Category: Your Money

Factors are short-cuts

Analyzing financial statements is a cumbersome process for most retail investors. Many don’t have the time, patience or expertise to dig through balance-sheets, income and cashflow statements. Most don’t find joy in reflecting on the many footnotes that accompany such statements. Here lies the attraction of single-factor investing.

Price-to-Earnings (PE) ratio is one such factor. We recently saw how there was no great advantage in investing in mutual funds that use PE to switch between debt and equity. It is a poor market timing indicator even when practiced by professional fund managers.

The ‘E’ in PE

The ‘earnings’ line-item is an accounting driven artifact that is easily gamed and has very little relationship with the company’s value. Here’s what Michael J. Mauboussin has to say about earnings, see appendix for the full note:

Even Shiller’s cyclically-adjusted P/E (or “CAPE”) has little predictive value in the short term. Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon. (Kitces)

Some investors also look at Price to Book and Return on Capital Employed. These ratios provide a convenient short-hand but are far from adequate in forecasting future earnings.

Besides what does the ratio of total assets to total liabilities measure anyway? Intangibles can’t be quantified. Are inventories adjusted to current market prices? Is the loan loss reserve adequate?

Bottom line: Assets are often overstated and liabilities understated. (Fool)

What does “capital employed” mean anyway?

1. No general agreement exists on how capital employed should be calculated, on whether initial or average capital employed should be used or on how profit should be defined.
2. Often, accounting profit rather than cash flow is used as the basis of evaluation.
3. It ignores the time value of money.

Take away

Every style of investing – value, momentum or factor – depends on finding historical patterns and extending them into the future.

Every valuation metric comes with a “yes, but…”

No single factor is a predictor of future returns.

Appendix

Dividends vs. Buy-backs

When firms are left with excess cash, they have the option of distributing money back to shareholders by either issuing dividends or buying back their stock.

All things being equal, investors should be indifferent whether a company pays dividends or engages in a buy-back.

The dividend irrelevance argument

The underlying intuition for the dividend irrelevance proposition is simple. Firms that pay more dividends offer less price appreciation but must provide the same total return to stockholders, given their risk characteristics and the cash flows from their investment decisions. Thus, there are no taxes, or if dividends and capital gains are taxed at the same rate, investors should be indifferent to receiving their returns in dividends or price appreciation. (Source: NYU)

Indian Taxes

In India, long-term capital gains in equity investments attract zero tax. Long-term is one year. However, there is a dividend distribution tax of around 28%. So if a company decides to pay Rs. 100 in dividend, only Rs. 72 reaches the shareholder.

In this scenario, companies that declare dividends are taking a step that is against the interests of the share-holder. Investors are better off if the company buys back stock from the open market instead.

Here are some of the largest dividend payers:

Conclusion

Small investors and fund managers should demand that the boards consider buy-backs over dividends.