Value Investing: Predicting Long-Term Profitability Based on Fundamental Data

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Value Investing: Predicting Long-term Profitability Based on Fundamental Data An Empirical Study in the Manufacturing Industry

by Vital Schwander (05-609-136)

Master’s Thesis

supervised by Prof. Dr. Andreas Grüner

University of St.Gallen

May 23, 2011
Master in Law & Economics

Abstract
Warren Buffett (1992) classifies the discussion about value and growth stocks as fuzzy thinking. With that statement, he argues that value investors must consider growth in their value calculations. This thesis shows in a first step that growth is only valuable if the company enjoys a durable competitive advantage. By examining the fundamental characteristics of companies with a durable competitive advantage, this thesis intends in a second step to assess the predictability of long-term profitability. The DuPont Identity serves as framework for that purpose. The objects of this investigation are companies within the manufacturing industry (Primary SIC Code between 2000-3999) that were listed in the United States between 1979 and 2009. The results show that companies with a durable competitive advantage exhibit specific characteristics in operating efficiency, asset use efficiency, and in the ability to meet short-term obligations. Furthermore, the thesis shows that long-term profitability, based on the investigated characteristics, is predictable to some extent. This thesis concludes by assembling the insights to a value strategy that is applied to manufacturing companies listed in Switzerland. The strategy exhibits an outstanding SMI-adj. compound annual growth rate of 13.19% over a period of 17.5 years.

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Acknowledgement
I would like to express my gratitude to Prof. Dr. Andreas Grüner for supervising this thesis and his assistant Lucia Ehn for her conceptual advices. I have furthermore to thank Mr. Hans Ulrich Jost for giving me insight into the daily business of a value fund at UBS AG. My sister 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 always supportive and motivating. Finally, I also would like to thank friends and colleagues for making life such an enjoyable experience.

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Contents
1 Introduction 1.1 1.2 Issues, Goals and Limitations . . . . . . . . . . . . . . . . . . . . . . . . . Structure and Empirical Approach . . . . . . . . . . . . . . . . . . . . . . 1 1 2 4 4 5 7 7 8

2 Value Investing—An Investment Paradigm 2.1 2.2 2.3 The Origin of Value Investing . . . . . . . . . . . . . . . . . . . . . . . . . Value and Other Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . Four Value Strategies by Illustration . . . . . . . . . . . . . . . . . . . . . 2.3.1 2.3.2 2.3.3 2.3.4 2.4 2.5 Piotroski’s F_Score . . . . . . . . . . . . . . . . . . . . . . . . . . Walter and Edwin Schloss . . . . . . . . . . . . . . . . . . . . . . .

Warren Buffett . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 UBS EMU Value Focus Fund . . . . . . . . . . . . . . . . . . . . . 12

Value vs Growth—Fuzzy Thinking! . . . . . . . . . . . . . . . . . . . . . . 13 Value Anomaly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 2.5.1 2.5.2 2.5.3 Behavioral Approach . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Risk-based Approach . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Competitive Advantage Based Approach . . . . . . . . . . . . . . . 16 17

3 Literature Review 3.1 3.2 3.3

Competitive Advantage . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Profitability Measurements . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Research Gap and General Approach . . . . . . . . . . . . . . . . . . . . . 21 22

4 Analysis of Long-term Profitability 4.1 4.2

Data Sample . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Analysis of Return on Equity Measure . . . . . . . . . . . . . . . . . . . . 26 4.2.1 Superior Performers . . . . . . . . . . . . . . . . ....
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