaken, if you multiply the two you should get the inverse of the PE ratio...I mean (B/M)x(ROE)=1/(PEratio) Meaning that a low PE ratio can reflect cheap and good quality stocks. Makes sense? :confused
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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Valuethinker » Wed Oct 11, 2017 3:52 pm

alex_686 wrote:
Wed Oct 11, 2017 9:40 am
Lauretta wrote:
Wed Oct 11, 2017 3:55 am
Thanks nedsaid! This has given me the opportunity to look up some balance sheets - something I am begining to teach mysef to read. Please excuse me if I say something silly - I am a complete beginner in this - I just wanted to confirm one thing: are 'book value' and 'stockholders equity' the same? One uses the former in the B/M ratio and the latter for ROE, but aren't they basically the same quantity? Perhaps a follow-up question would be: is there a good book or video or whatever to learn about balance sheets and financial statements in general?
Very different.

Equity = Assets - Liabilities.

Book value is part of assets but there are other things that fall into assets. I can't think of any good non-technical books on the subject - they run towards accounting text or other technical items. One exception might be Howard Mark Schilit's Financial Shenanigans.
I am very confused.

IFRS net asset value = assets - liabilities = Shareholders Funds

Us GAAP stockholders equity = assets - liabilities = book value?

Your book value is my net asset value?

The reason book works in stock valuation is that it is the hardest number to lie about. Also basically the most conservative number in accounting due to the application of the Prudence Principle to asset valuation (lower of historic cost or written down value). Also very high price to book stocks tend to be significantly overvalued. Otherwise book value tends to rapidly catch up due to accumulation of detailed earnings.

The accounting research says that high balance sheet accruals is the best signal of accounting funnies going on.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by alex_686 » Wed Oct 11, 2017 4:11 pm

Valuethinker wrote:
Wed Oct 11, 2017 3:52 pm
I am very confused.
Sorry to confuse you - All I was trying to say was that: book value +/- adjustments = assets

I would take the opposite side if book value is important. It can be manipulated. For some industries, like banking, it is a important measure. For others it less important. The predictive value of book value has been falling. We are moving from industries that have lots of assets that can easily be counted to industries with more intangibles.

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Re: Factor investing: should financial firms be excluded when screening for value?

Post by Lauretta » Fri Oct 13, 2017 1:59 pm

alex_686 wrote:
Wed Oct 11, 2017 4:11 pm
Valuethinker wrote:
Wed Oct 11, 2017 3:52 pm
I am very confused.
Sorry to confuse you - All I was trying to say was that: book value +/- adjustments = assets

I would take the opposite side if book value is important. It can be manipulated. For some industries, like banking, it is a important measure. For others it less important. The predictive value of book value has been falling. We are moving from industries that have lots of assets that can easily be counted to industries with more intangibles.
alex thanks for your input! - including the one above on financials; I have begun making some sense of balance sheets and it's becoming quite fun now that I begin to see how the different quantities and ratios are related to each other. :happy However, concerning your definition above, my understanding is that book value is assets minus liabilities (minus intangible assets too) so I am not sure why you write
book value +/- adjustments = assets
and don't subtract liabilities in your definition
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