Applying Fundamental Analysis for Growth Stocks

Partha Mohanram
Phillip H. Geier Jr. Associate Professor of Business Columbia Business School

October 9, 2007 Boston

Council Member Biography
Partha Mohanram is the Phillip H. Geier Jr. Associate Professor at Columbia Business School. His research focuses on the valuation of stocks, corporate disclosure and earnings management. His papers have studied the valuation of Internet stocks, the calculation of cost of capital, the use of fundamental analysis for valuing growth stocks, the analysis of earnings management related to executive compensation, and the impact of Reg FD on sell side analysts. He has published in top accounting journals and is on the editorial board of The Accounting Review. His research has been featured in the New York Times and he has appeared on CNBC. Prof Mohanram teaches Financial Statement Analysis and Valuation with an emphasis on exposing students to potential manipulations of financial statements. Prof Mohanram was a faculty member at the Stern School (NYU) from 1998-2003. He holds a B.Tech in Computer Science from IIT-Madras, an MBA from IIM-Ahmedabad and a PhD in Business Economic from Harvard.

Topics
► How fundamental analysis applies to growth stocks ► Applying the GSCORE to growth stock portfolios ► Historical portfolio results of the growth stock model ► Unsuccessful approaches of fundamental analysis to growth stock portfolios

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Fundamental Analysis for Growth Stocks
By Partha Mohanram Phillip H. Geier Jr. Associate Professor of Business Columbia Business School

About Me
• Professor at Columbia since 2003
– On NYU Stern Faculty since 1998

• Ph.D. in Business Economics From Harvard • Extensive Research Work on
– Valuation, with emphasis on early stage growth forms – Implied Cost of Capital – Earnings Management and Compensation

• Published in Leading Accounting Journals

• Editorial Board of The Accounting Review
• Teach Financial Statement Analysis to 2nd year MBAs, Executive MBAs and Executives

GSCORE Paper
Today’s presentation based on the paper
• “Separating Winners from Losers Among Low Book-toMarket Stocks using Financial Statement Analysis” • Presented at NYU, Harvard, Berkeley and the Review of Accounting Studies Conference • Published in the Review of Accounting Studies (2005)

Growth Stocks
• Growth Firms identified by their Market-to-Book (or Book-toMarket) ratio is.
– Firms in the top 20% of MB, or equivalently bottom 20% of BM considered growth stock.

• Empirical Fact
– Growth Stocks perform poorly, underperforming by almost 10% historically – Unclear if this is because of risk or mispricing – However, we do know that some growth stocks end up as the Googles and Microsofts of the world and others as the Dr. Koops.

• Growth stocks by definition have lofty valuations
– Can one apply fundamental analysis to systemically predict which ones deserve this and which don’t?

Fundamental Analysis in Growth Firms
• Why it may not work?
– Markets may use non-financial metrics – These firms are not “ignored” – Early stage firms – traditional ratios may not work

• Why it may work?
– In the long run, fundamentals will matter – Firms may be “hyped” systematically – While traditional ratios may not work, some other financial statement info may be useful

Modified Fundamental Analysis
• Focus on cross-sectional vs. time series
– Comparison of firm with other low BM firms in same industry (2 digit SIC code)

• Eight Yes/No Questions in three categories. Can be viewed as a “serial” stock screening method • Three kinds of signals
– Traditional profitability signals (ROA, CF ROA)
• No breakdowns into margins, turnovers etc

– Signals related to naïve extrapolation – ROA variability, growth variability
• Firms less likely to have “chance” high realization

– Separating out the low B firms from the high M firms
• Firms investing in the future (R&D, Capex, Advertising)

Basic Profitability Signals (3)
1. Is Firm more profitable than peers?
– Profitability defined as Net Income/Total Assets

2. Is Firm generating more cash flows than peers?
– Measured as Cash from Operations/Total Assets

3. Does the firm have lower accruals than peers?
– – Measured as difference between above two metrics An attempt to control for Accrual Anomaly of Sloan (1996)

Earnings and Growth Stability Signals (2)

– – –

Investors naively extrapolate current earnings and growth performance into stock price
Some firms may have lucky current realizations, not likely to persist Focus on firms with track record of stable earnings and growth Measure earnings and growth variability as variance of past earnings (NI/Assets) and sales growth respectively

1.

Does firm have less variable earnings than peers?

2.

Does firm have less variable (sales) growth than peers?

Investing in Future Signals (3)
• High valuations are all about the future


Which firms are investing in the future?
R&D, Capex, Advertising


Accounting treatment for these also depress current earnings and book values
Low B vs. High M Stocks

1. 2. 3.

Is firms R&D/Assets greater than peers? Is firms Advertising/Assets greater than peers? Is firms Capex/Assets greater than peers?

