Thread by @patrick_oshag

1/ Value strategies—which buy into stocks with low expectations—can be like IBM or like Apple.

When expectations are exceeded, as has been the case with Apple, you earn great returns. When expectations weren’t low enough, you get IBM

For both, future fundamentals drive results.

2/ With a crystal ball, a value investor could drastically improve their results. Among value stocks, returns diverge when sorted on good and bad future fundamentals (EPS growth).

Bad expectations + good results > bad expectations + bad results

3/ As blindingly obvious as this is, its helpful to see just how much of an impact future fundamentals have on value stocks.

Here we parse value stocks into groups based on their *forward* EPS growth. The spreads at the bottom are massive.

4/ This is true for more than just value stocks, but also for the market as a whole. Knowing future EPS growth would give you a huge edge. But the advantage (measured as return spreads) is more pronounced among value stocks. See how that advantage grows with concentration:

5/ The performance of the value factor through history is consistently dependent on the stocks that break from expectations in the right direction (the green bins here)

6/ This all means that finding data/signals/factors observable TODAY which are related to fundamental outcomes NEXT YEAR is a very worthy pursuit.

7/ We can bucket value stocks into equal bins (20% in each) by forward earnings growth.

We then build a set called “value traps” with bad momentum, bad trailing earnings growth, bad earnings quality, and bad balance sheets. Check out the bin distribution for value traps:

8/ You can see this in the actual earnings growth rates, too, broken down by decile. Look how bad the results are for value traps compared to value overall, especially on the bad end of the spectrum:

9/ Now, look at the inverse: value EXCLUDING traps (stocks left over). Here we see a tilt away from the worst bin and improved earnings growth over plain value at both ends of the spectrum

10/ If we then focus in more on what we call “value leaders” (top half of stocks remaining) we see the effect continue to improve.

11/ In real life, we don’t have a crystal ball. All we can do is try to shift the odds in our favor. This table shows how.

Specifically, “net shift” tells us how much we move the plain value group towards participating just in stocks with the best future growth.

12/ This style of alpha within the value factor has held up in the major periods in our sample (since 1962). Value leaders has outperformed simple value.

13/ and the underlying reason for this—the net shift towards the best future earnings bin—has been remarkably consistent through time.

14/ looking at the basic returns in two ways, this shows that within a factor like value, further work can be done—and that the source of returns can be altered. Value can be about BOTH multiple expansion and EPS growth.

15/ Coming full circle: it’s the earnings, stupid! If you can tilt odds towards better future fundamental growth within a basket of similarly priced, low expectations stocks, historically you’d have improved upon the ordinary value factor.

Full research piece, written with @Jesse_Livermore & @ChrisMeredith23 available here: osam.com/Commentary/alp…