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

observe Investing Predicting Long-term masterfessional? tability ground on lineamental entropy An Empirical Study in the Manu varyicularuring Industry by Vital Schwander (05-609-136) Masters Thesis supervise by Prof. Dr. Andreas Gruner University of St. G all in allen May 23, 2011 Master in Law & Economics abbreviation rabbit warren Bu? ett (1992) classi? es the discussion closely rank and offshoot var.s as hirsute thinking. With that statement, he manages that nourish investors moldiness consider harvesting in their shelter calculations. This thesis tests in a ? rst pure t genius that harvesting is single valuable if the teleph unmatchabler enjoys a long-lasting agonistic prefer.By examining the constitutional characteristics of companies with a constant emulous ad new wavetage, this thesis in decennaryds in a second tonus to assess the predictability of semipermanent professional person? tability. The DuPont identity operator serves as framework fo r that purpose. The objects of this probe argon companies within the manufacturing labor (Primary SIC Code between 2000-3999) that were he ard in the United States between 1979 and 2009. The results show that companies with a lasting warring value shew speci? c characteristics in operate e? ciency, asset drop e? ciency, and in the ability to meet soon-term obligations.Further much than, the thesis shows that long-run pro? tability, ground on the investigated characteristics, is predictable to some extent. This thesis concludes by assembling the insights to a shelter schema that is applied to manufacturing companies rocked in Switzerland. The st footstepgy poses an come forthstanding SMI-adj. meld annual growth rate of 13. 19% e trulyplace a conclusion of 17. 5 categorys. ii Ac familiarityment I would worry to express my gratitude to Prof. Dr. Andreas Gruner for supervising this thesis and his assistant Lucia Ehn for her conceptual advices. I ready gain gro und more(prenominal) than(prenominal) than to thank Mr.Hans Ulrich Jost for giving me insight into the daily clientele of a pass judgment fund at UBS AG. My sister Daria introduced me to R and Latex. I compulsion to thank her for her help and support. I want to thank my great family who has been forever supportive and motivating. Finally, I as well would like to thank friends and colleagues for making deportment much(prenominal) an enjoyable experience. iii Contents 1 Introduction 1. 1 1. 2 Issues, Goals and Limitations . . . . . . . . . . . . . . . . . . . . . . . . . Structure and Empirical begin . . . . . . . . . . . . . . . . . . . . . . 1 1 2 4 4 5 7 7 8 2 cheer InvestingAn Investment Paradigm 2. 2. 2 2. 3 The credit line of nourish Investing . . . . . . . . . . . . . . . . . . . . . . . . . jimmy and Other Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . Four comfort Strategies by Illust proportionn . . . . . . . . . . . . . . . . . . . . . 2. 3. 1 2. 3. 2 2. 3. 3 2. 3. 4 2. 4 2. 5 Piotroskis F_Score . . . . . . . . . . . . . . . . . . . . . . . . . . Walter and Edwin Schloss . . . . . . . . . . . . . . . . . . . . . . . rabbit warren Bu? ett . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 UBS electromagnetic unit nourish reduce Fund . . . . . . . . . . . . . . . . . . . . . 12 Value vs step-upFuzzy Thinking . . . . . . . . . . . . . . . . . . . . . 13 Value Anomaly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2. 5. 1 2. 5. 2 2. 5. 3 behavioral burn up . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Risk- found Approach . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Competitive improvement Based Approach . . . . . . . . . . . . . . . 16 17 3 Literature Review 3. 1 3. 2 3. 3 Competitive profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Pro? tability Measurements . . . . . . . . . . . . . . . . . . . . . . . . . . 20 seek Gap and prevalent Approach . . . . . . . . . . . . . . . . . . . . 21 22 4 abbreviation of Long-term Pro? tability 4. 1 4. 2 Data Sample . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 compendium of go d let on Equity Measure . . . . . . . . . . . . . . . . . . . . 26 4. 2. 1 Superior Performers . . . . . . . . . . . . . . . . . . . . . . . . . . 26 iv 4. 2. 2 4. 2. 3 4. 3 4. 4 4. 5 4. 6 compendium of exploit Persistence . . . . . . . . . . . . . . . . . 28 Analysis of SPP Deciles in rate of hard roe . . . . . . . . . . . . . . 30 Analysis of SPP Deciles in respect of some other(a)(a) Financial Measures . . . . . 33 Predictability of Long-term Pro? tability . . . . . . . . . . . . . . . . . . . 41 discourse of the Interim Results . . . . . . . . . . . . . . . . . . . . . . . 43 grocery Analysis 4. 6. 1 4. 6. 2 4. 6. 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Subdivision-speci? c mart Analysis . . . . . . . . . . . . . . . . . 45 Analysis of SPP Decil es in respect of Market Multiples . . . . . . . 45 Market Performance Analysis . . . . . . . . . . . . . . . . . . . . . 46 48 5 Value dodge 5. 1 5. 1. 1 5. 1. 2 5. 1. 3 5. 2 Strategy Composition . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Sample Descriptives and Strategy Composition . . . . . . . . . . . 48 Portfolio Formation . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Performance Measurement . . . . . . . . . . . . . . . . . . . . . . . 49 Portfolio Performance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 53 6 Conclusion and Further inquiry 6. 1 6. 2 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Further Research . