Trending Value Strategy

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How is the Trending Value Strategy Implemented?

Essentially, the Trending Value Strategy consists of two components: First, the Value Composite Indicator is calculated. The indicator is used to determine, which companies have the best valuation. From these companies, the companies with the highest price momentum over the past six months are selected.

Step 1: The Composition of the Value Composite Indicator

This indicator is designed to identify companies that are undervalued. Value Composite indicators are available in various versions, but they are primarily composed of the following valuation metrics. The Value Composite article provides more detail about the different variants. This article will discuss the Value Composite 2 indicator in more detail since it is a component of the Trending Value Strategy:

Price-to-Book Ratio

To determine the price-to-book ratio, the share price of a company is divided by the book value per share. Price-to-book ratios less than 1 indicate that shares are less expensive than their book value. Therefore, the share is undervalued and may offer a good investment opportunity.

Price-to-Sales Ratio

The price-to-sales ratio compares a company's share price with its sales. Similar to the price-to-book-value, it is preferable if the price-to-sales ratio is low.  A ratio, which is smaller than 1 means that an investor has to invest less than CHF 1 for every CHF 1 of sales.

EBITDA-to-Enterprise Value (EV)

EBITDA-to-EV uses a company's cash flows to evaluate the value of a company. An investor can determine whether a company has cash flow problems by comparing EBITDA to enterprise value. It is important for a company to have healthy cash flows in order to have a high valuation. As a measure of a company's ability to repay new debt and service existing debt, banks also pay attention to EBITDA.

Price-to-Cash Flow Ratio

The price-to-cash flow ratio measures the share price in relation to operating cash flow (OCF) per share. OCF includes non-cash expenses such as depreciation and amortization. The price-to-cash flow ratio can be used to evaluate stocks that generate positive cash flow but are unprofitable due to high non-cash expenses.

Price-to-Earnings Ratio

The price-to-earnings-ratio compares the current share price with the earning per share (EPS). In general, value stocks are those with a low price-to-earnings ratio. In other words, their share prices are undervalued since they trade at a lower price relative to their fundamentals.

Shareholder Return

An investor's shareholder return - also known as total shareholder return (TSR) - is the total amount they earn from a stock or share investment.

As a result, the Value Composite 2 examines whether a company is undervalued using several valuation metrics. The Trending Value strategy begins by calculating the Value Composite 2 for a list of companies. The initial list of companies may be compiled based on certain criteria, for instance, stocks valued at more than a particular market capitalization.

Step 2: The calculation of the Value Composite Indicator

For each of the six valuation metrics, each selected company is assigned a value from 1-100. As a rank, the value is based on comparisons between companies. Accordingly, if a company possesses the lowest price-to-sales ratio (1 out of 100) of all companies in the database, it will receive a price-to-sales rank of 1 - meaning it is ranked low (low is good). A company with a price-earnings ratio (P/E) that is in the highest percentile of all the companies in the database receives a P/E rank of 100. A value of 50 is considered neutral. If no value is available, the value of 50 is assigned.

Once all companies have been ranked per valuation metric, all individual rankings are added together to create a combined ranking per company. From 1 to 100, each company has been assigned a ranking number. Using this number, the companies are ranked and then categorized into percentiles of 1 to 100. The 10% of the companies with the lowest Value Composite value are then further analyzed.

Step 3: Momentum Factor

Momentum is the third component of the Trending Value Strategy. Momentum refers to buying stocks that have experienced the greatest increase in price over a certain period of time.  In the Trending Value Strategy, the so-called price momentum is applied. The objective is to buy the companies that have experienced the greatest six-month price increase, while at the same time remaining undervalued. Investments are made in 20-50 of the most promising companies.

Independent research has shown that stocks that have generated high returns for the past three to twelve months remain profitable. Consequently, the goal is to profit from this trend. One of the disadvantages of momentum strategies is their volatility.

Does the Trending Value Strategy Really Work?

In order to test the strategy, James O'Shaughnessy examined data from Standard & Poor's Compustat Active and Research database and the Center for Research in Security Price (CRSP) over a 45-year period between 1964 and 2009. Each month, he created 12 portfolios, held them for one year, and then calculated their average returns. This investment universe consisted of companies with market capitalizations of more than $200 million (adjusted for inflation). All stocks were equally weighted and included U.S. companies, while foreign stocks were eligible in the form of American Depository Receipts (ADRs). The study revealed the following results:

In the 45 years between 1964 and 2009, the All Stocks universe generated an average annual total return of 11.2% (market index).

The total annual return would have been 17.3% if the stocks had been selected based solely on the Value Composite indicator. It would have been possible to earn an annual average of 14.5% if only the six-month price momentum had been applied to the same period. Consequently, both strategies outperformed the market index (universe of all stocks). In contrast, if the two factors had been combined into the Trending Value Strategy (buying 25 best-performing stocks), the average annual return over 45 years would have been 21.2%. During the 45-year period between 1964 and 2009, the Trending Value Strategy outperformed the market by 10% annually.

There are many challenges associated with the implementation of such a strategy. Implementation requires time and a high level of expertise. Good wealth managers, who possess the necessary expertise, can assist you in implementing the Trending Value Strategy.