Originally published by PokfuLam Investments
New investment process based on academic advancements in equity research
By focusing on explaining how markets set prices, a new pricing model has been developed for the Australian, Asian, European and US markets;
Risk can be measured and incorporated in the investment process without the assumption of strong-form market efficiency as required for the use of beta or return volatility.
By valuing both the market and the stocks in it, we can manage both top down and bottom up factors to maximise returns and minimise risk.
Testing in the real investment world has produced significant outperformance in both Australia and Asia.
The Key Issues
The pricing behaviour of equity markets has been questioned since at least 1929, but despite this, an effective model that explains how market pricing works has not been established to date.
Fama (1991) confirmed that there had been no change from 1965, and a review of the literature since shows no widely accepted pricing model since.
Without such a model, markets cannot be proven to be rational: a key requirement for equity markets to be predictable, which in turn, is the key prerequisite for the commercial validity of any aspect of the equity business.
If markets cannot be proven to be rational, then prediction of markets is impossible, and the equity business loses its raison d’etre.
Therefore, it becomes impossible to estimate expected returns, quantify and analyse risk, to determine what is in prices and what isn’t, and ultimately, to predict markets. As such, the basis of any estimate to date must be subjective, based on an incomplete and untested process.
Quant has problems because the prerequisite strong-form efficiency assumption suffers from the same problem as rationality.
Thus, developments in both quantitative and fundamental methodologies demand the establishment of a working pricing model.
The Pokfulam Investments Market Pricing Model
Key to a model is establishing returns inherent in prices. There are only two potential answers: dividends, and/or capital gains. Dividends have been assumed since the 17th century, but nothing has been published on the role of capital gain expectations in influencing prices. Shiller (1981) and Campbell and Schiller (1988) proved that prices MUST contain capital gain expectations by default. They proved that pricing cannot be explained by any rational estimates of forecast dividends alone but didn’t go further to specifically analyse those expectations.
Thus, the issue becomes, what level of capital gains are reasonably included in prices at a point in time, and what rationally determines those expectations?
We have managed to answer these questions effectively by developing a model that explains both a large percentage of the variation in, and absolute levels of, market prices in the Australian, Asian, European, UK and US markets. Importantly, it proves that market pricing is substantially different from corporate pricing, including the widely-used DCF valuation methodology. The long-held assumption has been that there is, or should be, no difference between the market valuation of a listed company versus an unlisted one.
Our research finds that there is a significant difference between the valuation of traded stocks by stock markets, and traditional (unlisted) corporate valuations. If not, then the explanation of market pricing would be relatively simple.
A key finding of the research is the consistent behaviour of stocks in the immediate ex-dividend period that has a substantial impact on capital gains. This potentially explains why stocks continue to respond to changes in dividend policy, despite accepted theory (Dividend Irrelevancy Theorem: Modigliani and Miller (1961)) that theorises that dividend policy is irrelevant to market pricing. Given the wide acceptance of this theory, the findings potentially explain (in part) why there has not been further developments in the explanation of capital gain expectations, and market pricing generally.
By developing a working model, we have been able to also answer the other major question in equity pricing: the measurement and analysis of the Equity Risk Premium at a point in time, at both the market and individual stock levels. This makes equities more predictable than thought possible. Below is a chart of the S&P/ASX 200 price/earnings multiple since 1992 against what our model suggests as the multiple that the ASX200 index should trade on given the fundamentals as defined by the model.
This result in terms of explaining market pricing is unprecedented, with a regression coefficient between the model valuation line and the actual market pricing of the ASX200 of 0.86 (86% explanation of market pricing behaviour). These results enable us to make confident predictions on where the market will go in the medium term which lets us invest accordingly: either to buy more or to sell down until prices come back to a real meaning of “value” which works as a determinant of market prices.
Being able to achieve this result for a market is critical to the practice of investing in equities. Without such a model, it has been impossible to measure risk at a point in time, let alone explain and analyse it. By comparison, here are estimates of the equity risk premium (the extra expected return required to cover the risk of investing in the ASX200) based on our model:
NOTE: The “calculated” number is based on the assumption that all unexplained market movement is caused by a shift in perceived risk versus our estimate, used in the model.
By being able to explain a large percentage of changes in market prices over time, we can confidently assume that the clear majority of stocks in the ASX200 portfolio are priced in the same way.
As with the market, the pricing of risk is critical to the valuation of stocks. Without proof of strong-form market efficiency, beta is invalid as a measure of market-relative risk. Below are key factors in our quantification of relative risk process for individual in descending order of importance:
Business Exposures
Forecast Confidence
Return on Equity
Size
Short-Term Market Sentiment
Quality of Earnings
Liquidity
Cash Flow/EPS
Historical EPS Growth
Price to Book
Debt/Equity
Interest Cover
EPS Stability
Current Ratio
Price Volatility
We have also added systematic timing indicators that are critical to the performance of the process.
The Process has been used in the management of an absolute returns fund, achieving outperformance of the Morgan Stanley (NYSE:MS) Asia ex Japan Index of an average of 19.6% pa between June 1997 and February 2000.
From March 2009 to December 2012, the process was also used as the investment basis for an ASX200 Market Neutral fund, producing outperformance of the ASX200 Accumulation index of 6.48% p.a.
You can view part two of this series here and part three here.