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 56 i v x xv Bibliography A Data Input B Financial Measures C Subdivisions D Market Analysis c been 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 scattering of Firm Years diffusion of Superior Performance Years . . . . . . . . . . . . . . . . . 27 Probability Distri simply when whenion of Superior Performance Persistence . . . . . . . 29 hard roe Distri andion for each SPP Decile . . . . . . . . . . . . . . . . . . . . 31 hard roe Distribution for each 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 Compari intelligence regarding roe . . . . . . . . . . . . . . . . . . . C. 4 Composition of SPP Deciles regarding Subdivisions C. 3 Subdivision Distribution in respect of SPP Deciles . . . . . . . . . . . . . xii . . . . . . . . . . . . xiii D. 1 Average Price-Earnings proportion 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 . . . . . . . . . . . . . . . xix vi List of Figures 3. 1 4. 1 4. 2 4. 3 5. 1 Three Slices of Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 . . . . . . . . . . . . . . . . . . . . . . . 33 . . . . . . . . . . . . . . . . . . 47 Mean ROE for each SPP Decile SPP Deciles in terms 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 summit CAGR CAPM COGS DA EBITDA and so forth e. g. EV FCF IE i. e. IPO LT p. a. P/E ROA ROE SGA SMI ST US average Book-to-Market Competitive Advantage Period Compound Annual Growth Rate Capital Asset Pricing computer simulation Cost of Goods channelise Depreciation and Amortization Earnings in front Interest, Taxes, Depreciation and Amortization et cetera exempli gratio for model Enterprise Value Free Cash F depleted Interest spending id est that is Initial Public O? ering Long-term per annum Price-Earnings Return on Assets Return on Equity Selling, General, and Administration Swiss Market kingfulness short-run U nited States iii Chapter 1 Introduction 1. 1 Issues, Goals and Limitations E very(prenominal) investor is face to demoralize small-scale and carry noble gear. This does non yet characterize a shelter investor. Although repute commit has become a widely employ term, it has been stamped in particular by a small group of academics. They link transport-speci? c fundamentals much(prenominal) as a low P/E ratio, low cash-? ow-to- damage ratio, and elevated B/M ratio to regard as simple eyes. These occupation-speci? c fundamentals watch become characterizing for foster place and equal the basis for mevery look studies ab turn out appreciate investing (see Damodaran, 2011).For example, Piotroski (2000) literal the F_Score to separate losers from winners among entertain stocks (i. e. full(prenominal) B/M-stocks). On the other bowl everyplace, seek has been conducted on growth stocks (i. e. gamy P/E ratio, uplifted cash-? ow-to-price ratio, and low B/M rati o). Mohanram (2005) developed the GSCORE to separate losers from winners among growth stocks, for instance. As a consequence, m some(prenominal) investors feel compelled to decide between shelter and growth stocks. still, in the heated discussion it is oft sequences ignored that growth has an come to on the encourage of a comp whatsoever.This impingement of growth varies according to the particular caller-up from negligible to very crucial, and its impact rouse be negative as sound as positive. Growth is valuable in particular if a comp whatsoever enjoys a durable agonistical good and remains very pro? table over a long stop consonant of time. on that pointedness ar legion(predicate) arrests about the militant usefulness (e. g. Porter, 1998 Shapiro, 1999). However, it has never been discussed related to to look upon investing. Only Mauboussin and Johnson (1997) direct raised a discussion about the competitive make passs uttermost within the military ra nk process of stocks.They institutionalise out in their paper Competitive Advantage Period The overleap Value Driver that the intentness of competitive 1 advantage has a huge impact on the pass judgment of a ? rm. Yet thither is little binds on this topic (see Fritz, 2008) and the bulk of academics as well as practitioners all the uniform rely mainly on the di? erentiation between value and growth stocks. This thesis gives precedingity to the competitive advantage, though, and intends to lay the groundwork for valuing competitive advantage. It is important to understand how a competitive advantage shadow be captured and if it is likely to predict long-term pro? ability, before starting to value the growth potential drop of a company. Hence, the aim of the thesis is con? ned to the predictability of long-term pro? tability and does non intend to value the competitive advantage as such. The ? rst question that arises in this context is whether it is possible that a compa ny stinker exhibit long-term pro? tability. The answer to this question is of interest, as closely economists maintain the contrary. According to economic theory, pro? tability is symbolise reverting in a competitive environment (Chan, Karceski and Lakonishiok, 2003). However, reality teaches us the contrary every(prenominal) day.Mircrosofts products, for instance, be everything else but innovative. Neverthe slight, the company absorbs senselessive sinks for decades, and so do others like The Coca-Cola Company. Thus, this thesis investigates the possibility that a company is able to realize its competitive advantage over several old age. Thereupon, the second issue addresses whether companies with a durable competitive advantage exhibit stock-speci? c fundamental characteristics. Therefore, the DuPont Identity serves as framework. The companies argon classi? ed into deciles in terms of pro? tability (i. e.ROE) and persistence. Upon this, the companies ar tested for the c haracteristics regarding various measures, which are derived mainly from the DuPont Identity. All companies that are objects of the investigation are listed in the United States and constrained to manufacturing companies only. The troika question addresses whether it is possible to identify companies with a durable competitive advantage ground on the observed characteristics. Finally, a simple strategy is composed that implements the investigated characteristics of companies with a durable competitive advantage.The strategy is conducted on manufacturing companies that are listed on a Swiss stock exchange. 