Fundamental value estimates

Fundamental value seems like a straightforward investment approach. One simply looks for assets that are “cheap” or “expensive” relative to their rationally expected risk-adjusted discounted cash flows. In reality, conscientious estimation of fundamental value gaps is one of the most challenging strategies in asset management. It requires advanced financial modeling and often long waiting times for payoff. Few managers have the resources and patience for it. In macro trading, cheapness or dearness is commonly inferred from simple valuation metrics, such as real interest rates, real exchange rates or equity earnings yields. However, by themselves, off-the-shelve metrics cannot create much information advantage. Indeed, they regularly confuse forward-looking expectations with mispricing and lure investors into crowded value traps. Fundamental value should be estimated conscientiously or not at all. The minimum requirement for a valid valuation metric is some reasonable integration with related economic states and trends.

The fundamental issues with fundamental value

The conscientious approach

In finance, the fundamental value of a security or derivative contract refers to the expected risk-adjusted present value of all cash flows or, more generally, all associated entitlements or obligations. Estimating such value conscientiously would require three essential ingredients:

  • a specification of all relevant features of the security or contract;
  • an appropriate model of the uncertain environment (“stochastic parameters”);
  • an asset pricing model that discounts all cash flows or utility to a single present value, under consideration of uncertainty.

This conscientious approach reveals value gaps, differences between the present value and the market price. A contract is called “cheap” in case of a positive difference and “dear” in case of a negative difference. However, this conscientious approach also makes high demands on research, requiring [1] flexible financial modeling skills, [2] advanced statistical inference and [3] good judgment on what the relevant uncertainties look like (called “priors” in Bayesian analysis). In practice, few investors have the funds, capacity, and know-how for such research, leave alone the patience.

Valuation ratios

Most public talk of over- or undervaluation is just “opinion” (a view without much evidence) or “marketing”, a semi-informed view published by broker-dealers to stimulate discussions with clients and to solicit trading business. The preferred references for “cheapness” or “dearness” are simple price-based valuation ratios, such as trade-weighted real exchange rates, real interest rates or earnings yields. These simple ratios are easy to understand and to monitor in real time on Bloomberg or Reuters. They also have considerable intuitive appeal. For example, a real trade-weighted exchange rate informs on the effective inflation-adjusted appreciation or depreciation of a currency, which should be in accordance with economic performance and competitiveness. Real interest rates help to assess the plausibility of a particular path of monetary policy rates. And in the equity space, forward earnings yields in relation to real bond yields are a basic sanity check for stock prices.

However, simple valuation ratios are not valid approximations for fundamental value gaps. That is because there is always a reason why these ratios are high or low. The point is to sort the right from the wrong reasons. In other words, judgment on whether valuation ratios are too high or too low depends completely on context. Moreover, because standard valuation ratios are so popular and easy to monitor they cannot, by themselves, offer much information advantage. Hence, without further analysis valuation ratios cannot plausibly be a great source of investor value.

Repricing opportunities

The scarcity of reliable observable objective metrics for fundamental value can lead to huge profit opportunities for macro trading when markets undergo critical transitions. Critical transitions are structural changes in economic backdrop, operations, and institutions that precipitate a re-evaluation of prices or “new trading ranges”. It is in those times that conscientious estimation of fundamental value pays off. Quantitative indicators can help to identify the times when such a transition is underway, particularly metrics of instability, autocorrelation, and skewness of price moves (view post here).

More abstractly, value strategies ofter produce their highest returns when previous market trends have run their course and reverse (view post here). Value and momentum strategies often end up with opposite market views. There are two plausible reasons for this. First, value investors regularly bet against market trends that appear to ‘have gone too far’ by standard valuation metrics. Second, value stocks carry particularly high market risk or ‘bad beta’ and thus fare well when market risk premia are high and the market turns for the better. This typically coincides with ‘momentum crashes’ in oversold markets.

Absolute versus relative value

Absolute value means that a contract is cheap relative to its fundamental price estimate. Relative value means that a contract is cheap relative to another contract. It is usually easier to estimate relative fundamental value across similar contracts rather than absolute fundamental value. That is because similar types of contracts have most price factors in common and one can concentrate on those that are different. For example, all equity prices in one market have the same stochastic discount factor and all FX forward contracts that are traded against the USD have the same reference currency risks. Indeed, the empirical analyses support the intuition that it is easier to predict relative returns within an asset class than to predict absolute returns (view post here).

Practical hints

Fundamental value approaches in the macro space

The focus of valid fundamental value research in the macro space is to compare prices, yields or other valuation metrics with the economic conditions that are related to it.

