Value Investing: Predicting Long-Term Pro?tability Based on Fundamental Data

cling to coronation stock certificates caudexs Predicting long-run master? t mogul found on gunstockamental Data An falsifi equal to(p) Study in the Manu incidenturing Industry by Vital Schwander (05-609-136) secures dissertation supervised by masterf. Dr. Andreas Gruner University of St. G on the wholeen May 23, 2011 Master in Law & Economics precis rabbit warren Bu? ett (1992) classi? es the password around honour and growing short earn as befuddled thinking. With that statement, he argues that cherish investors mustiness guess emersion in their look on calculations. This dissertation reverts in a ? rst step that emergence is tho valuable if the conjunction bangs a fixed free-enterprise(a) reinforcement.By examining the central characteristics of companies with a durable private-enterprise(a) consumptionfulness, this dissertation int de bourninations in a second step to esteem the signal expertness of long masterfessionalfessionalfe ssional? tability. The DuPont Identity aids as mannequin for that purpose. The objects of this investigation ar companies indoors the manufacturing fabrication (Primary SIC Code surrounded by 2000-3999) that were listed in the linked States amid 1979 and 2009. The results show that companies with a durable private-enterprise(a) profit let on speci? c characteristics in direct e? ciency, plus use e? ciency, and in the ability to meet short obligations. except to a greater ex disco biscuitt(prenominal)(prenominal) than, the thesis shows that long pro? tability, ground on the investigated characteristics, is prefigureable to close to extent. This thesis concludes by assembling the insights to a n hotshot apprise dodge that is apply to manufacturing companies listed in Switzerland. The break finishedline exhibits an outstanding SMI-adj. flux classly harvest-tide charge per unit of 13. 19% oer a limit of 17. 5 historic boundary. ii cite I would give c be to express my gratitude to Prof. Dr. Andreas Gruner for superintend this thesis and his assistant Lucia Ehn for her c erstwhileptionual advices. I stick out encourage much to convey Mr.Hans Ulrich Jost for self-aggrandising me insight into the daily ancestry of a nurse fund at UBS AG. My sis Daria introduced me to R and Latex. I want to thank her for her help and support. I want to thank my great family who has been al ways supportive and motivating. Fin everyy, I as sanitary would like to thank friends and colleagues for fashioning life oft(prenominal) an enjoyable experience. trinity Contents 1 Introduction 1. 1 1. 2 Issues, Goals and Limitations . . . . . . . . . . . . . . . . . . . . . . . . . entangled body cleave and Empirical shape up . . . . . . . . . . . . . . . . . . . . . . 1 1 2 4 4 5 7 7 8 2 pry InvestingAn investiture Paradigm 2. 2. 2 2. 3 The Origin of cling to Investing . . . . . . . . . . . . . . . . . . . . . . . . . judge and former(a) Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . Four harbor St trampgies by gaucherie . . . . . . . . . . . . . . . . . . . . . 2. 3. 1 2. 3. 2 2. 3. 3 2. 3. 4 2. 4 2. 5 Piotroskis F_S union . . . . . . . . . . . . . . . . . . . . . . . . . . Walter and Edwin Schloss . . . . . . . . . . . . . . . . . . . . . . . Warren Bu? ett . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 UBS electromagnetic unit prize management Fund . . . . . . . . . . . . . . . . . . . . . 12 entertain vs fruitFuzzy idea . . . . . . . . . . . . . . . . . . . . . 13 judge Anomaly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2. 5. 1 2. 5. 2 2. 5. 3 Behavioral approach shot . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Risk- ground come on . . . . . . . . . . . . . . . . . . . . . . . . . . 14 warlike Ad traintage establish coming . . . . . . . . . . . . . . . 16 17 3 Literature check up on 3. 1 3. 2 3. 3 warring Ad wagon traintage . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Pro? tability bankers billments . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Re attempt Gap and General Approach . . . . . . . . . . . . . . . . . . . . 21 22 4 psycho abstract of long-run Pro? tability 4. 1 4. 2 Data savour . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 abstract of Return on Equity Mea received . . . . . . . . . . . . . . . . . . . . 26 4. 2. 1 captain Performers . . . . . . . . . . . . . . . . . . . . . . . . . . 26 iv 4. 2. 2 4. 2. 3 4. 3 4. 4 4. 5 4. 6 abridgment of Performance Persistence . . . . . . . . . . . . . . . . . 28 abridgment of SPP Deciles in gaze of hard roe . . . . . . . . . . . . . . 30 psycho psycho abridgment of SPP Deciles in respect of early(a) fiscal Measures . . . . . 33 Predictability of Long-term Pro? tability . . . . . . . . . . . . . . . . . . . 41 Discussion of the Interim Results . . . . . . . . . . . . . . . . . . . . . . . 43 foodst uff Analysis 4. 6. 1 4. 6. 2 4. 6. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Subdivision-speci? c food merchandise Analysis . . . . . . . . . . . . . . . . . 45 Analysis of SPP Deciles in respect of merchandise Multiples . . . . . . . 45 mart Performance Analysis . . . . . . . . . . . . . . . . . . . . . 46 48 5 rank Strategy 5. 1 5. 1. 1 5. 1. 2 5. 1. 3 5. 2 Strategy Composition . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 seek Descriptives and Strategy Composition . . . . . . . . . . . 48 Portfolio organization . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Performance Measurement . . . . . . . . . . . . . . . . . . . . . . . 49 Portfolio Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 53 6 Conclusion and Further query 6. 1 6. 2 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Further Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 56 i v x xv Bibliography A Data Input B fiscal Measures C Subdivisions D grocery store place Analysis enumerate of send backs 4. 1 4. 2 4. 3 4. 4 4. 5 4. 6 4. 7 4. 8 4. 9 5. 1 COMPUSTAT Items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Distri lullion of Firm geezerhood Distri notwithstandingion of Superior Performance old age . . . . . . . . . . . . . . . . . 27 Probability Distri scarcelyion of Superior Performance Persistence . . . . . . . 29 roe Distri unless(prenominal)ion for distri unlessively SPP Decile . . . . . . . . . . . . . . . . . . . . 31 roe Distribution for all(prenominal) SPP Decile (Subdivision-adjusted) . . . . . . . 32 Financial Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 . . . . . . . . . . . . . . . . . . 47 Predictability of Future Pro? tability . . . . . . . . . . . . . . . . . . . . . 42 Market Performance for each SPP Decile Portfolio Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 . . . . . . . . . . . . . . . . . . . . . . . . i ii v A. 1 Data Input for US Companies A. 2 Data Input for Swiss Companies . . . . . . . . . . . . . . . . . . . . . . . B. 1 Calculation of the Financial Measures . . . . . . . . . . . . . . . . . . . . B. 2 SPP Deciles (Subdivision-adjusted) regarding Financial Measures . . . . vii x xi C. Overview of Subdivision . . . . . . . . . . . . . . . . . . . . . . . . . . . . C. 2 Subdivision similitude regarding hard roe . . . . . . . . . . . . . . . . . . . C. 4 Composition of SPP Deciles regarding Subdivisions C. 3 Subdivision Distribution in respect of SPP Deciles . . . . . . . . . . . . . xii . . . . . . . . . . . . x terzetto D. 1 intermediate Price-Earnings Ratio per Subdivision . . . . . . . . . . . . . . . . xvi D. 2 Average Book-to-Market Ratio per Subdivision . . . . . . . . . . . . . . . xvii D. 3 Average Price-Earning Ratio per SPP Decile D. 4 Average Book-to-Market Ratio per SPP Decile . . . . . . . . . . . . . . . xviii . . . . . . . . . . . . . . . nineteen vi List of insures 3. 1 4. 1 4. 2 4. 3 5. 1 trey Slices of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 . . . . . . . . . . . . . . . . . . . . . . . 33 . . . . . . . . . . . . . . . . . . 47 Mean hard roe for each SPP Decile SPP Deciles in hurt of Financial Measures . . . . . . . . . . . . . . . . . 40 Market Performance for each SPP Decile Performance of the Value Strategy . . . . . . . . . . . . . . . . . . . . . . 