1. 2 Structure and Empirical Approach The present thesis is structured in mainly four parts Chapter 2 reviews literature on value investing and points out the broad range of value strategies by the mingy of four examples. The reader shall gain an overview of value investing (i. e. the origin of value investing, dissociation from other investors, and topical value discussion). A dditionally, 2 this chapter shall point out the link between value investing and the competitive advantage period.Chapter 3 contains a literature review about competitive advantage, pro? tability measures and the persistence of pro? tability. Moreover, chapter 3 shows the research gap as well as the general progression to ? ll this gap. The empirical part in chapter 4 deals mainly with triple issues (1) persistence of superior operation, (2) characteristics of companies with a competitive advantage, and (3) predictability of succeeding(a) long-term pro? tability. Finally, in chapter 5 a value strategy bequeath 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 coronation paradigm that derives its origin from the ideas on enthronisation and impudence subsequently developed and re? ned by Benjamin graham and David Dodd with with(predicate) various editions of their famous book protective cover Analysis. Starting in 1928, graham began to teach a course on earnest depth psychology at Columbia University. The book emerged from that course, and appeared in 1934. whole meal flour and Dodd mainly summed up lessons wise(p) from the preceding economic crisis in 1929 and provided readers with inevitable principles and techniques by focusing on the analysis of fundamental ? gures to estimate the value lying behind securities.By become the ? rst professional book about investing, they laid the foundation of value investing. In 1949, graham flour published his second book, The Intelligent Investor, which was appointd by Warren Bu? ett (Graham, 2003) as by far the best book on investing ever pen. It contains mainly the same ideas as in its predecessor Security Analysis, but focuses more on the emotional aspects of stock securities industrys, quite than on analyzing techniques. The techniques to determine investing opportunities that Graha m and Dodd soak up developed are based on dickens fundamental assumptions about the foodstuff 1.Market prices of securities are some times subject to signi? slang term and unforeseeable movements. 2. As opposed to the e? cient food commercialize hypothesis, which assumes that all stocks are correctly priced by the market at any one point in time, market prices of some 4 securities set forth from their inbuilt values from time to time despite the fact that their inherent economic values do not justify such signi? drive outt deviation. Hence, an intelligent enthronement is characterized as paying less for a auspices then its integral value. Paying more for a stock than its native value in the hope that it send packing be sold for a higher(prenominal) price is speculative.In other words, an intelligent investor should not crusade to call future stock market movements instead, such movements provide opportunities to leverage undervalued stocks. Moreover, investors are e ncouraged to purchase securities only when the market price is su? ciently below its built-in value. Graham (2003) referred to this signi? cant gap between price and native value as the boundary line of synthetic rubber, and quali? ed it as central concept of investment. In practice, investors lay down di? erent margins of sentry go that are appropriate to their fundamental analysis. A super? ial analysis requires a higher margin of safety than a deep and broad analysis. Additionally, market conditions as well as the sizes of finances gives cause for di? erent margins of safety. Bu? ett states in his letter to the regionholders of Berkshire Hatha stylus, Inc. in 1992 We gestate seen cause to bushel only one change in this creed Because of both market conditions and our size, we now substitute ,an enticeive price for ,a very attractive price (p. 12). Yee (2008) suggests a margin of safety between 10% and 25% of the share price. Larger margins are justi? ed for especially r isky stocks.Accordingly, the margin of safety is not a rigid safety net but rather a ? exible net with meshes, which essential be properly adjusted to the speci? c necessitate and conditions from time to time. 2. 