Balance Sheets Matter

Every financial transaction passes through the balance sheet. So, don’t underestimate its importance in finding mispriced stocks. Transaction such as sales, expenses or capitalized expenses, depreciation, capital expenditures, stock issuance, all impact the BS. Further, assets are recorded at original cost not fair market value. Therefore assets such as real estate acquired years ago often present an opportunity.

An interesting post on alphaarchitect.com, “Value Investing Research: O-Score and Distress Risk”

Article summarized key investing “take away” from an academic paper Book-to-MarketEquity, Distress Risk, and Stock Returns by Griffin and Lemmon (2002 Journal of Finance).

“The paper examines the relationship between book-to-market equity, distress risk,and stock returns. Among firms with the highest distress risk as proxied by Ohlson’s ~1980! O-score, the difference in returns between high and low book-to-market securities is more than twice as large as that in other firms. This large return differential cannot be explained by the three-factor model or by differences in economic fundamentals. Consistent with mispricing arguments, firms with high distress risk exhibit the largest return reversals around earnings announcements, and the book-to-market effect is largest in small firms with low analyst coverage.”

Low P/B (high book to market) is a market anomaly offering investors alpha. The higher risk theory was that low P/B (high book to market) outperformed because low P/B stocks were riskier. This was proven wrong by testing distress risk using the O score (Ohlson). In fact the higher P/B (low book to market) were riskier measured by the O score. The variance of returns from low P/B (high book to market) to high P/B was more than twice as large. The mispricing is more profound for high distress low P/B compared to high P/B high distress. Lastly the inefficiency impact is largest for small companies with little or no analyst coverage. A simple low P/B strategy outperforms on average.

The following is a sample of stocks meeting these filtered criteria. 1) Bottom 30% for P/B 2) stable share count or reduction from 2012, 3) market cap less than 140M 4) Strong Recent Insider Buying

Click for quotes on the stocks Below