STREET DOGS

Regarding profitability, it’s easy to understand why companies that make high returns on capital tend to be superior investments. A stock is ultimately a share in the ownership of a business. The more profitable the business, the more profitable an investment in its stock.

Valuation is about paying a fair price for the stock. A high-quality business deserves an aboveaverage valuation. But you still want to make sure you are not paying unrealistically high prices, since even the best companies can generate disappointing returns when purchased at irrational valuation levels.

So what’s irrational? Here’s where value investing — buying with a margin of safety — gets more difficult. An investor looking to buy undervalued stocks might select one with a low price-toearnings ratio. The hope is the price will rise such that its priceto-earnings ratio will rebound to a level more in line with its peers.

However, research by U-Wen Kok suggests the opposite is more likely to happen: the price-toearnings ratio will return to normal levels but only because the earnings in the denominator fall.

“The problem,” Kok says, “is with strategies that scan for stocks with low price-to-earnings or price-to-book ratios, and upon finding them, declare the stocks offer compelling value to investors. Such quantitative valueseeking strategies have become increasingly common, but all they do is systematically identify companies with temporarily inflated accounting numbers and should not be confused with value strategies that use a comprehensive approach in determining the intrinsic value of the underlying securities.

“Fundamental-to-price ratios don’t really reflect the true, underlying economics of the companies. ’Value’ is an abstract adjective and simply not something a quantitative screen can find by itself,” Kok says.