In 1992-1993, Eugene Fama and Kenneth French published several academic papers that provided investing ideas that expanded on the classic Capital Asset Pricing Model (CAPM). They showed that over long periods of time, 90% of returns from diversified portfolios can be explained by 1) beta (the essential CAPM factor explaining excess portfolio returns over market returns), 2) valuation and 3) size.  We recognize that no model is infallible and believe that human behavior is impossible to quantify. However, the Fama-French findings are extremely useful variables to use for screening potential investment candidates to include in a diversified portfolio. Below are the value factors we consider in our investment decision framework.  Graphic representations of each factor analysis yield similar images

Price-to-Book (P/B) ratio: This is the ratio of a company’s market value relative to its GAAP book value. Book value is found on a company’s balance sheet and represents the total value of a company’s assets minus the value of its debt and other liabilities. We focus on this metric when analyzing the value of a company. We prefer to invest in companies with low price to book ratios.  Traditionally, growth stocks have high P/B ratios.  In the graph below, the Fama-French study demonstrates that over a substantial time frame encompassing multiple economic cycles, the lowest decile stocks ranked on by P/B multiple had the strongest performance.  The analysis continues with an almost sequential hierarchy as 2nd decile stocks were the second best performers all the way to 10th decile stocks (highest P/B valuations)  being the worst performers.

Price-to-Cash Flow (P/CF) ratio: The P/CF ratio is the ratio of a company’s share market value to its operating cash flow per share. Operating cash flow (OCF), as the name implies, is the cash a company earns from its normal business operations. One standard definition: OCF = EBIT (Earnings Before Interest & Taxes) + Depreciation – Taxes.  OCF is a good measure of the strength of a company.  In theory, companies with a lower P/CF will tend to perform better than those with a higher P/CF.  We prefer to invest in companies with consistent cash flow and solid cash flow margins.  Growth companies frequently are relatively young and unestablished. As a result they may have little to no stable operating cash flow and correspondingly exhibit high P/CF multiples.

Price-to-Earnings (P/E) ratio: The P/E ratio is the ratio of a company’s share market value to its net income per share.  The P/E ratio is a widely known concept but we prefer the inverse ratio, the E/P ratio or earnings yield, for comparative analysis to bonds, REITs, preferreds and various arbitrage strategies.  Again, typical growth companies are relatively nascent in existence and probably have nominal or no earnings resulting in high P/E ratios.  Following simple math logic, a company that has a high earnings yield correspondingly must have a low P/E ratio.