The GSCORE Metric
• Combine 8 binary signals into single metric, GSCORE
– Made it simple; no weighted measure or continuous measure

• Can take value from 0 to 8
• If this works
– Low GSCORE firms should perform poorly – High GSCORE firms should perform well

Individual Examples
High GSCORE SAMPLE TICKER CSCO ACN MSFT LLTC NAME CISCO SYSTEMS INC ACCENTURE LTD MICROSOFT LINEAR TECHNOLOGY CORP GSCORE (end of 2005) 8 8 7 7 Return (in 2006) 30.5% 28.4% 24.9% -13.8% Works YES YES YES NO

Low GSCORE SAMPLE TICKER OPWV SIRI AMTD MICC NAME OPENWAVE SYSTEMS INC SIRIUS SATELLITE RADIO INC TD AMERITRADE HOLDING CORP MILLICOM INTL CELLULAR SA GSCORE (end of 2005) 2 2 2 2 Return (in 2006) -50.4% -24.4% -12.8% 25.3% Works YES YES YES NO

Portfolio Results (from Paper)
TABLE 4. Returns to an Investment Strategy Based on GSCORE for Low BM Firms. Panel B: Distribution of SRET1 (One-Year Size Adjusted Returns) GSCORE 0 1 2 3 4 5 6 7 8 ALL HIGH (6,7,8) LOW (0,1) HIGH – LOW t-statistic/ z-statistic Bootstrap Result p-value N 614 2191 4038 4378 3974 3477 2139 803 110 21724 3052 2805 Mean -19.1% -17.0% -14.0% -12.7% -6.7% -3.2% 1.3% 6.8% 11.4% -8.7% 3.1% -17.5% 20.6% 10.41*** 0/1000 (0.000) 10% -87.8% -86.1% -84.8% -83.1% -71.8% -62.7% -54.0% -49.7% -51.9% -76.4% -52.6% -86.3% 25% -61.7% -62.4% -61.4% -57.4% -46.0% -38.5% -31.2% -23.9% -22.5% -50.7% -29.1% -62.1% Median -34.7% -34.0% -30.9% -25.2% -15.7% -10.2% -5.1% 0.0% -0.2% -19.1% -3.7% -34.0% 30.3% 21.23*** 0/1000 (0.000) 75% 2.7% 5.0% 7.6% 10.8% 16.9% 18.3% 20.4% 23.3% 21.1% 14.3% 21.1% 4.5% 90% 62.0% 52.8% 60.1% 60.6% 61.4% 56.3% 57.6% 62.7% 62.4% 58.6% 58.9% 54.7% % Positive 26.2% 27.4% 28.6% 31.3% 36.4% 39.7% 44.0% 49.9% 50.0% 34.6% 45.8% 27.2% 18.6% 15.12*** 0/1000 (0.000)

Portfolio Results (2 year Horizon)
Panel D: Distribution of SRET12 (Two-Year Size Adjusted Returns) GSCORE 0 1 2 3 4 5 6 7 8 ALL HIGH (6,7,8) LOW (0,1) HIGH – LOW t-statistic/ z-statistic Bootstrap Result p-value N 614 2191 4038 4378 3974 3477 2139 803 110 21724 3052 2805 Mean -36.1% -32.8% -26.4% -22.4% -9.9% -6.2% 0.9% 13.4% 15.5% -15.9% 4.7% -33.5% 38.3% 14.25*** 0/1000 (0.000) 10% -120.8% -116.3% -114.4% -111.7% -102.0% -92.1% -81.0% -73.1% -64.1% -106.5% -77.5% -117.8% 25% -92.5% -91.1% -88.6% -86.7% -71.9% -61.1% -49.3% -41.2% -38.4% -77.2% -46.9% -91.4% Median -58.1% -56.5% -54.2% -46.4% -30.5% -21.1% -11.8% -1.7% -4.3% -36.1% -8.8% -57.0% 48.2% 21.24*** 0/1000 (0.000) 75% -10.6% -5.9% -1.9% 7.5% 21.4% 22.3% 28.1% 40.4% 34.0% 14.7% 31.5% -7.2% 90% 50.0% 60.1% 69.4% 74.5% 90.6% 81.8% 82.9% 108.3% 121.7% 79.1% 89.6% 58.2% % Positive 26.2% 27.4% 28.6% 31.3% 36.4% 39.7% 44.0% 49.9% 50.0% 34.6% 45.8% 27.2% 18.6% 15.12*** 0/1000 (0.000)

Results Across Time (1 year Horizon)
GSCORE Strategy return: Return to a strategy of going long in High GSCORE Firms and going short on low GSCORE Firms 50.0%

40.0%

30.0%

20.0%

10.0%

0.0% 1979 -10.0% 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

-20.0%

• Post 2001 numbers based on additional analysis

Analysis of Results
• Robust Across Time
– Unlikely to be driven by “risk” based explanations

• Most of the Returns from the Downside
– Need to have the ability to short – Difficult to pick “undervalued” gems in this highly valued space

• Robust across partitions
– Size, Analyst Following, Liquidity, Exchange Listing – Should allay implementability concerns

Implications
• This approach helps identify which stocks to avoid.
– Important for investors who can use this approach to separate the wheat from the chaff.

• This strategy can be profitable if one has the ability and willingness to short • Basic Fundamental Analysis has a role to play in the growth stock space as well.
– Don’t waste your time looking for the next “new paradigm”. – One has to tailor fundamental analysis to suit growth stocks where it is all about expectations and long term performance.

• Strategy works well in portfolios – with at least 50 stocks in both groups (high GSCORE and low GSCORE stocks).
– It may not work well with individual picks.