Limitations
Avoiding Losers
March 2, 2012
Limitations
While the required business performance probability provides an innovative approach to equity valuation that is independent of most other analysis frameworks, the returns of the Dow Jones RBP indexes during the bear market from October 2007 through February 2009 indicate that the "avoiding losers" strategy is limited when almost all stocks are losing value. During that period, the Dow Jones RBP U.S. Large-Cap Market Index lost 40.85% while the benchmark Dow Jones U.S. Large-Cap Total Stock Market Index lost 40.96%. Meanwhile, the median RBP probability for the S&P 500 at the end of July 2007 was 70%, and 250 companies had stock prices estimated to be sustainable at probabilities between 75% and 100%. Obviously, though, those probabilities were vastly overstated given the performance of the RBP index in the following period. While the required business performance probability is being marketed as a tool to avoid underperforming stocks, the limitation of the RBP valuation is that it cannot quickly incorporate macro-economic shocks into these probabilities, particularly since only quarterly financial reporting is used to update the revenue model. In fact, a falling stock price will increase the RBP probability that the price can be supported until the next financial reporting cycle, at which time the RBP model is reset.
Conclusion
The required business performance probability is an innovative technique for estimating equity valuation from a different perspective. While its analysts are still required to do some non-systematic interpretation of the financial statements, Transparent Value attempts to minimize the biases and subjectivity that may limit the effectiveness of many types of equity research. Once the RBPP values are calculated, both the index construction and fund portfolio weightings are completely rules-based, resulting in a fundamental index, albeit one with a proprietary financial metric. The historical performance of the Dow Jones RBP indexes appears to support the alpha-generating power of the probability rankings, but it's important to warn investors that the RBPP values are historically back-filled and potentially subject to look-back biases. Given the relatively short history, the high annual expense ratios (1.5%) and high turnover (of greater than 100%) in the Transparent Value funds, it remains to be seen whether they can outperform cap-weighted index funds as the RBP indexes have.
Michael J. Reed, who spent ten years as a managing director in Morgan Stanley's Process Driven Trading, runs his own RIA consulting firm, MJ Reed Investment Consulting in Bridgewater, Conn.
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