Value Series IV: Using P/B Ratio Creates a Solid Investment Foundation for Caterpillar Employees

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For Caterpillar employees, understanding and using basic valuation metrics like the Price-to-Book ratio can help you make better decisions and position your portfolio for the long haul - especially during volatile markets,  '  says Kevin Landis, of the Retirement Group, a division of Wealth Enhancement Group.

As a Caterpillar employee or a retired person, data-driven investment strategies like those of great investors can set your portfolio up for growth despite market volatility,  '  says Paul Bergeron, of The Retirement Group, a division of Wealth Enhancement Group.

In this article we will discuss:

1. Important valuation metrics for investors include Price-to-Book and Price-to-Earnings ratios.

2. Value investing strategies versus glamour investing strategies.

3. Equal-weighted portfolios and Kelly Weighting to Maximize Long Term growth.

High volatility in the markets today means it seems like the right time to review key value metrics from our four-part series. We know that as a Caterpillar employee or retiree with little market analysis experience, the valuation process can be confusing. But we are here to tell you that valuation need not be complicated to be successful. Simple valuation techniques like the price-to-book ratio are generally easy to apply and have worked well when done so correctly. And sometimes investors want their clients to beat the market.

You are one of those investors - check out this strategy from investment greats. Some value investors have beaten the average annualized returns of the S&P 500 historically - and many have decades of track record proving it. Caterpillar employees should know the tactics of Warren Buffett, Benjamin Graham, David Dodd, Charlie Munger, Christopher Browne and Seth Klarman. Their investment style focuses on four metrics of a value investment.

These are the Price to Earnings Ratio, Price to Cash Flow Ratio, High Dividend Yield and Price to Book Ratio. These metrics are clear indicators of an undervalued security. Once overvalued security was returned to fair value then we would see positive returns on that security. Those metrics can help you position yourself in the market for higher returns for Caterpillar employees. We will examine the effect of investing based on some characteristics and how their investment returns are correlated. Today, I close out the four-part TRG value Series with the absolute king of metrics, the Price-to-Book Value ratio (P/B) - book value is preferred by many Value investors to cash flow and earnings metrics because Book Value is more stable year over year versus cash flow and earnings which can vary greatly.

Such a property is important to watch for those at Caterpillar who understand that while a business at a cyclical trough with lower cash flow or price-to-earnings might look expensive on price-to-cash flow or price-to-earnings the same business may look cheap on price-to-book value. This is because book value will not drop much or at all in a downturn - and vice versa. Thus, price-to-book value provides a more reliable picture of a company's normal business performance that Caterpillar employees can use to improve their investment decisions and investment performance, the argument goes. Benjamin Graham popularized the indicator in his books Security Analysis and the Intelligent Investor.

Nobel Prize winning Eugene Fama and research partner Kenneth French used the ratio to describe stock returns in their three-and five-factor models. Professor Joseph Piotroski employs the ratio as the only valuation measure in his F-Score methodology. We understand how data-driven research matters to Caterpillar employees and retirees. The results of two Fama and French backtests of the book value-to-market equity (inverse of the PB ratio) data set from 1926 to 2013 are shown below. By December 2013, the sample had 3,175 firms (Carlisle-PB, P2).

Value decile had the 459 stocks with the highest earnings yield and glamour decile had the 404 stocks with the lowest earnings yield. Those glamour stocks average USD 7.48 billion and the value stocks USD 2.54 billion - that average is skewed by the biggest companies. For context the 3,175th company has a market capitalization of USD 404 million today (less than average, but still investable for most investors). Portfolios are formed June 30 and rebalanced annually. When accounting for this backtest, Caterpillar employees may remember that two portfolios are weighted by market capitalization - that is, bigger firms contribute more to the portfolio performance and smaller firms contribute less.

Figure 1 shows that the value decile has outperformed the glamour decile by 12.6 percent compounded (17.7 percent in the average year) over the full period compared with 8.6 percent for the glamour decile (10.9 percent in the average year) (Carlisle-PB, P3). These are far below the returns on the price-to-earnings and cash-flow ratios mentioned earlier. But despite the irregularity, Caterpillar employees need to know that earnings and cash flow backtests went back to only 1951 and book value return data goes back to 1926. The difference is due to the 1929 crash, which inflated returns. The effect of the crash is obvious; the value decile took twenty years to recover.