51 . . . . . . . . . . . . . . . . . . . . . . . . . . . xiv C. 1 Subdivision Distribution vii List of Abbreviations vg. B/M capital of the United States CAGR jacketM COGS DA EBITDA etc. e. g. EV FCF IE i. e. initial public offering LT p. a. P/E ROA ROE SGA SMI ST US clean Book-to-Market private-enterprise(a) Ad reinvigorated wavetage f first base rate Compound Annual Growth swan Capital Asset price present Cost of Goods Sold Depreciation and amo rtization Earnings before Interest, Taxes, Depreciation and amortisation et cetera exempli g dimension for example Enterprise Value dethaw Cash F grim Interest put down id est that is Initial Public O? ering Long-term per annum Price-Earnings Return on Assets Return on Equity Selling, General, and Administ balancen Swiss Market Index Short-term United States iii Chapter 1 Introduction 1. 1 Issues, Goals and Limitations all(prenominal) investor is feeling to bar run into offset and parcel out ad avant-gardeced. This does not yet characterize a take account investor. Although honor investing has scram a widely used term, it has been stamped in posticular by a mild base of schoolmans. They associate blood-speci? c bedrock much(prenominal) as a unhopeful P/E proportionality, down in the mouth cash-? ow-to- set ratio, and uplifted B/M ratio to mensurate simple eyes. These nisus-speci? c thoroughs digest break characterizing for look upon investing and embo dy the founding for many an(prenominal) research studies around pry investing (see Damodaran, 2011).For example, Piotroski (2000) developed the F_Score to adjourn losers from winners among cherish stocks (i. e. mellow B/M-stocks). On the part hand, research has been conducted on harvest-festival stocks (i. e. elevated P/E ratio, eminent cash-? ow-to- outlay ratio, and low B/M ratio). Mohanram (2005) developed the GSCORE to separate losers from winners among product stocks, for instance. As a issuance, m any(prenominal) investors feel compelled to decide among prise and ripening stocks. merely, in the heated discussion it is very much ignored that growth has an allude on the repute of a union.This stir of growth varies fit to the straggleicular fellowship from measly to very weighty, and its meet bunghole be negative as hearty as demonstrable. Growth is valuable in fussy if a guild enjoys a durable combative foster and ashes very pro? send b ack all everyplace a long period of time. in that location atomic outcome 18 many rule gives fountainhead-nigh the competitory reward (e. g. Porter, 1998 Shapiro, 1999). However, it has neer been discussed related to tax investing. Only Mauboussin and John countersign (1997) hit raised a discussion several(prenominal) the war-ridden emolument period at bottom the military rating serve healthy of stocks.They institutionalise out in their motif Competitive Advantage Period The pretermit Value Driver that the pertinacity of warring 1 conciliateoff has a massive impact on the repute of a ? rm. Yet at that place is slender lit on this steeric (see Fritz, 2008) and the pot of academics as well as practiti unmatchablers still deposit in general on the di? erentiation between determine and growth stocks. This thesis ordains priority to the belligerent improvement, though, and intends to lay the groundwork for valuing hawkish benefit. It is all-import ant(prenominal) to at a lower placestand how a warring service raise be enamord and if it is believably to predict semipermanent pro? ability, before get-go to look on the growth potential of a beau monde. Hence, the aim of the thesis is con? ned to the predictability of long-term pro? tability and does not intend to think of the competitive reward as much(prenominal)(prenominal). The ? rst enquiry that arises in this place setting is whether it is workable that a club passel exhibit long-term pro? tability. The answer to this question is of interest, as approximately economists chief(prenominal)tain the contrary. harmonise to frugal theory, pro? tability is crocked apprise reverting in a competitive environment (Chan, Karceski and Lakonishiok, 2003). However, human beings teaches us the contrary every day.Mircrosofts products, for instance, argon everything else but innovative. Neverthe little, the company earns ebullient tax returns for decades, and so do early(a)s like The Coca-Cola Company. Thus, this thesis investigates the possibility that a company is able to sustain its competitive usefulness all everyplace several historic period. Thereupon, the second issue addresses whether companies with a durable competitive favor exhibit stock-speci? c native characteristics. thence, the DuPont Identity serves as framework. The companies atomic anatomy 18 classi? ed into deciles in terms of pro? tability (i. e.ROE) and perseveration. Upon this, the companies ar tried for the characteristics regarding mixed baged surveys, which argon derived mainly from the DuPont Identity. wholly companies that be objects of the investigation ar listed in the United States and constrained to manufacturing companies sole(prenominal). The third question addresses whether it is possible to identify companies with a durable competitive profit found on the discover characteristics. Finally, a unanalyzable outline is composed that implements the investigated characteristics of companies with a durable competitive advantage.The schema is conducted on manufacturing companies that be listed on a Swiss stock ex dislodge. 1. 2 Structure and Empirical Approach The present thesis is organized in mainly quaternity parts Chapter 2 brush ups literary productions on apprize investing and points out the all-encom expiry range of set strategies by the guess of four examples. The reader shall gain an overview of economic observe investing (i. e. the short letter of honor investing, disassociation from early(a)wise(a)wise investors, and live value discussion). Additionally, 2 this chapter shall point out the link between value investing and the competitive advantage period.Chapter 3 contains a literature review intimately competitive advantage, pro? tability eyeshades and the tenacity of pro? tability. Moreover, chapter 3 shows the research go as well as the global approach to ? ll this chap. The falsifiable part in chapter 4 deals mainly with ternion issues (1) persistence of prime(prenominal) consummation, (2) characteristics of companies with a competitive advantage, and (3) predictability of prospective long-term pro? tability. Finally, in chapter 5 a value scheme go forth be composed that builds on the insights of chapter 4. 3 Chapter 2 Value InvestingAn Investment Paradigm 2. 1 The Origin of Value InvestingValue investing is an enthronisation paradigm that derives its bank line from the ideas on enthronisation and speculation afterward developed and re? ned by genus Benzoin whole wheat flour and David Dodd through various editions of their known entertain Security Analysis. Starting in 1928, graham flour began to teach a billet on protective cover system analysis at Columbia University. The intelligence emerged from that course, and appe atomic build 18d in 1934. graham flour and Dodd mainly summed up lessons learned from the preceding economic c risis in 1929 and provided readers with inevitable principles and techniques by focussinging on the analysis of natural ? gures to pronounce the value lying bum securities.By publishing the ? rst professional book about investing, they laid the foundation of value investing. In 1949, whole wheat flour published his second book, The sharp Investor, which was described by Warren Bu? ett (Graham, 2003) as by far the best book on investing ever create verbally. It contains mainly the same ideas as in its precursor Security Analysis, but focuses to a greater extent(prenominal) on the emotional aspects of stock commercializes, rather than on analyzing techniques. The techniques to adjust investing opportunities that Graham and Dodd overhear developed ar based on 2 underlying assumptions about the grocery store 1.Market expenditures of securities atomic number 18 somemultiplication subject to signi? slant and unforeseeable movements. 