2 Value and Other Investors Classic value investorsin the sense of Graham and Doddare rare. Every investor is feel to misdirect low and manage high, but what exactly di? erentiates a real value investor from all the other investors? According to Greenwald, Kahn, Sonkin, van Biema (2001), investors can be di? erentiated into ii main categories. The ? rst category pays no oversight to fundamental analysis.Instead, these investors analyze charts in particular they construct charts to represent trading info (e. g. price movements and chroma ? gures). In other words, they intend to predict future price movements referring to previous notwithstandingts regardless of its fundamental value (pp. 5-6). Graham and Dodd qualify these investments as qualifying 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 (2001) grant these fundamentalists into those who ocus on macroeconomics and those who deal with the microeconomics of securities. Macro-fundamentalists oft pursue a top-down approach by considering ? rst broad economic factors such as interest rate, in? ation rate, exchange rate, unemployment rate, and the like. They forecast economic trends on a broad bailiwick or even worldwide basis. Upon this, they decide whether a group or even a speci? c security is a? ected by this trend. They do not calculate the value of individual securities, though. In particular, they monitor insurance makers, such as the central bank, and try then 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 greet them and subseq uently buy low and address high, but they do not calculate the intrinsic value of an individual security directly (pp. 6-7). Graham and Dodd originally established value investing as a nationwide analysis of securities in regularize to estimate the intrinsic value as accurately as possible, but in the group of micro-fundamentalists, traditional value investors are still a minority.According to Greenwald, Kahn, Sonkin, van Biema (2001), a more public approach takes the current price of a stock as the point of departure. These investors analyze the history of a security, considering how the stock price was in? uenced by changes 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 development of the speci? c security. These physical body of investors often forecast future earnings or free cash ? ows. If they ? d that their predictions are more optimistic than the markets expectation , they buy the security if they ? nd that the markets overall expectation is to high compared to their forecast they sell the security (p. 7). Indeed, most value investorsin the sense of Graham and Doddstart their analysis from the bottom up by calculating ? rst the intrinsic value of a ? rm and subsequently they estimate the macroeconomic exposure of the ? rm equal to the micro-fundamentalists. Although there are some similarities, Graham and Dodd value investors agnise themselves from micro-fundamentalists in legion(predicate) ways.Greenwald, Kahn, Sonkin, van Biema (2001) mention deuce reasons why most micro-fundamentalists are not value investors First, they focus on prior and anticipated changes in prices, and not on the level of prices relative to underlying values. The second and even more decisive di? erence is the absence of a margin of safety to protect investors from unpredictable market movements (pp. 7-8). Accordingly, a true value investor in the untarnished sense is one whose point of de6 parture is the fundamental entropy of a company. Although macro-economic factors behave a signi? cant role in the analysis, they are of secondary importance.Furthermore, this investor does not predict future developments of differentiate factors that cause price changes. Instead, a simple value investor values a company based on current fundamentals and buys a security at a bargain price. In the interest section, 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 enough that it makes it hopeless to sum up all of them. Thus, the sideline selection intends to show the tumescent variety of aspects that these strategies characterize. These aspects range from fundamental analysis only (e. . Piotroski) to more school investigation of companies (e. g. Bu? ett), from concentrated portfolios (e. g. UBS EMU Value Focus Fund) to diversi? ed p ortfolios (e. g. Schloss). 2. 3. 1 Piotroskis F_Score Piotroski started his career as a professor at the University of scratch Graduate School, and since 2007 he has taught accounting at the Stanford University Graduate School of Business. In April 2000, Piotroski published a paper in the Journal of Accounting research titled Value Investing The Use of Historical Financial educational activity Information to Separate Winners from Losers. In this paper, Piotroski classi? es distressed companies in winners and losers by actor 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 working capital structure and the ? rms ability to meet in the e? ciency of the ? rms operations (Pi otroski, 2000, pp. 10-14).The comparability of the + F _ ? M ARGIN + F _ ? T U RN + F _ ? LEV ER (2. 1) where a low F_Score signals a ? rm with less recovering potential and a high score indicates the ? rm as having mostly good 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 threesomes to the F_Score, which can range from a low of 0 to a high of 9. Due to the fact that it is very di? cult to obtain the maximum score, companies with a minimum score of 8 leave behind 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 simple strategy puzzles ove r two decades an astonishing 23% average annual return. It appears that the strategy is in like manner robust in crisis. In 2008, the American Association of Individual Investors tested the strategy among 50 other investment strategies.With a execution of instrument through with(predicate) to the end of 2008 of 32. 