What is the Trending Value strategy?
The trending value strategy is a strategy that combines value and momentum factors. The companies with the lowest valuation(value strategy) and the greatest price increase in the last 6 months(momentum strategy) are selected on the basis of certain company key figures. The strategy was developed by James O’Shaughnessy and is described in his bestseller “What Works on Wall Street: The Classic Guide to the Best-Performing Investment Strategies of All Time”.
How is the Trending Value strategy implemented?
The Trending Value strategy consists of two components: First, the so-called Value Composite Indicator is calculated and the companies with the best valuation are selected based on this. Then the companies with the highest price momentum over the last six months are selected .
Step 1: The composition of the Value Composite Indicator
The aim of the indicator is to find undervalued companies. There are different versions of the Value Composite indicator, but the variants are basically based on a composition of the following financial ratios. If you are interested in the different variants in more detail, you can find them here in the article on the Value Composite. The Value Composite 2 indicator is discussed further below, as this is part of the Trending Value strategy:
Price-to-book ratio
This ratio compares the market capitalization of a company with its book value. To do this, the company’s share price per share is divided by the book value per share. A price-to-book ratio of less than 1 means that you have to pay less than one Swiss franc for one Swiss franc of book value. The book value is made up of real estate, warehouses, cash and other tangible assets – see also the article on the balance sheet. The share is therefore undervalued and can offer a good investment opportunity.
Price/sales ratio
The price/sales ratio compares the share price of a company with its revenue. Here, too, the lowest possible figure is considered advantageous. A ratio of less than 1 means that an investor has to pay less than CHF 1 for every CHF of revenue.
EBITDA/Enterprise Value (EV)
EBITDA/EV uses a company’s cash flows to assess the value of the company. When EBITDA is compared to enterprise value, an investor can tell if a company has cash flow problems. A company with healthy cash flow will have a high value. Banks also pay attention to EBITDA as it is an indicator of the company’s ability to service debt and repay the principal of new debt.
Price/cash flow ratio
The price/cash flow ratio compares the share price with the operating cash flow (OCF) per share. Compared to free cash flow, OCF also includes non-cash expenses such as depreciation and amortization. The price/cash flow ratio is particularly useful for the valuation of shares that have a positive cash flow but are unprofitable due to high non-cash expenses.
Price/earnings ratio
The price/earnings ratio is the ratio of the current share price to earnings per share (EPS). Companies with a low price/earnings ratio are often considered value stocks. This means that they are undervalued because their share prices are trading lower in relation to their fundamentals.
Shareholder return
The shareholder return is the total amount that an investor achieves from an investment, in particular from shares or company shares.
The Value Composite 2 therefore uses several indicators to examine whether a company is undervalued. The Trending Value strategy starts with a selection of companies for which the Value Composite 2 indicator is calculated. The companies can be included in the list based on certain criteria, for example shares above a certain value of market capitalization.
Step 2: Calculating the Value Composite Indicator
Each selected company is given a score from 1-100 for each of the six financial ratios, which is considered a rank. Since the score is a rank, it is based on the comparison between the companies in the list. For example, if a company has a price-to-sales ratio that is in the lowest percent (1 out of 100) of all companies in the database, it is given a price-to-sales rank of 1 – it is therefore lowly rated. If a company has a price/sales ratio that is in the highest percentage of all companies in the database – i.e. it is highly valued – it is given a price/sales rank of 100. A value of 50 is regarded as neutral. If no value is available, the value of 50 is automatically assigned.
Once all companies have been included in a ranking list for each key financial figure, all individual rankings are added together to create a combined ranking list for each company. Each company now has a ranking number from 1-100, which is used to rank the companies. They are then grouped into percentiles from 1 to 100. The focus is then on the 10% of companies with the lowest Value Composite score. These companies have a low valuation and are analyzed in more detail in the third step.
Step 3: Momentum factor
The third part of the trending value strategy consists of a momentum factor. This means that shares are bought that have recorded the highest price increase over a certain period in the past. The so-called price momentum is used in the trending value strategy. The aim is to buy the companies with the highest six-month price increase that are still valued at a low level.
Many independent researchers have found that shares that have achieved high returns in the last three to twelve months continue to perform well. The aim is therefore to profit from this trend. The disadvantage of the momentum strategy is that it can be very volatile. Investments are made in the 20-50 best companies.
Does the Trending Value Strategy really work?
To test the strategy, James O’Shaughnessy used data from Standard & Poor’s Compustat Active and Research database and the Center for Research in Security Price (CRSP) over the 45-year period from 1964 to 2009. He formed 12 separate portfolios each month, which were held for one year, and then calculated the average returns of all 12 portfolios. The investment universe included companies with a market capitalization of over USD 200 million(adjusted for inflation). All stocks were equally weighted and included US companies, while foreign stocks were eligible in the form of American Depository Receipts (ADR). The results of the study showed the following:
Over the 45-year period between 1964 and 2009, the All Stocks universe achieved an average annual total return of 11.2% (market index).
If the shares had only been selected according to the Value Composite indicator, the total annual return would have been 17.3%. If only the six-month price momentum had been used over the same period, the average annual return would have been 14.5%. Thus, both strategies outperformed the universe of all stocks (market index).
However, if the two factors had been combined into a trending value portfolio strategy (buying the top 25 stocks), the average annual return over 45 years would have been 21.2%. In summary, the trending value investment strategy outperformed the market by 10% every year over the 45-year test period between 1964 and 2009.
Such a strategy is not easy to implement. Implementation takes time and very good specialist knowledge. Specialized experts such as an asset manager – with the necessary expertise – can help you to develop and implement a trending value strategy for you.