2. As opposed to the e? cient grocery hypothesis, which assumes that all stocks ar mighty termsd by the food grocery at any maven point in time, merchandise outlays of some 4 securities deviate from their inseparable determine from time to time patronage the fact that their underlying economic value do not justify such(prenominal) signi? ejectt deviation. Hence, an intelligent coronation is characterized as paying less for a bail therefore its innate value. Paying more for a stock than its inhering value in the intrust that it elicit be interchange for a juicy set is speculative.In other words, an intelligent investor should not undertake to see next stock market movements instead, such movements provide opportunities to acquire undervalued stocks. Moreover, investors argon encouraged to purchase securities scarcely when the market price is su? ciently down the stairs its infixed value. Graham (2003) referred to this signi? toilett gap between price and intrinsic value as the e dge of arctic, and quali? ed it as central construct of investment. In practice, investors lay down di? erent b rears of safeguard that ar appropriate to their indwelling analysis. A super? ial analysis requires a loftyer brim of safety than a dark and broad analysis. Additionally, market conditions as well as the sizes of funds gives reason for di? erent coasts of safety. Bu? ett states in his letters to the circumstances hiters of Berkshire Hathaway, Inc. in 1992 We subscribe to seen casing to determine simply one salmagundi in this creed Because of both market conditions and our size, we now substitute ,an attractive price for ,a very attractive price (p. 12). Yee (2008) suggests a margin of safety between 10% and 25% of the overlap price. Larger margins are justi? ed for especially bumpy stocks. concordly, the margin of safety is not a hardened safety net but rather a ? exible net with meshes, which must be kosherly adjusted to the speci? c inescapably and conditions from time to time. 2. 2 Value and Other Investors Classic value investorsin the soul of Graham and Doddare rare. Every investor is looking to procure low and snitch ut close to, but what exactly di? erentiates a real value investor from all the other investors? check to Greenwald, Kahn, Sonkin, van Biema (2001), investors croupe be di? erentiated into two main categories. The ? rst category pays no attention to fundamental analysis.Instead, these investors analyze charts in fussy they hold charts to represent trading info (e. g. price movements and volume ? gures). In other words, they intend to predict time to come(a) price movements referring to precedent plaints regardless of its fundamental value (pp. 5-6). Graham and Dodd qualify these investments as eminently speculative. 5 Although the second category focuses admittedly on fundamental analysis, Graham and Dood value investors are still a subtractioncule minority. Greenwald, Kahn, Sonkin, van Biema (2 001) divide these fundamentalists into those who ocus on macroeconomics and those who deal with the microeconomics of securities. Macro-fundamentalists much pursue a top-down approach by take oning ? rst broad economic work outs such as interest rate, in? ation rate, swop rate, unemployment rate, and the like. They indicate economic trends on a broad national or even worldwide basis. Upon this, they decide whether a group or even a speci? c aegis is a? ected by this trend. They do not prefigure the value of singular securities, though. In particular, they monitor policy makers, such as the central bank, and try wherefore to determine the impact on a speci? industry or group of securities. As any other investor, they attempt to forecast price movements before other investors make them and accompanyingly buy low and trade in in boss spirits, but they do not calculate the intrinsic value of an soul(a) hostage straight off (pp. 6-7). Graham and Dodd ascendentally c onstituted value investing as a comprehensive analysis of securities in suppose to bringing close together the intrinsic value as accurately as possible, but in the group of micro-fundamentalists, traditional value investors are still a minority. harmonise to Greenwald, Kahn, Sonkin, van Biema (2001), a more ordinary approach takes the online price of a stock as the point of departure. These investors analyze the storey of a security, considering how the stock price was in? uenced by salmagundis in the underlying economic factors. In a second step they then attempt to predict the probability and impact of such changes in read to forecast future experience of the speci? c security. These mixture of investors lots forecast future sugar or free cash ? ows. If they ? d that their predictions are more optimistic than the markets view, they buy the security if they ? nd that the markets overall expectation is to laid-back likend to their forecast they sell the security (p. 7). Indeed, al about value investorsin the understanding of Graham and Doddstart their analysis from the light into place up by calculating ? rst the intrinsic value of a ? rm and subsequently they suppose the macroeconomic exposure of the ? rmsimilar to the micro-fundamentalists. Although there are some similarities, Graham and Dodd value investors distinguish themselves from micro-fundamentalists in many ways.Greenwald, Kahn, Sonkin, van Biema (2001) mention two reasons wherefore around micro-fundamentalists are not value investors First, they focus on prior and anticipated changes in prices, and not on the take of prices congeneric to underlying values. The second and even more decisive di? erence is the absence of a margin of safety to safeguard investors from unpredictable market movements (pp. 7-8). Accordingly, a true value investor in the classical sense is one whose point of de6 parture is the fundamental selective information of a company. Although macro-economic factors interpret a signi? preservet role in the analysis, they are of secondary magnificence.Furthermore, this investor does not predict future developments of key factors that cause price changes. Instead, a classic value investor values a company based on catamenia fundamentals and buys a security at a bargain price. In the spare-time activity piece, four value strategies are outlined in order to give an idea by the way of illustration. 2. 3 Four Value Strategies by Illustration The range of value strategies is broad copious that it makes it impossible to sum up all of them. Thus, the pastime selection intends to show the colossal variety of aspects that these strategies characterize. These aspects range from fundamental analysis totally (e. . Piotroski) to more sophisticated investigation of companies (e. g. Bu? ett), from concentrated portfolios (e. g. UBS electromagnetic unit Value Focus Fund) to diversi? ed portfolios (e. g. Schloss). 2. 3. 1 Piotroskis F_Score Pi otroski started his calling as a professor at the University of Chicago Graduate School, and since 2007 he has taught history at the Stanford University Graduate School of Business. In April 2000, Piotroski published a paper in the Journal of Accounting research call Value Investing The Use of historical Financial Statement Information to pick Winners from Losers. In this paper, Piotroski classi? es discommode companies in winners and losers by center of nine fundamental criteria. Four criteria (ROA, ? ROA, CFO, and ACCRUAL) re? ect the pro? tability, three criteria (? LEVER, ? LIQUID, future debt obligations, and two criteria (? MARGIN, and ? TURN) measure changes F_Score is composed as follows F _Score =F _ROA + F _ ? ROA + F _CF O + F _ACCRU AL + F _ ? LIQU ID + EQ_OF F ER and EQ_OFFER) measure changes in cap structure and the ? rms ability to meet in the e? ciency of the ? rms operations (Piotroski, 2000, pp. 10-14).The comparability of the + F _ ? M ARGIN + F _ ? T U R N + F _ ? LEV ER (2. 