Caterpillar employees should also note that the glamour decile hasn't grown since 2000. To make a comparison possible of the performance of the book value with that of earnings and cash flow over the same period I also measured returns starting in 1951. Since 1951, the low P/B value decile has produced a compound annual growth rate of 15.0 percent and an average annual return of 17.9 percent. The glamour decile delivered a 9.6 percent CAGR and an AAR of 12.6 percent over the same period (Carlisle-PB, P5). Such returns approximate those of the low P / CF and P / E studies over the same period. In their study, the quintile of the lowest P / E stocks outperformed the high P / E quintile.

Its portfolio with the lowest P / E stock returned 11.61% annualized versus 4.83% for the highest P / E portfolio and 7.55% for the used universe of stocks. This graph shows how the cumulative returns fare (not even close). Caterpillar employees can use this information to avoid investing in underperforming assets and to identify economic trends driving higher ROI. They mean absolutely nothing unless you're running an index or hugging an index. The simplest portfolio weighting scheme is to equally weight each position (and If we're willing to take a little more volatility for a little more return, we can also Kelly weight our best ideas). The Kelly Weighting is determined by the Kelly Criterion - a formula for determining what percentage of capital should be invested in each trade to maximize long-term growth.

The two components of the formula (Kelly% = W-[(1 - W) / R]) are the winning probability (W) and the win / loss ratio (R). The win/loss ratio is the sum of the positive trade amounts minus the negative trading amounts. Its result will tell investors how much of their total capital to invest. Through Kelly Weighting, employed or retired investors from Caterpillar can understand their exposure to each asset in their portfolio and make better asset allocation decisions. Caterpillar employees should also include equal weight return statistics for book value. On average, the value generated 20.2 percent compounded return (27.3 percent on average) over glamour's 6.3 percent compounded return (10.4 percent on average) in the equal weight backtest (Carlisle-PB, P10).

From 1951 onwards the equally weighted P/B value decile has generated a compound annual growth rate (CAGR) of 20.0 percent and an average annual return (AAR) of 25.4 percent (Carlisle-PB, P11). The glamour decile returned a CAGR of 6.4 percent and an AAR of 10.8 percent over the same period. Those returns approximate those of the low P / CF and P / E studies during the same period. With this information in mind, Caterpillar employees have to understand that the value portfolios delivered better book value per dollar invested versus the glamour portfolios (4.57x average versus 0.25x in the glamour portfolios) (Carlisle-PB, P12). Value outperformed glamour since 1999 by 15.9 percent compounded and 16.1 percent in the average year in the equal-weight portfolios (Carlisle-PB, P13).

We know how data-driven solutions are for our Caterpillar employees and retirees so here is another study on P/CF ratio. Exhibit 6 below shows global all-cap results across three price metrics in a Brandes Research Institute study. They confirmed a consistent premium across all metrics. Focus is on P/CF ratio and outperformance in decile 10 value stocks. The smallest outperformance between decile 1 glamour stocks and decile 10 value stocks was observed with P/B measurement, where the average outperformance was 7.1% (Brandes, p. A nationwide Group of financial advisors known as The Retirement Group.

We only plan for and design retirement portfolios for transitioning corporate employees. And each representative of The Group has been handpicked by The Retirement Group in select cities throughout the United States. Each advisor was screened for pension expertise, financial planning experience and portfolio construction knowledge. TRG believes in teamwork to find solutions to our clients' problems. A conservative investment philosophy guides the team in constructing client portfolios with laddered bonds / CDs / mutual funds / ETFs / Annuities / Stocks and other investments.

They handle Retirement / Pensions / Tax / Asset Allocation / Estate / Elder Care issues. This document uses different research tools and techniques. All attempts to estimate future results involve assumptions and judgments and are therefore only tentative estimates. The law, investment climate, interest rates and personal circumstances will all change and will affect how accurate our estimations are and how appropriate our recommendations are. Such a plan requires ongoing change sensitivities as well as constant re-examination and alteration of the plan.

So update your plan a few months before your expected retirement date and do an annual review. Nothing contained herein shall be construed as an attempt by The Retirement Group, LLC or any of its employees to practice law or accounting. We look forward to speaking with any tax and/or legal professionals you may select regarding the implications of our recommendations. Through your retirement years we will continue to update you on issues affecting your retirement via our complimentary and proprietary newsletters, workshops & periodic updates. Or call us at (800) 900-5867.

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Sources:

1. Investopedia. 'Using the Price-To-Book (P/B) Ratio to Evaluate Companies.'   Investopedia , 7 Mar. 2018,  https://www.investopedia.com/investing/using-price-to-book-ratio-evaluate-companies/?utm_source=chatgpt.com .