  • In the fixed income space, longer-term yields can be decomposed into expected real rates, real term premia, expected inflation rates, and inflation risk premia (view post here). Fundamental value gaps can arise from mispricing any of these components.
    Often the main challenge is to separate term premia from unbiased forward rate expectations. A simple practical approach for estimation expectations is to adjust conventional yield curves for median error curves, i.e. recent historic tendencies of implied future yields to over-predict realized spot yields (view post here). However, this approach gives no good estimate of the variation in term premia overtime. Term premia can be estimated based on term structure models that separate expected short-term rates and risk premia. Such models benefit from including macroeconomic variables. In particular, long-term inflation expectations plausibly shape the long-term trend in yield levels. Meanwhile, cyclical fluctuations in inflation and unemployment explain slope and curvature (view post here). Inflation risk premia can be both positive and negative, depending on whether inflation is perceived to be negatively or positively correlated with equity returns and economic growth (view posts here and here). A positive correlation of inflation and equity returns means that the inflation risk premia charged on nominal bonds are negative, i.e. investors on balance accept a yield discount.
    Over time the character of fixed income markets evolves in accordance with the economy’s key structural parameters, such as sovereign risk, inflation expectations, and the central bank regime. Hence, models must consider time-varying parameters, time-varying volatility and even model uncertainty (view post here).
  • In the equity space, forward earnings yields are a common and valid basis for fundamental value estimates, particularly if they are adjusted for risk or volatility (view post here). Earnings yields and differentials between equity dividend yields and bond yields have historically been indicators of misalignments and future stock market corrections (view post here). Unlike fixed-income yields, equity yields are based on judgment and accounting rules. Indeed, accounting terms, such as investment and book value, are easily misunderstood and confused with economic concepts. Accounting is as much driven by assessment of risk as it is by economic value (view post here).
    Estimating fundamental value gaps often requires adjusting off-the-shelf conventional valuation ratios. For example, market-wide forward earnings forecasts usually follow price adjustments with a lag, and this predictability can be used to increase the quality of real-time forward earnings yields (view post here). Meanwhile, the information value of equity dividend yield can be enhanced, by measuring a “shareholder yield” that integrates dividends with other forms of cash returns such as share buybacks and debt redemption (view post here), which have played a crucial role in the U.S. market.
    Another popular metric for equity valuation is the market-to-book ratio, which divides a company’s stock market value by its book value. The ratio has historically predicted equity returns in the long run. However, profitability and investment value-added explain most of the variations in the market-to-book ratio and must be taken into consideration for investment strategies based on market-to-book ratios (view post here).
  • In the foreign exchange space, valuation gaps are often analyzed based on “smart” concepts of real trade-weighted exchange rates, which are typically some combination of real effective exchange rate and economic performance data. For example, empirical research suggests that real exchange rates that are adjusted for relative productivity growth and product quality differences are indicative of currency overvaluation or undervaluation (view post here). Currency value measures that reflect a country’s competitiveness plausibly have some predictive power for a currency’s future trajectory and its equity market’s relative performance (view post here). Moreover, apparent misalignment of effective exchange rates that go against the desired relative monetary policy stance is a key indicator of FX intervention risk (view post here). A complementary indicator to trade-weighted exchange rates is debt-weighted exchange rates. The latter use weights based on foreign-currency denominated debt and measure the effect of exchange rate changes on the cost of funding. While trade-weighted depreciation supports economic growth through the “trade channel”, debt-weighted depreciation usually slows economic growth through the “financial channel”, particularly in EM economies (view post here). That is why these two concepts are best watched simultaneously.
  • In the emerging market space, external current account balances are the most popular indicator of valuation gaps for currencies and local-currency bonds. Thus, most investors believe that current account deficits measure overvaluation and addiction to external financing. In reality, external balances and cross-border financing are only vaguely related. Vulnerability to “stops” in financial flows does not depend on trade and capital flows (“net concept”) but only on the volume and origin of financing (“gross concept”)(view post here). In order to diagnose “overvaluation” one needs a broad set of competitiveness indicators and to diagnose vulnerability one needs the international investment position.

Contract and market specifics

A necessary condition for estimating fundamental value is a full understanding of the contract and the underlying asset. This is should not be taken for granted. Investment managers engage in some contracts only sporadically and for narrow purposes. They may not have time and patience to consider the implications of all detail. In the past areas of negligence included:

  • consideration of counterparty default risk for the overall risk profile of over-the-counter derivatives,
  • sector and company profiles of country equity index futures,
  • restrictions to convertibility and exchange rate flexibility in emerging market currencies,
  • scope, triggers and consequences of default events for constituents of CDS indices.

Even simple standard exchange-traded contracts may not deliver the underlying at the time and place it would be needed. In instructive example have been commodity futures in the base metal space, where at expiry holders looking for delivery would have had to accept long delays in the load-out from designated warehouses. This actually led market rationing and high premiums for physical metals over exchange traded spot prices (view post here).