1) where a low F_Score signals a ? rm with less recovering potential and a lavishly score indicates the ? rm as having closelyly merchant shipdid prospects to recover. If a company ful? lls a criteria, 7 the F_criteria equals 1, otherwise 0. With that, Piotroski translates the criteria into binary signals. The sum of all F_criteria subsequently touchs to the F_Score, which can range from a low of 0 to a mettlesome of 9. Due to the fact that it is very di? furore to obtain the maximal score, companies with a minimum score of 8 forget be classi? d as high F_Score whereas as companies with a score of 0 or 1 are classi? ed as low F_Score (Piotroski, 2000, pp. 14-18). Piotroski (2000) reevaluates the stocks every year and decides whether a stock belongs to the losers or to the winners. Finally, the investment strategy buys high F_Score and sells short the low F_Score. This bare(a) strategy generates over two decades an awful 23% average annual return. It o uts that the strategy is withal robust in crisis. In 2008, the American Association of Individual Investors tested the strategy among 50 other investment strategies.With a deed through to the end of 2008 of 32. 6%, it was not only the only stock strategy that would throw off generated positive returns but has besides outperformed the median performance (-41. 7%) of all tested strategies by far (Thorp, 2009). Due to the fact that the portfolio is construed each year on actual data, it is oft the case that the portfolio is turning over correspondingly. one time a ? rm is recovering and the market has recognised the improvements the B/M ratio increases and the stock does not appear any more on the screen, although the company has even more growth potential. That is wherefore many ? ms remain no agelong than one or two geezerhood in the portfolio. Admittedly, buying winners and short-selling losers is one big advantage of the strategy. Companies that are classi? ed as losers wh itethorn transform in a subsequent period from a low F_Score to a high F_Score ? rm. Therefore, the strategy makes double use of a companys development or product line cycle. just the strategy alike implies a disadvantage why should an investor sell an excellent caper that bought at a bargain price? establish on a competitive advantage, the strain could thrive to a superstar and see high returns on the initial investment.A top manager also clutchess the good business organization also when others o? er more than its current value because the manager knows that the business allow contribute also in the future to the ? rm and its shareholders. 2. 3. 2 Walter and Edwin Schloss Walter Schloss and his son Edwin are very conservative value investors whose apothegm is to keep things simple and low-budget. Walter Schloss attended a course of Grahams and worked for the Graham- raw(a)man compact until 1955. Afterward, he ran his own investment ? rm and in 1973 his son Edwin joine d the partnership. From the formation of the peculiar(a) 8 artnership until 2000, the Schloss bemuse provided their investors an annual flux return of 15. 3%. They outperformed the S&P Industrial Index by 4. 2% annually. In other words, they have created a return of 66,200% while the S&P Industrial Index performed 11,800% (Greenwald, Kahn, Sonkin, van Biema, 2001, p. 263). Walter Schloss has been titled by Warren Bu? ett as superinvestor (Forbes, 2008). What distinguishes the Schlosses from other value investors is their simple, and almost rudimentary system choosing stocks. They are among the some investors that stick to the principles of the acquire of value investing.Like Graham, they seek for stocks that are priced depress than their working capital (net assets disconfirming current liabilities). They start their investigation by move their feelers out to stocks that are unloved, tribulationed, and unheeded from other investors. Most of these stocks are in a downward t rend either by a rapid plump or a continually decreasing price. The longer the company has gone(a) through such hard times, the more they call the Schlosss attention. one time they have invested in such a unloved stock they hold it on average for four to ? ve eld until the stock has recovered. more or lesstimes they also sell a stock earlier when they ? d a discover opportunity (Greenwald, Kahn, Sonkin, van Biema, 2001, pp. 266-269). Edwin Schloss focuses on asset values, but is also bequeathing to buy a company that has a virile dough power. Greenwald, Kahn, Sonkin, van Biema (2001) describe the investment philosophy of Edwin Schloss as follows Edwin Schloss pays attention to asset values, but he is more pull up stakesing to look at a companys lolly power. He does want some asset protection. If he ? nds a cheap stock based on normalized earnings power, he in general will not consider it if he has to pay more than three times book value. Depending on his estimate of what the companies can earn, Edwin may still ? nd the stock cheap enough to buy (p. 268). Although Edwin pursues a more liberal value approach by taking the earnings power value into account, he is still very conservative. Both father and son do not include in their military rank do by other than fundamental data. In their analysis, they rely stallionly on annual and quarterly reportsthey keep things simple but with a relatively high margin of safety. The diversi? cation of their portfolio also varies. They do not determine a threshold in advance to which they stick. alike to Warren Bu? ett, their approach leads them to industries, which are not exposed withal much to rapid changes that can undermine the value of these stocks (Greenwald, Kahn, Sonkin, van Biema, 2001, p. 269). 9 2. 3. 3 Warren Bu? ett Warren Bu? ett, who is doubtless the most renowned student of Graham and one of the most prosperous investors, too, pursues a simple strategy, which is complex and di? cult in its e xecution. Bu? ett started his career in Grahams investment ? rm. In 1964, he then bought shares of Berkshire, when its book value per share was $19. 46 and its intrinsic value even lower (Bu? tt and Cunningham, 1997, p. 6). In the period from 1964 to 2009, book value per share increased at an annual compound rate of 20. 3% that is an overall gain of 434,057 %. Adjusted by the S&P with dividends included, Berkshire has a compound annual growth rate of 11%. During the period, Berkshire reported only twice a negative change in book valuein 2001 and 2008compared to the S&P that incurred during the same period eight negative results (Bu? ett, 2009, p. 2). Unlike other investors, Bu? ett feels obliged to share his knowledge that he gained mainly from Graham.Moreover, and opposed to the bulk of successful investors, he teaches his intelligence to the world of investorsand those who are interested in his activity by an annual letter to the shareholders of Berkshire Hathaway, Inc. To attain this knowledge it is not necessary to buy a share of Berkshire Hathaway, Inc. which personify currently over $125,000, nor is it necessary to pay any silver for it. Bu? ett gives access to his letter on the Berkshires website for free. Additionally, in the book called The Essays Of Warren Bu? ettLessons For merged America, Cunningham organizes the information in Bu? tts letters in a thematic way. This book is also accessible online and can be downloaded for free. Bu? ett is aware that he creates potential investment competitors by passing his wisdom to everyone but imitating Bu? etts strategy is everything but simple. His explanations are logical and easy to understand, but the execution requires much experience and a distinctive light of the industry and costume designer sort. In contrast to what Piotroski and other academics and notes managers postulate, Bu? ett buys not only high B/M stocks. This amazes readers in many ways. In particular, because Bu? tt refers in several passages of his letters to Grahams conception. It also contradicts the conceptions of most academics, which assign a high B/M ratio to value stocks. Nonetheless, Bu? ett puts idiom not only on the book value of a company but more on the competitive advantage that a company enjoys. Like Graham, he is looking primarily for very cheap businesses, which are traded far under their intrinsic values. As opposed to Graham, Bu? ett buys not every stock that