Stockholm School of Economics Bachelor Thesis in Accounting and Financial Management May 2017 Value investing; A quest for alpha in the Nordic region Back-testing the strategies developed by Joel Greenblatt and Joseph Piotroski Abstract: This thesis evaluates the performance of the Magic formula and F-score. The investment strategies are applied to the entire Nordic region over the period of 2005-2015 and the returns evaluated using the CAPM and Fama & French's three-factor model. The success of each investment strategy is found to be dependent on the measure of risk, and while the Magic formula manages to generate excess return, the F-score produces a higher alpha when tested using the CAPM and Fama & French's three-factor model. Furthermore, the estimation of the SMB and HML factor portfolios suggests that over the course of 2005- 2015 the Nordic region appears to have a positive size premium and a negative value premium. Keywords: MFI, F-Score, Value Relevance of Accounting Measures, Value Investing, Abnormal returns, CAPM, Fama & French’s three-factor model, Efficient Market Hypothesis Authors: Jonas Wahlström 23314, Alfons Rosendahl Jagut 23316 Tutor: Stina Skogsvik1 1 First of all the authors would like to thank their tutor Stina Skogsvik for her guidance and support. Additionally, the authors are very appreciative of the insightful comments from the opponents and fellow students during the seminars. 0 1. Introduction 2 1.1 Background 2 1.2 Purpose 3 2. Theoretical framework, empirical research and previous studies 4 2.1 Theory 4 2.1.1 Efficient market hypothesis 4 2.2 Market anomalies and empirical contradictions of EMH 4 2.2.1 Fundamental analysis of accounting information 5 2.2.2 Size matters 5 2.2.3 The B/M and value effect 6 2.2.4 Mean reversion 7 2.3 Investment strategies 7 2.3.1 Piotroski’s F-score 7 2.3.2 Greenblatt´s Magic Formula 9 2.4 Previous studies 10 3. Method 12 3.1 Portfolio Evaluation 12 3.2 Portfolio creation and rebalancing 14 3.3 Calculation of returns, volatility and beta 16 3.3.1 Calculation of returns 16 3.3.2 Abnormal return test; CAPM and Jensen’s alpha 17 3.3.3 Sharpe ratio 19 3.3.4 Fama & French’s 3 factor model 20 3.4 Hypotheses 22 1. Can the MFI beat the market in the Nordic region? 23 2. Can the F-score strategy beat the market in the Nordics? 23 3.5 Potential biases 23 4. Empirical data and results 24 4.1 Data collection 24 4.1.1 Region and time span 24 4.1.2 Market and choice of risk-free rate 24 4.1.3 Sample selection 25 4.2 Results 26 4.2.1 Accumulated annual returns 26 4.2.2 Abnormal returns according to Jensen’s Alpha 28 4.2.3 Fama & French three-factor model 30 4.2.4 Abnormal returns according to Fama & French’s three-factor model 30 5. Analysis and discussion 32 5.1 Analysis and discussion 32 5.2 Validity of results 35 5.3 Reliability of results 37 6. Conclusions 37 7. Further research 39 8. Appendix 40 8.1 The scoring process used by Piotroski 40 8.2 Test of the HML factor estimated in the Nordics 41 8.3 Sensitivity analysis; replacing the market index 41 8.4 Test of the SMB factor estimated in the Nordics 42 8.5 The outperformance of small cap stocks in the Nordics 42 9. Complete list of references 43 1 1. Introduction 1.1 Background Greenblatt and Piotroski are two of the most popular practitioners of the investment paradigm called value investing. The philosophy is derived from the ideas of Benjamin Graham and David Dodd (1934) and has since been made famous by the high-profile investor Warren Buffett, amongst others. Generally the idea involves performing fundamental analysis in order to find securities valued below their intrinsic value, and by buying cheap stocks investors gain a “margin of safety” which allows them to make investments with minimal downside risk. This hopefully allows them to identify bargains in the stock market. (Mihaljevic 2013) Whether it is possible to do so have for long been a subject of academic debate. In 1970 Eugene Fama further developed the efficient market hypothesis which states that all securities are fairly priced, and that prices fully reflect all available information. According to the theory there would not be possible to outperform the market without taking on additional risk proportional to the higher returns. When reviewing the theory Fama (1970) found support of the market being in a semi-strong form of efficiency, and that stock prices should fully reflect all publicly available information. Despite so some investors, including Benjamin Graham, Warren Buffett, and John Templeton, have systematically managed to beat the market using fundamental analysis. Further evidence supporting the case for a weak form of market efficiency is Ou & Penman (1989) who showed that financial statements contain