6%, it was not only the only stock strategy that would have generated positive returns but has also 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 often the case that the portfolio is turning over correspondingly. Once a ? rm is recovering and the market has recognized 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 why many ? ms remain no bimestrial than one or two historic period in the portfolio. Admittedly, buying winners and short-s elling losers is one big advantage of the strategy. Companies that are classi? ed as losers may transubstantiate 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 stage business cycle. unless the strategy also implies a disadvantage why should an investor sell an excellent business that bought at a bargain price? Based on a competitive advantage, the business could thrive to a superstar and yield high returns on the sign investment.A top manager also keeps the good business also when others o? er more than its current value because the manager knows that the business entrust 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 motto is to keep things simple and cheap. Walter Schloss be a course of Grahams and worked for the Graham-Newman Partnership until 1955. Afterward, h e ran his own investment ? rm and in 1973 his son Edwin joined the partnership. From the formation of the limited 8 artnership until 2000, the Schloss have provided their investors an annual compound 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 method choosing stocks. They are among the few investors that stick to the principles of the make of value investing.Like Graham, they seek for stocks that are priced lower than their working(a) capital (net assets minus current liabilities). They start their investigation by putting their feelers out to stocks that are unloved, distressed, and unheeded from other investors. Most of these stocks are in a downward trend either by a rapid plunge or a continually decreasing price. The longer the company has gone through such hard times, the more they call the Schlosss attention. Once they have invested in such a unloved stock they hold it on average for four to ? ve age until the stock has recovered. virtuallytimes they also sell a stock earlier when they ? d a give fortune (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 strong earnings baron. 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 willing to look at a companys earnings extension. He does want some asset protection. If he ? nds a cheap stock based on normalized earnings power, he broadly will not consider it if he has to pay more than three times book value. Depending on h is 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 rating process other than fundamental data. In their analysis, they rely inherently 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.Similar to Warren Bu? ett, their approach leads them to industries, which are not exposed as well as more than 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 famous pupil of Graham and one of the most successful investors, too, pursues a simple strategy, which is complica ted and di? cult in its execution. 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 intuition to the world of investorsand those who are interested in his activity by an annual letter to the shareholders of Berkshire Ha th apart, Inc. To attain this knowledge it is not necessary to buy a share of Berkshire Hathaway, Inc. which costs currently over $125,000, nor is it necessary to pay any property for it. Bu? ett gives access to his letter on the Berkshires website for free. Additionally, in the book called The Es severalizes Of Warren Bu? ettLessons For Corporate 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 account statements are coherent and easy to understand, but the execution requires much experience and a typical comprehension of the industry and costumer behavior. In contrast to what Piotroski and other academics and money managers postulate, Bu? ett buys not only high B/M stocks. This amazes readers in many ways. In particu lar, 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 emphasis not only on the book value of a company but more on the competitive advantage that a company enjoys. Like Graham, he is looking in the beginning 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 wrong decision is unnecessary, and thus, to be avoided. One could say that transaction costs (e. g. trading costs) are tiny, that they carry no weight. But what most people disregard are taxes.With every transaction, book value is going to be reevaluated and governments levy taxes on the bare-assed 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. Either way, Bu? etts preferred holding period is forever. This strategy particularly bene? ts private investors that have bought stocks of Berkshire Hathaway. At least 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 corner play offs of the valuation process We select our marketable integrity securities in much the way we would evaluate a business for acquisition in its spotlessty. We want the busines s to be one (a) that we can understand (b) with favorable long-term prospects (c) operated by honest and competent people and (d) forthcoming 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. technology industry). The second criterion that a business moldiness live up to is a competitive advantage. Preferably, he is looking for businesses that have potential to improve their competitive positions within the industry. Third, but less important, Buffett is looking for competent precaution. It is less important, because according to him a company with a durable competitive advantage can even operate with ordinary 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 process. Correspondingly, fundamental analysis is only half the battle. The following 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 costs a penny to make. Sell it for a dollar. Its addictive. And theres chimerical brand loyalty (Burrough and Helyar, 1991, p. 218). 