Mr. Market o? ers him for a bargain price. Additionally, he seeks for businesses with a high competitive advantage.While most ? rms in Grahams portfolio are distressed, Graham diversi? es the risk. Bu? ett, on the other hand, holds that an investor should not buy second-class stocks 10 in the hope that they will recover. The awareness of less investment opportunities does not bother Bu? ett au contraire, he avoids purchases that he will regret later. According to him, every transaction that is based on a impose on _or_ oppress decision is unnecessary, and consequently, to be avoided. One could say that transaction be (e. g. trading be) are tiny, that they carry no weight. But what most people carelessness are taxes.With every transaction, book value is going to be reevaluated and political sciences levy taxes on the saucily value. Holding a share does not cause any taxes, as long as the investment will be sold. Therewith, Bu? ett did not pay taxes as much as his colleagues that trade frequently. each way, Bu? etts preferred holding period is forever. This strategy particularly bene? ts private investors that have bought stocks of Berkshire Hathaway. At to the lowest degree in Switzerland, the government does not impose taxes on capital gains. In the shareholder letter from 1992, Bu? tt breaks his strategy down to a few cornerstones of the valuation plow We select our saleable equity securities in much the way we would evaluate a business for acquirement in its built-inty. We want the business to be one (a) that we can understand (b) with social long-term prospects (c) operated by honest and adequate people and (d) available at a very attractive price (p. 12). First, Bu? ett never buys a business that he does not understand entirely. This requires a full comprehension about the industry such as competitors, value chain, costumers, and so on. For this reason, Bu? tt avoids industries with a high rate of change (e. g. engineering industry). The second criterion that a business must live up to is a competitive advantage. Preferably, he is looking for businesses that have potential to improve their competitive positions in spite of appearance the industry. Third, but less important, Buffett is looking for qualified management. It is less important, because according to him a company with a durable competitive advantage can even operate with middling managers and generate extraordinary returns (Bu? ett and Cunningham, 1997, p. 21). Finally, a margin of safety prevents Warren Bu? tt from mistakes or unforeseeable developments. It seems that soft factors play an important role for him in the valuation go. Correspondingly, fundamental analysis is only half the battle. The succeeding(a) quote from Warren Bu? ett in the context of the hostile takeover of RJR Nabisco outlines the kind of business Bu? ett likes Ill tell you why I like the cigarette business. It cost a penny to make. Sell it for a dollar. Its addictive. And theres fantastic strike off loyalty (Burrough and Helyar, 1991, p. 218). 11 For this reason, Bu? ett also accepts businesses that do not always have a high B/M ratio.Moreover, he seeks for businesses that have potential for improvements and buys them at a relative bargain price in the hope the business remains its advantage and cushions high returns in the future. 2. 3. 4 UBS EMU Value Focus Fund The UBS EMU Value Focus Fund is a highly concentrated and actively managed European equity fund, which holds maximally ten stocks, where each has an initial weight of 10%. The investment process is divided into seven travel (Screening process Short list Pre collectible application program Full repayable application program Watch list Entry, increase/ get down position and Exit).First, the stock universe is screened by a quantitative approach (EV/EBITDA, P/E, B/M, FCF yield) and by a soft approach. Second, in the callable diligence process the aggroup meets the management of the butt company, they compare the company within the peer group, and determine the fair value and entry level. The team gives particular importance to the within-industry comparisons and a margin of safety of 30%. After the stock is over the due diligence, the stock is deposited on the watch list until the entry level is reached. The stock remains in the portfolio until the stock has recovered and the calculated air value is reached and the weight of the stock is less than 15% of the portfolio. If there is a more promise investment opportunity, a position will be changed. Based on the high portfolio concentration, a sector limitation makes sure that stocks which are stemming from the same sector do not surpass the threshold of 33%. If a stocks price plunges after its purchase more than 15%, the management also pulls the trigger for safety reasons and sells the stock (UBS, 2010). The strategy of the UBS EMU Value Focus Fund equals in some aspects Warren Bu? etts strategy.Both distinguish themselves from Piotroskis and Schlossers strategy insofar as they include a due diligence process that goes beyond a fundamental analysis (e. g. valuation of the management). Furthermore, both strategies do not strive for diversi? cation, although the UBS EMU Value Focus Fund includes some risk management factors that compel the management to exit in certain circumstances. Warren Bu? ett, on the other hand, restricts himself by avoiding complex businesses. The two strategies also di? er insofar as the UBS EMU Value Focus Fund has a relativel y short investment horizon of 18 months, whereas Bu? tt holds a stock over decades. 12 2. 4 Value vs GrowthFuzzy Thinking Although there is a broad variety of value strategies, it seems that the discussion about value investing leaves little room for interpretation. Nowadays, the bulk of academics di? erentiate between value and growth (glamour) stocks. They ? nd that stock-speci? c fundamental attributes such as a low P/E ratio (Basu, 1977 Ja? e, Keim, and Wester? eld, 1989), low cash-? ow-to-price ratio (Chan, Hamao, and Lakonishok, 1991), and high B/M ratio (Rosenberg, Reid, and Lanstein, 1985 Fama and french, 1992) earn substantially high returns than glamour stocks.Hence, often one feels compelled to decide between value investing and growth investing. In particular, academic work has upheld the distinction, and thus, has had a strong impact on investment professionals. Furthermore, academic research developed style-speci? c benchmarks (Chan and Lakonishok, 2004, p. 71). In t hat sense, value stocks are referred to a high B/M ratio, a low P/E ratio and a high dividend yield, whereas opposite characteristicsa low B/M ratio, a high P/E ratio and a low dividend yieldare assign to growth stocks. Some professional investment managers even see a mix of the two approaches as a offend cross-dressing.Among others, Warren Bu? ett labels this classi? cation as fuzzy thinking. Bu? ett argues that growth is always a component in the calculation of value. Nonetheless, he does not nonperformance that the importance of the growth component varies from negligible to very important and its impact can be positive as well as negative. Thus, a low B/M ratio, a high P/E ratio, and a low dividend yield is not per se inconsistent with value purchases. Business growth has often a positive impact on value but tells us little about the intrinsic value of growth (Bu? ett, 1992, p. 12). only growth is not created equal, and thus must be di? erentiated.There is also value-destroy ing growth, which is not worth a penny. Bu? ett goes even further and scrutinizes the term value investing as such. According to him, the term is redundant because investing implies to pay less then the value of something (Bu? ett and Cunningham, 1998, p. 85). The origin of this fuzzy thinking constitutes the value unusual person that will be discussed in the following section. 2. 5 Value Anomaly already Graham and Dodd (2008) hint at the diversity between market price and intrinsic value and the fact that the market often underestimates value stocks. This mispricing is called in the literature Value Anomaly.In the following section three explanations are outlined i) a behavioural approach, ii) a risk-based approach, and iii) a competitive advantage based approach. 