Workshop Portfolio The Low Price/Book Value Ratio

The Low Price to Book strategy (one of the value strategies in the new Workshop portfolio) is very simple and performed well last year. We are using it in the Workshop portfolio because we feel a need to balance our growth stocks with value stocks. This strategy has outperformed the S&P historically, but the high returns are focused in the top 3 stocks. Because this is a value strategy, it should help smooth out some of the volatility in the portfolio.

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By Todd Beaird (TMF Synchronicity)
January 9, 2001

The Workshop Portfolio is off and running! Unfortunately, the complications of setting up a portfolio that has, in effect, sub-portfolios, has caused more technical problems than we anticipated. We think it is important to track the returns from each strategy, so we are tackling the problems head-on. We hope to have the portfolio return numbers up and running with the Friday column.

Two of the strategies in our Portfolio are new to the "official" Workshop strategies. One of them is Low Price/Book ("LowP/B"). This strategy is one of the few "value" strategies developed in the Workshop. The other is CAP-RS, which we will tackle next week.

The selection process for Low P/B is straightforward: 1) Take the top 500 stocks by market cap from Value Line's 1700 stock database, 2) rank them by the ratio of share price to book value, and 3) buy the top one, three, or five, etc. and hold for your designated time period.

That's it.

But how does it work? "Book Value" is the value of a company's assets minus its liabilities. In a perfect world, book value would be the value of the company if it were liquidated. When the share price of a company is low in relation to its liquidation value, the company is a real bargain. In theory. If only this were true! We could sweep up companies trading at a fraction of their real value, and sell them when the stock price inevitably rose.

Unfortunately, book value is subject to the vagaries of accounting.

Assets are usually listed on a company's balance sheet at the price the company paid for them, and this amount is depreciated over a period of time. Often, this amount has no relation to the Fair Market Value of those assets and a number of investors find book value to be a very unreliable indicator of the value of a company. However, one can argue that for many large companies, a low price-to-book ratio is an indication that the company is undervalued relative to other similarly sized companies.

At the Workshop, our primary focus isn't with rationalizations. We want to see the results! Here's the historic performance of the strategy, from 1986 through 2000. We are using the average return of 12 portfolios, one started in January 1986 and renewed every January through January 1999, plus one started in February 1986 and renewed every year through February 1999, etc. for 12 portfolios that have run for 14 years each ending at some point in 2000.

Ranks  CAGR  GSD(M) Sharpe
1-3     28%   28%   0.88
4-10    14%   22%   0.51
1-5     23%   24%   0.79
1-10    19%   21%   0.72
S&P 500 18%   17%   1.05

(Thanks as always to Jamie Gritton for his wonderful backtest website.)

As you can see, the LowP/B strategy has outperformed the S&P 500 index using the top 3, 5, and 10 picks. However, there are some concerns. The outperformance for LowP/B is entirely in the top three stocks of the strategy. Stocks 4 through 10 have underperformed the index. While the top stocks of a good strategy should do better than those farther down in the rankings, that effect is extreme with Low P/B and it causes us some concern. Are the two factors we are using, market cap and low price to book ratio, really picking winning stocks, or are those good returns just a random statistical cluster?

Low P/B is a newer strategy. It was developed by Alan Levine (alevine) about one year ago and tested on data from 1986 through 1999 so there is virtually no out-of-sample data for additional support. There have been some outside studies that indicate that stocks with a low ratio of price to book value have outperformed the market, but those use different groups of stocks over different time periods than our screens. For what it's worth, a three-stock, annual LPB strategy returned 28% for 2000, compared to a 9% loss for the S&P 500. That's good to know, but as out-of-sample data, it's pretty skimpy.

We don't have a lot of value strategies in the Workshop, and this year has made it plain that we need to consider that aspect of our strategy design. We have included Low P/B and the Foolish Four in the portfolio as the two most tested value strategies that we know of. As we've stated before, our goal is to use multiple strategies that are not strongly correlated. If one strategy has a bad year, hopefully one or more of the other strategies will take up the slack. To really do that right, we probably need more choices since most of our strategies are very growth- and momentum-oriented.

Remember that our goal over the long run is to get market-beating returns with less volatility than any single, high-return strategy generates.

Will the LowP/B strategy help us towards that goal? That remains to be seen. We're using LowP/B in the Workshop portfolio because it appears to beat the market but more importantly it shows a low correlation with the other strategies we are using. That low correlation should mean that it will tend to do well when the other strategies are having a hard time -- as it certainly did last year. I'm using it in my own Small Money portfolio for the same reason. But we could always be wrong. There's a reason we tell people not to mimic our portfolios. Instead, read the Workshop articles and read the discussion on the Foolish Workshop board for ideas on how to construct your own portfolio.

Have you taken our Workshop survey, yet? It's very important that we get input from all of our community, not just the outspoken folks on the message board, but all of you who just read these articles and maybe check out the message boards occasionally. We want to make this area as useful for you as we can and we need input from you (yes, you) if we are to do that efficiently. Please, click that link and take the survey today.

Next week we'll review another strategy that also starts with large-cap stocks but looks for growth instead of value: CAP-RS. We'll see you then -- same Fool time, same Fool channel!