Quality Investing: the Role of Profitability to Separate Good From Bad Stock in Value Investing

Yanuar Dananjaya,Renna Magdalena

doi:10.18535/ijsrm/v9i1.em03

Abstract

This paper examines how company measurement of profitability can be used to enhance the return of value investing strategy. In value investing strategy, stocks that are deemed cheap based on certain measurement are purchased. It is expected that the price of cheap stocks will increase in the future, and thus resulting in high return. In the heart of this strategy is the assumption that investors overreact to bad news. Thus bad news of a company will result in reduction of stock price below its fundamental value, resulting in undervaluation of the stock. The problem with this strategy is that not all cheap stocks are undervalued. Some cheap stocks are genuinely problematic, and their cheap valuation is already reflecting the fair value of the stocks. Thus portfolio formed using value investing might contain cheap stocks that are not undervalue, but instead fairly valued in that cheap level. One way to screen fairly valued cheap stock is by using profitability measurement as addition to value measurement. In this way stocks that are chosen are cheap stocks of the company with high profitability, and thus enhancing the probability of undervalued stocks. In this research, it is found that adding ROIC to the usual PER factor in value investing strategy increases that one year portfolio return. Quality investing, in which profitability measurement is added to value measurement in value investing, is thus a potential strategy to be used by investor

Highlights

Various research has shown that stocks with lower P/E Ratio will result in higher abnormal return in the future
It was asserted that stocks with low P/E Ratio does not mean the market price is lower than the stock intrinsic value, and cannot be seen as cheap stock
The results suggest that low P/E Ratio is indication of cheap stocks, and purchasing them can result in higher stock return in the future

Summary

Introduction

Various research has shown that stocks with lower (higher) P/E Ratio will result in higher (lower) abnormal return in the future. The phenomena of lower (higher) P/E Ratio stocks result in higher (lower) abnormal return in the future is explained by De Bondt and Thaler (1985) as result from investor overreaction. Positive news about the company will result in overreaction from investor that will bid the stock price above its fair value. When price of the stock goes down to its fair value, abnormal return will be low. Investors will overreact to negative news about the company by selling the stocks until stock price down below its fair value, resulting in low P/E Ratio. The effect of P/E Ratio to future return is formalized by Fama and French (1993) in Fama-French 3 Factors Model.

Methods

Discussion

Conclusion