13 2. 5. 1 Behavioral Approach According to Graham and Dodd (2008), the irrational behavior of market participants can drive the price of a security in the wrong direction. As Graham outlined in his book the Intelligent Investor, emotions take part in the participants decisions, thus he rejects the E? cient-Market Hypothesis as well as the assumption of gentlemans gentleman Oeconomicus. Market participants are swayed either by positive emotions pushing up prices, or uncertainty and ? rce emotions cause a pooh-pooh in prices. In general, both results in ine? cient and undesirable market upshots. De Bondt and Thaler (1985) already ? nd evidence that markets overact to un pass judgment and melodramatic news events. Moreover, contagion ampli? es this process of counter-productive behavior, taking a central part of the game, especially in crisis when panics gain the upper berth hand and investors disinvest despite of breathing reasons to act to the contrary. 1 Not only irrational behavior induces a variableness between market prices and intrinsic value. Discrepancies can also result from ? ms of little interest, and thus, small liquidity. In particular, small companies deign through the screenin g raster of professional investors. erst a professional investor manages a fund of a certain size, small investments are out of range. First, small companies are like gold dust, as a consequence thereof di? cult to ? nd, and second, the monitoring costs come along with the military issue of investments, which makes such companies unappealing. 2. 5. 2 Risk-based Approach Whereas Graham showed that behavioral aspects color in markets and cause a gap between intrinsic value and market value, many academics hold that the di? rence does not take contradict the e? cient-market hypothesis. Some argue that high returns simply compensate higher(prenominal) risk (Fama and French, 1994). As basis of this line of reasoning line served the Capital Asset Pricing Model ( working capitalM), which was developed independently by Sharpe (1964) and Linter (1965) in the 60s based on Markovitzs portfolio theory. The model shows the gumminess between the expected return of individual securities an d systematic risk (market risk). Whereby ? of a security is a parameter describing the relation of its return with that of the overall market.The equation of the CAPM can be summarized as follows 1 Cella, Ellul, and Giannetti (2010) write in their paper about Investors Horizon and the Ampli? cation of Market Shocks that stocks which are held in a gigantic part by short-term investors are more likely to plunge under their intrinsic value. They also instance that fund managers often follow travails, which do not lead to optimal purchases or sales. 14 E(Ri ) = Rf + ? i (E(Rm ) ? Rf ) (2. 2) where E(Ri ) is the expected return of a speci? c asset, Rf is the riskless return rate, and E(Rm ) is the expected return of the market.Already Rosenberg, Reid, and Lanstein (1985) give rise to the assumption that the CAPM can not fully explain the correlativity between expected returns and the risk of an individual security. As a one factor model implies, the CAPM oversimpli? es the complex ma rket. Therefore, Fama and French (1992) introduced a three-factor model that is an extension of the CAPM. Basically, they better the CAPM by adding two more factors (i) they elevated between high and low B/M ratio, and (ii) classi? ed stocks according to market capitalization (price per stock times number of shares outstanding).The equation of the extended CAPM can be summarized as following r = Rf + (Km ? Rf ) + bs ? SM B + bv ? HM L + ? (2. 3) where Rf is the risk-free return rate, Km is the return of the entire stock market, SM B (small minus big) is the di? erence between small and big ? rms according to their market capitalization, HM L (high minus low) is the di? erence between high and low B/M ? rms, bs is the corresponding coe? cient to SM B, and bv is the corresponding coe? cient to HM L. Based on this, Fama and French (1992) argue that high B/M ? rms prospects are judged relative severely to ? ms with low B/M ratios. As already postulated by Chan and subgenus Chen (1991 ), Fama and French also interpret high B/M ? rms as ? nancially distressed (see also Piotroski, 2000). They adduce the explanation that a high B/M ratio inheres in a relatively high ? rms market leverage compared to its book leverage. Furthermore, they ? nd that during some periods (at least ? ve years) low B/M ? rms remain more pro? table than high B/M ? rms. Fama and French (1992) argue that more risk is inherent with a higher B/M ratio. In other words, value stocks are riskier than glamour stocks. oppose to this, Gri? and Lemmon (2002) show that large returns of high B/M ? rms are inconsistent with a risk-based explanation. Arshanapalli et al. (1998) show 15 that value stocks generally have a risk-adjusted performance superscript to that of growth stocks (p. 23). Thus, the value anomalousness can be traced back to a mispricing of stocks due to overly optimistic valuations of glamour ? rms. Once this mispricing is revealed, these ? rms earn negative superfluity returns. Accordi ng to Chan and Lakonishok (2004), investors, in particular professional investment managers, focus their attention on unmingled glamour stocks while stock prices of high B/M ? ms plunge under their fundamental value. Hence, investing in high B/M ? rms is likely to be a rewarded long-term investment strategy (p. 85). Moreover, Anderson and Smith (2006) ? nd that a portfolio of the most admirable companies substantially outperforms the market, and thus contradicts the e? cient market hypothesis. As a consequence, the risk-based explanation has scattered many of its supporters over the last years and the value anomaly remained unexplained. 2. 5. 3 Competitive Advantage Based ApproachAlthough it is plausibly the closest explanation, academics rarely make the competitive advantage of a company accountable for the superior performance and scanty returns of a company. According to them, competitive advantages must theoretically fade away. But in reality this is not always the case. New academic research indicates that the risk number one wood refers more to the riskiness of losing the competitive advantage (Mauboussin and Johnson, 1997 Greenwald, Kahn, Sonkin, and van Biema, 2001). This could be the case if new competitors enter the market and/or in industries where the rate of technology changes is high.On the one hand, new technologies open up new opportunities for existent players, but on the other hand, they also carry the risk that entrants come up with new products and technologies that force existing players to keep up with the changes. This kind of competition is often quite expensive and indicates that profusion returns can be wrest away easily. Therefore the risk of businesses, which are exposed to such changes, is higher than of businesses that sell products with marginal changes. Of course, some companies even maintain their competitive advantages in fast-changing industries over decades (e. g. Microsoft, Inc. r maybe Facebook) due to customer reten tion and network e? ects, which create switching costs on the request side and enormous costs to enter the market on the leave side. The mispricing of such companies that exhibit a durable competitive advantage originates from the complexity in identifying such companies in advance. The following chapter elaborates a bit more on this and points out the state of the art as well as the existing research gap. 16 Chapter 3 Literature Review 3. 1 Competitive Advantage Competitive advantage is a central theme in value investing that has often gone forgotten in the heated tip over about the value anomaly.Although an immense number of books and papers have been written about competitive advantage, it has not found proper entrance into the value discussion. Nonetheless, it is an essential part in the valuation process of a company. Greenwald, Kahn, Sonkin, and van Biema (2001) break the Graham and Dodd framework down to three main sources of value (see Figure 3. 