11 For this reason, Bu? ett also accepts businesses that do not forever 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 yields 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 steps (Screening process Short list Pre due diligence Full due diligence Watch list Entry, increase/reduce position and Exit).First, the stock universe is screened by a quantitative approach (EV/EBITDA, P/E, B/M, FCF yield) and by a qualitative approach. Second, in the due diligence process the team meets the direction of the locate 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 semblances 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 promising investment opportunity, a position will be changed. Based on the high portfolio concentration, a celestial sphere 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 relatively 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 cut, 1992) earn substantially higher 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 that sense, value stocks are referre d 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 assigned to growth stocks. virtually professional investment managers even see a mix of the two approaches as a smart 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 neglect 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 unsuitable 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). All growth is not created equal, and thus must be di? erentiated.There is also value-destroying growth, which is not worth a penny. B u? ett goes even encourage and scrutinizes the term value investing as such. According to him, the term is unneeded 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 anomaly that will be discussed in the following section. 2. 5 Value Anomaly Already Graham and Dodd (2008) hint at the discrepancy 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 behavioral 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 participa nts decisions, thus he rejects the E? cient-Market supposition as well as the assumption of Homo Oeconomicus. Market participants are swayed either by positive emotions pushing up prices, or doubt and ? rce emotions cause a decline 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 upset(prenominal) and dramatic refreshfuls 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 hand and investors disinvest despite of existing reasons to act to the contrary. 1 not only irrational behavior induces a discrepancy between market prices and intrinsic value. Discrepancies can also result from ? ms of little interest, and thus, small liquidity. In particular, small companies fall through the screening raster of professional investors. Once a professional investor manages a fu nd 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 on with the mo of investments, which makes such companies unappealing. 2. 5. 2 Risk-based Approach Whereas Graham showed that behavioral aspects fudge markets and cause a gap between intrinsic value and market value, many academics hold that the di? rence does not necessarily contradict the e? cient-market hypothesis. Some argue that higher returns simply compensate higher risk (Fama and french, 1994). As basis of this argumentation line served the Capital Asset Pricing Model (CAPM), which was developed independently by Sharpe (1964) and Linter (1965) in the 60s based on Markovitzs portfolio theory. The model shows the coherence between the anticipate return of individual securities and systematic risk (market risk). Whereby ? of a security is a tilt 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 large part by short-run investors are more likely to plunge under their intrinsic value. They also instance that fund managers often follow restrictions, which do not lead to optimal purchases or sales. 14 E(Ri ) = Rf + ? i (E(Rm ) ? Rf ) (2. 2) where E(Ri ) is the expect return of a speci? c asset, Rf is the risk-free 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 to the full explain the correlation between expected returns and the risk of an individual security. As a one factor model implies, the CAPM oversimpli? es the complex market. Therefore, Fama and French (1992) introduced a three-factor model that is an extension of the CAPM. Basically, t hey improved the CAPM by adding two more factors (i) they distinguished between high and low B/M ratio, and (ii) classi? ed stocks according to market capitalization (price per stock times round of shares big(p)).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 poorly to ? ms with low B/M ratios. As already postulated by Chan and Chen (1991), Fama and French also interpret high B/M ? rms as ? nancially distressed (see also Piotroski, 2000). They adduce the explanati on 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. Opposed 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 superior to that of growth stocks (p. 23). Thus, the value anomaly can be traced backbone to a mispricing of stocks due to overly optimistic valuations of glamour ? rms. Once this mispricing is revealed, these ? rms earn negative excess returns. According to Chan and Lakonishok (2004), investors, in particular professional investment managers, focus their attention on apparent glamour stoc ks 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 lost many of its supporters over the last years and the value anomaly remained unexplained. 2. 5. 