information that can be used to forecast future stock returns, Lev & Thiagarajan (1993) who found a set of accounting fundamentals to have strong value relevance while Abarbanell & Bushee (1998) showed that those measures can be used to generate an annualized abnormal return of 13.2%. Numerous other investment strategies have also been developed with the purpose of exploiting various market inefficiencies. Having established it is possible to generate abnormal returns, what is the easiest way to do so? If you ask Joel Greenblatt the answer would be - by magic. The successful hedge fund manager and adjunct professor Joel Greenblatt (2006) is the father of an investment strategy named “The Magic Formula Investing” which identifies companies that trade at low valuations whilst having high returns on capital. Using a stock ranking methodology based on those ratios he consistently managed to beat the market by 18.4% per annum. Various 2 academics have published studies which shows that several other market anomalies exists as well, amongst those the over performance of high book-to-market firms is one of the most well-known (Rosenberg, Reid & Lanstein 1985, Lakonishok, Shleifer & Vishny 1994).This anomaly has been combined with nine fundamental key ratios into an investment strategy developed by the American professor Joseph Piotroski (2000) called the “F-score”. His model has shown the ability to single out both winners and losers amongst the high book-to- market firms, resulting in an annualized return of 23%. 1.2 Purpose The two investment strategies, F-score and MFI, examined in this thesis have been thoroughly tested in the US market, but do they work in the Nordic region as well? This thesis aims to find out whether this is the case. Moreover, the study also aims to compare the results of the two models and will therefore have considerable practical relevance for an investor seeking to invest in the Nordic stock market. As far as these authors are aware there are no previous studies testing and comparing both models using data from all of the Nordic countries, and earlier attempts to replicate these investment strategies in one of the Nordic countries have faced the problem of having small sample sizes and have thus been forced to either adjust the original models or to settle with potentially skewed results. When investigating whether any of the investment strategies do beat the market when applied in the Nordic region the return of the portfolios will be benchmarked against the MSCI Nordic, and afterwards, adjusting for risk, any return will be tested using the Sharpe-ratio, Jensen's Alpha and Fama & French´s (2012) three factor model (Sharpe 1966, Jensen 1978, Fama, French 2012). In this thesis the term excess return is defined as the return of the portfolio being tested in excess of the market, while abnormal return is defined as the return that cannot be explained by any of the capital asset pricing models. As there is no previous data readily available on the three component factor portfolios in a Nordic stock market context this thesis will estimate the return of the so called SMB and HML factor portfolios. This opens up for a discussion about the whether the size and value effect persists in the Nordic region. 3 2. Theoretical framework, empirical research and previous studies 2.1 Theory 2.1.1 Efficient market hypothesis As previously mentioned the efficient market hypothesis states that prices should reflect all available information and that it should be impossible to generate abnormal returns. Investors claiming to beat the market by showing excess returns would according to this theory then only have taken on more risk. When defined by Roberts (1967) three degrees of the efficient market hypotheses (EMH) were outlined; strong, semi-strong and weak form of efficiency. In the weak form of efficiency past prices cannot be used to determine future price movements, rendering technical analysis useless. The semi-strong form of efficiency states that all publicly available information is incorporated into prices, implying that fundamental analysis is useless in predicting stock returns. The strong form of efficiency claims that all information, both public and private, is incorporated into the price of a security. In this strong form of efficiency even monopolistic information commonly regarded as inside information would not render any success in generating abnormal returns. In his research Fama (1970) conducted a large empirical study of the EMH and found evidence suggesting markets are in a semi-strong form of efficiency. Various academics has since supported the EMH and verified the findings of Fama, including Burton (1973), Samuelson (1973) and Jensen (1978) amongst others.