AFG Valuation vs. Traditional Value-Based Metrics

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Over the next several weeks, we would like to share some updates on our quantitative research. Our first update on this will highlight some insight we can learn by comparing the output of AFG’s valuation model to a more traditional metric. (In this case, Price to Earnings)

Quantitative strategies based on P/E can achieve decent returns, as noted by the performance in the following graph. The “top half” of P/E, which would consist of the lower half of P/E stock’s would return $5.51 as of 4/30/2010 from $1.00 invested on 9/25/1998, based on a monthly turnover strategy. Alternatively, we can see that a “bottom half” strategy would only return $2.77 over this same time period.

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As a direct comparison to this, we can see on the following chart that a similar strategy based on AFG’s Percent to Target – Current metric yields $6.88 for the top half and $2.27 for the bottom half.

Extending this even further, when we expand our Buy & Sell portfolios to only include the top and bottom quintiles of AFG’s Percent to Target – Current, we can see that these returns improve even further in the following chart. The top quintile reaches $9.86, while the bottom quintile only returns $1.81.

The most interesting analysis from this comes from looking at P/E through the same quintile focus. Under these parameters, a P/E model simply falls apart, as noted in the following chart. The top quintile and bottom quintile both underperform the overall universe.

Exploring the Relationship between Percent to Target and P/E in a Variety of Universes

The charts below highlight the annualized return spreads relative to the entire benchmark of note. For example, the upper left corner shows that the top half of Percent to Target for the entire AFG Universe outperforms the overall universe by nearly 6% each year, and the bottom half of Percent to Target underperforms the overall universe by nearly 6% as well. As we then move to the right across each graph, our focus shifts away from the overall benchmark to the individual sectors within each benchmark. To properly interpret this, it is important to note that simply using the default quantitative model for Percent to Target – Current to define our Buy and Sell universe, we can witness significant outperformance in the overall universe, as well as the S&P 500, Russell 1000, and Russell 2000, as well as most of the sectors within each benchmark. (We can see that this simple strategy does not work as well in the Russell 2000 Transportation Sector, the Russell 1000 Consumer Durable Sector, or the S&P 500 Consumer Services sector. In the coming weeks, we will address how our quantitative rules expand to include momentum, quality, and accuracy variables to improve our screening process further.)

One last important point to digest – we have recreated the Top Half/Bottom Half spread charts using P/E as our target variable, which you will find below. It is important to note the significant difference we see here, where there are many benchmarks and sectors where the model breaks down with either flat or inverted return spreads.

Be on the lookout for more quantitative updates over the coming weeks. We will shift our focus to AFG’s Buy/Sell parameters, as well as several newer variables including EM Momentum and Earnings Quality.

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