Manager Research Newsletter: May 2017

Valuation Metrics Matter...At Least Some of Them
by John Lloyd, CFA, FRM, CAIA

Considering where valuations currently stand among major equity indices, a good reality check is to see which fundamental measures have provided alpha over time. Earlier this year, Morgan Stanley research issued a report called "All About Values."1 In particular, the report analyzed data going back to 1980 across multiple global asset classes and tested the effectiveness of 24 different metrics. From a manager research perspective, getting a sense of what valuation measures work better than others is helpful in identifying skilled managers. Across the equity market, Morgan Stanley looked at trailing P/E, forward P/E (12 months), CAPE, P/BV, P/S, dividend yield, and ROE. Among these metrics, they found that P/BV and P/S appeared to be the most useful measures. Interestingly, the measure that proved to be less useful in a buy low/sell high methodology was one of the most commonly used measures in our industry: trailing P/E.

This may lead one to ask, "What about other measures used by fundamental equity managers?" A recent article in the Financial Analysts Journal analyzed the effectiveness of cash flows.2 The researchers looked at S&P 1500 data starting in 1994 and deciled the results using their direct method cash flow. The results: they found that the highest cash flow decile outperformed the lowest decile by more than 10% annually.

Continuing on the cash flow theme, what about free cash flow? Late last year, Epoch Investment Partners, the subadvisor of MainStay Epoch Global Equity Yield Fund (EPSYX), released their findings on an extensive analysis on free cash flow. They looked at the period from the end of 1989 through the middle of 2016, a span of more than 26 years. Specifically, they examined the predictive ability of trailing free cash flow yield. This analysis did not involve any forecasts of future free cash flow, but relied instead on trailing figures.

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Their findings were consistent across various universes of stocks, including U.S. large-cap, U.S. small-cap, and global equities. In particular, companies with higher free cash flow yields performed better than companies with lower free cash flow yields. When they conducted their analysis on the Russell 1000 Index, stocks in the top quintile outperformed the overall average by roughly 5% per year. Meanwhile, stocks in the bottom quintile underperformed the average stock by about 6% per year - an approximate 11% difference between the top and bottom quintiles. The top quintile exhibited slightly more volatility than the average stock, but not dramatically so, while the bottom quintile stocks were the most volatile.

Figure 1 shows the cumulative relative performance of each quintile versus the overall average, and it paints an impressive picture. The chart shows the ratio of the value of a dollar invested in each quintile to a dollar invested in the average stock. When a line is rising, that quintile is outperforming the average stock. When the line is falling, the quintile is underperforming. As remarkable as the cumulative results are, they do not mean that the top quintile outperformed each year. In fact, of the 26 full calendar years included in the chart, the top quintile outperformed in 17 years and underperformed in nine years. The reason that the cumulative results are so strong, even with the top quintile underperforming roughly a third of the time, is that when the top quintile did underperform, the margin tended to be small. Conversely, when it outperformed, it sometimes did so by wide margins.

Turning to a global universe, the research team at Epoch also found that free cash flow yield was an effective predictor of performance within the MSCI World Universe. Figure 2 shows the cumulative relative performance of the five quintiles. As was the case with the Russell 1000, the top quintile generated the strongest long-term relative performance. However, it struggled to outperform in the last five years, even as the bottom quintile continued to underperform.

While each of the three research pieces uses different time series and methodologies, collectively, the theoretical logic and the empirical evidence make a convincing case for relying on specific types of valuation metrics, while dismissing others. As a key metric for investment decisions, it appears that cash flow is one approach that has a high degree of consistency, especially free cash flow.

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1 Source: Morgan Stanley, "All About Values," February 26, 2017, Low, Sheets, Naraparaju, Tang, and Volynsky.

2 Source: Financial Analysts Journal, "Are cash flows better stock return predictors than profits?" first quarter 2017, Foerster, Tsagarelis & Wang.

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