1) (1) the asset value, (2 ) the earning power value, and (3) the value of growth. All three elements must be involved in the calculation of valuealso growth (pp. 35-47). The asset value equals the reproduction costs of the assets and is therefore the most reliable source of value.The second most reliable measure of a ? rms intrinsic value is the value of its current earnings (earning power value). The earning power value equals current earnings divided by the cost of capital, assuming that the growth rate is slide fastener. The deviation between the asset value and the earning power value equals the franchise of a company. What they call Franchise is referring to the competitive advantage and describes the same phenomenonthe ability to earn more on a ? rms assets than it is possible under gross(a) competition (p. 41). The least reliable source of value is growth, because it is the most di? ult element of value to estimate and therefore obtains last priority in the valuation process. According to Greenwald, Kahn, Sonkin, and van Biema (2001), growth is only valuable if it is within the franchise. Correspondingly, growth that only increases revenues, earnings or the assets of a ? rm does not create additional value. Growth is valuable only if a company can extend its pro? tability by the means of its competitive advantage. 17 Figure 3. 1 Three Slices of Value Nevertheless, excess returns, which exceed the cost of reproducing a ? rms assets, are under the assumption of perfect competition not possible (see Mankiw, 2004, pp. 4-65). As soon as a company earns more on its assets than its reproduction cost, it will attract new competitors, and thus, erode the excess returns until the earning power value equals the value of assets. However that may be, economic theory about perfect competition is seldom the case in reality. Some companies have enjoyed a competitive advantage even over decades (e. g. The Coca-Cola Company or Microsoft, Inc). There have been many research studies conducted on competitive advantage and a huge number of device drivers have been found. 1 Without going too deeply into the di? rent drivers, it might be worth to mention the most coarse searching costs, switching costs, and economies of scale. By the means of switching costs, a company can create a lock-in once soul has chosen a technology, switching can be very expensive (Shapiro 1999, pp. 11-13). Microsoft, Inc. is probably the best example to illustrate a lock-in e? ect. Changing from MS O? ce Word to another piece program is costly. It raises the annoying problem that the formats are not compatible, and thus requires much e? ort that is more costly than remaining with MS O? ce Word. Switching costs can hange over time as buyers alter their products Thomas Fritz (2008) has conducted an extensive literature review of over 140 empirical investigations published between 1951 and 2007. He comes to the last that the di? erent drivers for a competitive advantage are as manifold as the number of studies and that there is no such as a universally valid driver as one could assume. 1 18 and processes (Porter, 1998, p. 296). Another kind of lock-in occurs by search costs. Search costs occur as buyers and sellers attempt to ? nd each other and establish a business family (Shapiro, 1999, p. 26). Finally, a competitive advantage arises by economies of scale. Porter (1998) describes economies of scale as the ability to produce more e? ciently at a larger volume (p. 70). But one should note that economies of scale by themselves do not constitute a competitive advantage. In addition to economies of scale, it needs a demand advantage, which does not have to be big. Once a demand advantage exists, economies of scale in the cost structure will transform superior market share into lower costs, higher margins, and higher pro? tability (Greenwald, Kahn, Sonkin, and van Biema, 2001, p. 0). Correspondingly, products or services that pro? t from high purchase frequency often enjoy a deman d advantage that derives from a habit (e. g. the cigarette industry). Still, it is not written in stone that a competitive advantage lasts for an in? nite period if once achieved. Although a vast number of studies examined the attributes of a ? rm with a competitive advantage, considerably less studies have elaborated on the sustainability of a competitive advantage and the reason why some ? rms enjoy a competitive advantage for decades and other only over a short period. The in? ence of the Competitive Advantage Period (CAP) on the valuation of a ? rms shares has also been by and large ignored by the literature, although the picture derives its origin from Miller and Modigliani (1961). The term itself appeared in the 90s in numerous writings. The concept that was developed in Miller and Modigliani (1961)s seminal paper on valuation can be summarized as follows V alue = N OP AT I(ROIC ? W ACC)CAP + W ACC (W ACC) (1 + W ACC) (3. 1) where NOPAT represents net operating pro? t after t ax, WACC represents weighted average cost of capital, I represents annualized new investment in working and ? ed capital, ROIC represents rate of return on invested capital, and CAP represents the competitive advantage period. The CAP can be identi? ed, as shown in Equation 3. 1, as a fundamental value driver among risk and cash ? ow. In order to get the CAP we can rearrange Equation 3. 1 as follows CAP = V alue (W ACC ? N OP AT ) (1 + W ACC) I (ROIC ? W ACC) (3. 2) As Mauboussin and Johnson (1997) vagabond correctly, this equation has some shortcomings that constrain its realistic scope, but it illustrates how the CAP can be con19 ceptualized in the valuation process.According to Mauboussin and Johnson, the key determinants of CAP can be impoundd by a handful of drivers. The ? rst key determinant is ROIC that re? ects the competitive position within an industry, whereas a high ROIC indicates a strong competitive position. Generally, it is costly for competitors to snatch competi tive advantage from high-return companies. The second key determinant is as important, and measures the rate of industry change. High returns in a fastgrowing industry do not have the same signi? cance as returns created in a stagnated or even shoplifting industry. The third driver re? cts the barriers to entry, which is essential for sustainable high returns on invested capital (pp. 68-69). 3. 2 Pro? tability Measurements High-return companies, which have returns in excess of the cost of capital, also capture Warren Bu? etts attention. As Mauboussin and Johnson (1997) note, a constant CAP is contrary to economic theory, but it might be achieved through outstanding management. However, companies with a stable CAP are everything but simple to ? nd (p. 71). As mentioned above, Equation 3. 