International Evidence for our favorite Value metric: Enterprise Multiples

International Evidence for our favorite Value metric: Enterprise Multiples

November 24, 2015 Architect Academic Insights, Value Investing
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The Enterprise Multiple Investment Strategy: International Evidence

Abstract:

The enterprise multiple (EM) predicts the cross section of international returns. The return predictability of EM is similarly pronounced in developed and emerging markets and likewise strong among small and large firms. An international portfolio of low-EM firms outperforms a portfolio of high-EM firms by about 1% per month. The EM value premium is individually significant for the majority of countries, remains largely unexplained by existing asset pricing models, is robust after controlling for comovement with the respective U.S. premium, and is highly persistent for up to 5 years after portfolio formation, making it a promising strategy for investors.

Alpha Highlight:

Jack and I started work on a paper in 2010 that highlighted the results of a study we conducted to identify the top valuation metric. The results? EBITDA/TEV came out on top. This metric didn’t win all the time, but it seemed to be the most robust over the long-haul. Next, we wrote an entire book dedicated to quantitative value and once again found that enterprise multiples/yields performed the best (specifically EBIT/TEV), and they could be improved through the addition of quality metrics. Finally, we wrote a paper that explored all the value investing metrics posted on the AAII website and found that none of them can reliably beat EBIT/TEV. Sheesh…I’m getting tired just thinking about all the work we’ve done on value metrics…

…But we aren’t the only ones to identify the historical benefits to buying cheap companies based on enterprise multiples. For example, Loughran and Wellman published a paper in the JFQA in 2011, and it it they claim that enterprise multiples are a “strong determinant of stock returns.” And now we have the paper under discussion, which highlights what we’ve known internally for some time now–enterprise multiples have worked in international markets.

Key Findings:

This paper examines 40 non-U.S. countries from 1981 to 2010. The sample includes 22 developed markets and 18 emerging markets. Using the same method as Fama-French, the authors create 6 value-weighted portfolios formed on size and EM. Then they compare the performances of low EM portfolios, high EM portfolios and EMD portfolios (enterprise multiple difference, i.e., low EM portfolios-high EM portfolios, similar to Fama-French’s HML metric)

  • Enterprise value = market value of equity + debt + preferred stock – cash and short-term investments
  • Enterprise Multiple (EM) = EV/EBITDA
The Enterprise Multiple International Evidence
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Conclusions

A few key points from the paper:

  1. An international portfolio of low-EM firms outperforms a portfolio of high-EM firms by 0.95% per month, with a t-stat of 6.97. What’s more, international EM premiums are 2 times higher than the corresponding U.S. EM premiums studied by Loughran and Wellman (2011).
  2. The EM premiums are significantly positive in all 40 non-US countries. Especially, 18 out of the 22 developed markets have significant t-stat (>2) and 8 out of 18 emerging markets have significant t-stat (>2).
  3. When they rank country EM premiums from high to low, the top 5 developed countries are: Portugal, Australia, Switzerland, Sweden and Austria, and the top 5 emerging markets are: Pakistan, Brazil, Peru, Argentina and Thailand. 

Clearly, the enterprise multiple approach to value investing works well in non-US markets, at least it has done so historically. Investors who believe these results might continue, who want international diversification, and believe in the value anomaly, should look for international value strategies based on enterprise multiples. We have offerings exclusively focused on these metrics, but we encourage readers to study all offerings available.

Appendix

Here is the visual depiction of the results posted above in the table.

The Enterprise Multiple International Evidence_by country
The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

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Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.

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About the Author

Wesley R. Gray, Ph.D.

After serving as a Captain in the United States Marine Corps, Dr. Gray received a PhD, and was a finance professor at Drexel University. Dr. Gray’s interest in entrepreneurship and behavioral finance led him to found Alpha Architect. Dr. Gray has published three books: EMBEDDED: A Marine Corps Adviser Inside the Iraqi Army, QUANTITATIVE VALUE: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and DIY FINANCIAL ADVISOR: A Simple Solution to Build and Protect Your Wealth. His numerous published works has been highlighted on CBNC, CNN, NPR, Motley Fool, WSJ Market Watch, CFA Institute, Institutional Investor, and CBS News. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.


  • Andrew M.

    Has anybody done a study on EM with respect to cross sectional industry or sector performance? Is EM picking up cheap industries or is it really picking up cheap stocks irrespective of industries?

  • industries are typically cheap and the stocks are correlated…so you eat industry concentration when you atttempt to exploit the anomalies…and that is painful for the vast majority of capital in the market. The minute you make life easier for big pools of capital–e.g, sector-neutralize–performance drops on a risk-adjusted basis.

  • Steve

    The consistency is almost crazy, I love it! Nice visual of the table…

  • Hombre Sinombre

    Nice paper, Wes and Jack.

    Does your paper mention the effect of currencies for dollar-based investors? (I am aware, for example, that Japanese yen declines offset gains in the stock market during recent past.) How would the costs of currency hedging affect the portfolio returns if an investor wished to neutralize effects of currency movements, and is there any evidence to support not doing so?

    Thanks for your further thoughts!

    Doug

  • Doug,
    Over the time periods we’ve analyzed FX hedging doesn’t do much. If one considered the frictional costs and brain damage associated with FX hedging the value-add is probably negative. Going forward that may change