Quantitative Screening for Undervaluation
Over the past 25 years, a growing series of studies in empirical finance have identified specific combinations of quantitative business characteristics that are strongly associated with extraordinarily high long-term returns. Many of these are the straightforward fundamental ratios familiar to most value investors such as P/B, P/E, EV/EBITDA, and others, while some are more sophisticated measures of accounting fairness, financial leverage, and long-term profitability requiring significant prior calculation.
When correctly applied, using these kinds of objective criteria can enable the individual investor to acquire valuable business assets for a fraction of their true worth, secure dependable streams of cash flow at minimal cost, and exploit predictable errors in market sentiment to achieve consistently above average profits over the long term. My research begins with a comprehensive screening of financial databases extracted from recent and historical SEC filings in order to identify a candidate set of value stocks with an optimal combination of the specific characteristics that have historically correlated with outstanding long-term returns.
Of course, blindly relying on these quantitative ratios without further investigation can lure investors into "value traps" where fraud, a deteriorating business environment, or unethical management behavior can eliminate any prospect of profit. Based on my personal experience as a successful value investor for over 10 years, before making an investment I will carefully review regulatory filings and frequently speak with company management, in order to identify situations where these quantitative measures appear genuinely supported by real-world business value, and where management and directors appear strongly aligned with common shareholders' interests. Building a portfolio of stocks with these qualities is, very simply, the only known way to beat the market.
Sample version of Deep Value screen (October 2004)
Microsoft Excel file, 55KB
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