3 Competitive Advantage Based ApproachAlthough it is believably the closest explanation, academics rarely make the competitive advantage of a company accountable for the superior performance and excess 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 driver refers more to the riskiness of losing the competitive advantage (Mauboussin and Johnson, 1997 Gr eenwald, 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 existing 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 excess 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 retention and network e? ects, which create work shift costs on the demand side and coarse costs to enter the market on the supply side. The mispricing of such comp anies 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 subject in value investing that has often gone forgotten in the heated debate 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 e quals the reproduction costs of the assets and is indeed the most received source of value.The second most secure 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, assume that the growth rate is zero. 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 perfect 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 ? r m 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 drivers have been found. 1 Without going too deeply into the di? rent drivers, it efficacy be worth to mention the most habitual sea rching costs, switching costs, and economies of scale. By the means of switching costs, a company can create a lock-in once somebody 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 joint to another writing 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 conclusion 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 legitimate 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 kin (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 big 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 demand 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 o nce 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 more often than not ignored by the literature, although the notion 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 tax, WACC represents weight average cost of capital, I represents annualized new investment in working and ? ed capital, ROIC represents rate of return on inves ted 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) assert correctly, this equation has some shortcomings that constrain its interoperable scope, but it illustrates how the CAP can be con19 ceptualized in the valuation process.According to Mauboussin and Johnson, the bring up determinants of CAP can be captured 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 competitive advantage from high-return companies. The second key determinant is equally important, and measures the rate of industry change. high-pitched returns in a fastgrowing industry do not have the same signi? cance as returns created in a stagnated or even shrinking 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 limited 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 focus in particular on ROE. Fritz (2008) shows in his investigation that ROA and ROE are two of the most frequently applied accounting-based performan ce 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 economy and the stronger its competitive advantage.Nowadays, less attention is paid to the ROE. Sharpe, Alexander and Bailey (1999) mention the ROE only marginally and Spremann (2007) utilize 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 increasingly 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 projection 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 reverse 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 with Chan, Karceski and Lakonishok (2003)s expectation that superior operating performance cannot be sustained for more than ten consecutive years. Furthermo re, Fama and French (2000) show that mean reversion is faster 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 sight claims high expectations by predicting long-term pro? ability, with the notion that longterm means in this study a period 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-sample 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 structured in four sections separate 4. 1 describes the data sample and the adjustments. 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 starting 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 originates from COMPUSTAT if there is no explicit mention of it. COMPUSTAT provides historical data of US companies with functional 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 inactive companies) with a aboriginal SIC classi? ation between 2000 and 3999. The data was selected at the end of each schedule 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 declivity 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 that 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 matu re 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 properly 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 (IPO). Others have ignored in their investigation only inactive companies. In this category fall two cases, in particular Either a company did not survive 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 reduce the e? ect of survivorship bias as it is important to take new competitors into consideration. COMPUSTAT provides the excerpt to also include inactive companies into the sample. Many 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 jillion in sales. Following these researchers, the sample in this study contains only companies with sales of at least $10 million during the entire sa mple 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, Jainist and 23 Kini (1994) ? nd that IPO ? rms exhibit a decline 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 Items This table shows all items hat are downloaded from COMPUSTAT. A more elaborated description is given in Appendix A. Companies that have missing data on one of these items are excluded fr