I got this idea to do this article from Patrick O'Shaughnessy and Meb Faber, two big-time financial bloggers, financial executives, and portfolio managers. Both of them are considered "quants" (short for quantitative) meaning they both tend to use a more empirical (evidence-based, numerical) approach. On a podcast together they did a "Factor Draft." In which they each drafted five factors they deemed to most important toward developing a strategy.
You can check it out at investorfieldguide.com/meb/
Wow, this is actually super nerdy. But stick with me.
It was pretty cool to see two quants in action, picking out metrics for evaluating stocks.
It is important to note that, the draft order does not necessarily reflect the top 10 "best" as the usefulness of these metrics are subjective, and some metrics may work together in tandem better than other metrics.
Here were the results:
1. Enterprise Value/EBITDA (Meb)
4. Market Cap (Meb)
5. Total Price Returns (Meb)
8. 200 Day Moving Average (Meb)
9. 10 Year CAPE (Meb)
2. Buy Back Yield (Patrick)
3. Free Cash Flow/ EV (Patrick)
6. Accruals (Patrick)
7. ROIC - Return on Invested Capital (Patrick)
10. Price/Sales (Patrick)
Team Meb Analysis
So first overall went to EV/ EBITDA... a favorite of many quants. Let's break that down because it is a mouthful.
Enterprise value, similar to market cap is a way to express the value of a company. The difference is Enterprise value takes into account a company's debt, minus their cash.
That may seem counterintuitive, but if you subtract a company's cash and add their debt what you are left with is the true value of the "business" and what is needed to finance the buisness. Say you are considering buying a profit machine (for lack of a better word) you are less concerned with the cash the machine has already made and more concerned with what keeps it running (its debt), and ultimately how much money it makes... which leads us to the other side of the equation.
EBITDA is a fancy way to express the earnings the company makes before "arbitrary" things like taxes, one-time write-offs, and other expenses are subtracted from a companies earnings, to make it a purer proxy for the companies profitability.
So with EV/EBITDA, Meb is getting metrics that includes how much money a company generates given: operating expenses, its valuation, and the cost to finance the business. Whew.
Now let's see how Meb uses that information plus other, factors to find desirable companies.
(4) Market Cap - Meb wants smaller companies with more growth potential
(5) Total Price Returns - Meb wants to see the company's stock trending upward
(8) 200 Day Moving Average - Meb - A technical signal to tell if a stock's growth may have gotten ahead or behind itself relative to the market.
(10) 10-year CAPE - CAPE is a fancy P/E (price/earnings) ratio which takes into account economic cycles (CA= cyclically adjusted). This is a similar metric to EV/EBITDA, comparing valuation to earnings, but with exposure to macro indicators.
Mebs factors trend toward smaller companies, which may be undervalued, but are trending upward.
Team Patrick Analysis
(2) Buyback Yield - I was surprised to see this and had to research it a bit. It refers to what percentage of the companies outstanding share was bought back by the company over a 12-month period. When a company uses its capital to buy back shares it means management thinks shares are possibly undervalued as well as having shareholder interest in mind. Seems to be a favorite of the O'Shaughnessy Asset Managment method.
(3) Free Cash Flow/EV - Free cash flow is similar to income but is different in that it represents how much cash is created as no financial engineering can take place like when revenue is realized. Then you compare that to enterprise value to understand how the company is valued relative to how much cash the company produces. It is very similar in practice to EV/EBITDA.
(4) Accruals - Accruals refer to when revenues or expenses are realized, meaning when they end up on companies financial statement. Factored accruals mean that if a company has higher accruals, it is subject to more uneven revenue streams and expenses.
(7) ROIC - Return on Invested Capital - When a company makes investments you want to see those investments generate a return.
(10) Price/Sales - Price to sales is pretty different metric than Patrick's other chosen metrics, as it is not a value metric as it is solely related to revenue. I like price to sales because as a more growth-oriented investor I like to see companies getting hot and increasing sales while maybe worrying about profitability later in the life-cycle of the company.
Overall Patrick's factors trends toward quality (healthy financials) and value.
Patrick's approach while quantitative is more traditional value, where Meb's approach involves more technical analysis combined with growth.
Overall I tend to like Meb's team a little better even though I am personally not a "quant."
Regaurdless, this is a fun exercise in understanding factors and how they work with each other.
Who do you got?