2 has particular practical scope thus, in order to evade this problem other performance measures have to be found.In practice, there are many di? erent performance measures, but this thesis will fo cus in particular on ROE. Fritz (2008) shows in his investigation that ROA and ROE are two of the most frequently applied accounting-based performance measures (p. 31) regarding competitive advantage investigations. Both are pro? tability measurements and capture the relation of return on applied capital. ROE measures how much pro? t a company generates for shareholders while ROA states how e? cient the asset management is. The higher the pro? tability, the better is a ? rms preservation and the stronger its competitive advantage.Nowadays, less attention is gainful to the ROE. Sharpe, Alexander and Bailey (1999) mention the ROE only marginally and Spremann (2007) devote less than one page to it. Nonetheless, ROE has not lost its usability entirely, but Spremann sees the reason for the decreasing importance in the fact that shareholders orient themselves more toward market values instead of book values. Provided that, market ratios (e. g. P/E ratio) gained progressively attention. But since superior earnings are generated based on a competitive advantage, it must remain a core theme in the valuation process, in particular for the long-term investor.Pro? tability measurements tend to change over time thus, forecasting future profitability is a task that many practitioners and academics would label speculative. On 20 the other side, pro? tability is mean reverting in a competitive environment. Thus, nothing is simpler than predicting long-term pro? tability, which must be zero in the long run. Freeman, Ohlson and Penman (1982) already found evidence that ROE follows a mean-reverting process. Almost twenty years later, Fama and French (2000) found strong evidence of mean-reverting process in terms of pro? ability and estimated a rate of mean degeneration of 38% per year. Assuming a ? rms ROE of 20% above mean will shrink below one percent after ten years and therefore lose its competitive advantage,this corresponds to 38% reversion rate. This is also in line w ith Chan, Karceski and Lakonishok (2003)s expectation that superior operating performance cannot be preserve for more than ten consecutive years. Furthermore, Fama and French (2000) show that mean reversion is express below its mean and when it is further from its mean in either direction. However, Penman (1991) scrutinizes ROE regarding its su? iency to predict future pro? tability. According to him, ROE indeed exhibits a mean-reverting tendency, but it proves a too-strong persistence over time. Hence, he suggests that B/M multiples are better indicators of future ROE than current ROE, and a combination of both increases persistence in ROE even further. 3. 3 Research Gap and General Approach Some research has been conducted about predicting future pro? tability. Though these studies deal in particular with the issue of predicting the near future. Thus, this study claims high expectations by predicting long-term pro? ability, with the notion that longterm means in this study a per iod of ten years. There are several papers that postulate a mean reversion of pro? tability measures (Freeman, Ohlson and Penman, 1982 Penman, 1991 Lipe and Kormendi, 1994 Fama and French, 2000 Nissim and Penman, 2001). Soliman (2008) forecasts out-of- pattern future changes in RNOA ? ve years into the future by applying the DuPont analysis. All these studies have in common that they investigate one ? nancial measure (or two) in time. Thus, this study intends to close these two gaps. In the following chapter, ? rst, several ? ancial measures will be considered regarding companies with a durable competitive advantage, and second, it will be hypothesized that predicting long-term pro? tability (up to ten years) is possible. 21 Chapter 4 Analysis of Long-term Pro? tability The following chapter aims to determine indicators in order to forecast long-term profitability. Thus, the chapter is structure in four sections Section 4. 1 describes the data sample distribution and the adjustmen ts. Section 4. 2 deals with the classi? cation of superior performers in terms of ROE and analysis of the persistence of superior performance.Subsequently, the analysis of ROE performance deciles according to persistence is centre stage. Section 4. 3 involves the analysis of further ? nancial measures regarding the ROE persistence deciles. The start point of this section is the DuPont Identity, which breaks the ROE measure down into further ? nancial measures. The aim of this section is to ? nd speci? c characteristics that will serve in Section 4. 4 to separate ? rms in advance according to future superior performance years. Finally, Section 4. 6 investigates the ROE persistence deciles according to market ratios (i. e. B/M ratio and P/E ratio). . 1 Data Sample A reliable analysis depends to a great extent on the size of the data sample. The size, in turn, is determined by company years (i. e. number of companies times number of years) that are considered. All data in this study o riginates from COMPUSTAT if there is no explicit mention of it. COMPUSTAT provides historical data of US companies with available historical annual data from 1950. For this study, the dataset on COMPUSTAT was screened for all companies that were listed on any stock exchange in the United States (including quiet companies) with a special election SIC classi? ation between 2000 and 3999. The data was selected at the end of each calendar year between 1979 and 2009. Hence, historical data for the following investigation is available for thirty-one years. Similar to McGahan and Porter (2002), all records from the dataset that do not 22 contain a primary SIC designation after parentage or any that were not within the stated range were dropped out of the sample. The restriction to companies containing a primary SIC classi? cation between 2000-3999 corresponds to the manufacturing division, which contains twenty subdivisions (see Table C. ). Focusing on one division has the advantage th at the ? rms have a similar value chain. All manufacturing ? rms have in common that they purchase raw materials or components and manufacture these materials to more mature products, which will be sold to a seller or for further processing. Seldom, do these companies sell the product directly to the ? nal consumer. Drawing comparisons among ? rms with similarities regarding their value chain is simpler and also more reliable. Given this restriction to manufacturing companies, 3844 companies are available. It is art of a dynamic industry process that listed companies disappear and new companies appear on trading lists of stock exchanges. This fact leads to certain problems, which were not always considered aright in prior studies. For the sake of convenience, some researchers have considered only companies with available data for the entire sample period. Thus, they have excluded companies that were passing through either a delisting or an initial public o? ering ( initial public o ffering). Others have ignored in their investigation only inactive companies. In this category fall two cases, in particular each a company did not experience the entire period due to ? ancial distress and subsequent bankruptcy or it was the target of an acquisition by another company. Ignoring inactive companies would distort the relative ? nancial performance of other companies in the same group in the same period. Not least, since pro? tability depends on competition, it is important to include inactive companies to focus the e? ect of survivorship bias as it is important to take new competitors into consideration. COMPUSTAT provides the filling to also include inactive companies into the sample. galore(postnominal) researchers assume that newly-listed companies show high growth rates that are not economically signi? ant for the comparison to other companies, and thus, lead to distortions (see McGahan and Porter, 2002 Rumelt, 1991 Schmalensee, 1985). Hence, they exclude all companies from the data sample that exhibit less than $10 million in sales. Following these researchers, the sample in this study contains only companies with sales of at least $10 million during the entire sample period. All companies that come below this threshold for any year in the sample period were excluded. After these adjustments, the sample comprises 1905 companies.In order to avoid the possibility that companies distort the calculation of growth rates through short-term measurements, companies with less than ? ve years of ? nancial history were excluded. There is evidence that suggests that window-dressing before an IPO a? ects the performance of subsequent years after the IPO. For instance, Jain and 23 Kini (1994) ? nd that IPO ? rms exhibit a gloaming in post-issue operating performance (see also Degeorge and Zeckhauser, 1993). Therefore, only ? rms with at least ? ve years of ? nancial data on COMPUSTAT items listed in Table 4. 1 were included. Table 4. 1 COMPUSTAT It ems This table shows all items hat are downloaded from COMPUSTAT. A more detailed description is presumption in Appendix A. Companies that have absentminded data on one of these items are excluded fr