The Lakonishok Approach to Value Investing: A Payoff for Patience

    by Wayne A. Thorp

    The Lakonishok Approach To Value Investing: A Payoff For Patience Splash image

    Josef Lakonishok and his colleagues are quickly dispelling the adage “those who can’t do, teach.”

    Lakonishok, a professor at the University of Illinois at Urbana-Champaign, along with fellow academicians Andrei Shleifer of Harvard University and Robert Vishny of the University of Chicago, formed LSV Asset Management in 1994. The firm uses quantitative models to find value-oriented companies and has seen its assets under management balloon to $61 billion as of June 30 from just over $6 billion in 2001—an impressive increase of over 900%.

    Lakonishok is a contrarian investor who believes that investors with patience can profit from a value-oriented investment approach.

    Over the long run, according to Lakonishok, value outperforms growth because investors don’t expect much from it. When a value stock does better than expected, investors are pleasantly surprised and are more apt to reward the company by bidding up the stock.

    In contrast, Lakonishok believes investors expect too much from growth stocks. It is unrealistic to believe strong growth lasts forever. Eventually, the company will miss an earnings target or lower their earnings guidance, and the market will punish the stock price.

    In the book “Investment Titans” (McGraw-Hill, 2001), Jonathan Burton talks with Lakonishok about his approach. The Lakonishok screen in AAII’s Stock Investor Pro fundamental stock screening and research program is an interpretation of Lakonishok’s methodology as outlined in this book. The screen seeks mid- and large-cap firms that have:

    • Price multiples that are lower than the respective industry norm;
    • Rising price momentum; and
    • Upward estimate revisions.

    Screen Performance

    The AAII Lakonishok screen is built into AAII’s Stock Investor Pro. In addition, the companies passing this screen are posted each month on and the performance of these stocks in hypothetical portfolios is tracked on-line.

    The Lakonishok screen has outperformed the large-cap S&P 500 index and other broad market indexes since the beginning of 1998.

    Figure 1 shows that the Lakonishok approach has generated a cumulative return of 247.5% over the period from January 1998 through August 2006, while the S&P 500 is up only 34.4% over the same period.

    Profile of Passing Companies

    The characteristics of the stocks currently matching the Lakonishok criteria are presented in Table 1.

    Given that Lakonishok seeks value companies, it is not surprising to find that the median price-earnings ratio of 17.2 for those companies currently passing the AAII Lakonishok screen is below the median for all exchange-listed stocks of 19.0.

    This is not the case when it comes to the price-to-book-value ratio, as the median for the Lakonishok stocks is 2.9 while the median value for exchange-listed stocks is 2.1. Further investigation shows that only nine of the 30 companies that passed the AAII Lakonishok screen as of September 8, 2006, have a price-to-book-value ratio that is below their respective industry median (not shown in the table).

    While there are no elements of growth in the AAII Lakonishok screen, those companies currently passing the screen have a higher median historical earnings growth rate (17.9%) than that of the typical exchange-listed stock (11.5%). However, the market does not have the same opinion for the future prospects of these stocks. The median estimated earnings growth rate of the passing companies is 12.8%, while the median value for all exchange-listed stocks is 14.4%.

    The median market capitalization of the Lakonishok stocks is $3.1 billion, compared to only $436.8 million for all exchange-listed stocks. Larger stocks tend to be more mature, and older, more mature firms tend to have fewer growth opportunities going forward.

    The AAII Lakonishok screen requires a stock to have outperformed the S&P 500 over the last 26 weeks and at least maintained that price strength over the last 13 weeks. The companies currently passing the AAII Lakonishok screen have outperformed the S&P 500 by a median value of 11%. Meanwhile, the typical exchange-listed stock has underperformed the S&P 500 by 1% over the same period.

    Lastly, Lakonishok looks for stocks with rising earnings estimates. Over the last month, the median consensus earnings estimate for the current fiscal year of the current Lakonishok companies has increased almost 2%.

    Figure 1.
    Performance of Lakonishok Screen

    Table 1. Lakonishok Portfolio Characteristics
    Portfolio Characteristics (Median) Lakonishok Exchange-
    Price-earnings ratio (X) 17.2 19
    Price-to-book-value ratio (X) 2.9 2.1
    EPS 5-yr. historical growth rate (%) 17.9 11.5
    EPS 3-5 yr. estimated growth rate (%) 12.8 14.4
    Market cap. ($ million) 3,144.50 436.8
    Relative strength vs. S&P (%) 11 -1
    Current yr. EPS estimate revision over last month (%) 1.95 0
    Monthly Observations
    Average no. of passing stocks 28  
    Highest no. of passing stocks 89  
    Lowest no. of passing stocks 4  
    Monthly turnover (%) 90.6  

    Passing Companies

    Table 2 lists the 30 companies that passed the Lakonishok screen as of September 8, 2006. It is ranked in descending order by relative price strength over the last 13 weeks.

    The current roster of passing companies—30—is slightly larger than the historical monthly average of 28.

    In order to qualify as potentially undervalued, a company’s price-to-book, price-to-cash flow, price-earnings, or price-to-sales ratio needs to be below the respective industry median. But companies that may meet one of these criteria may not meet your own personal definition of “undervalued.”

    Take for example Symantec Corp., an Internet and network security firm. One reason the company passed the AAII Lakonishok screen is because its current price-to-book-value ratio of 1.5 is below its industry median of 2.6. However, if you look at the company’s other price multiples, you might begin to question its “value” status. Symantec’s trailing price-earnings ratio is a dizzying 268.3, while the industry median is 32.4. (Trailing earnings were hurt by a write-off of $284 million of in-process research and development expense associated with the acquisition of VERITAS Software Group in July of 2005, in addition to other merger-related charges. However, the company’s forward price-earnings ratio of 16.8 is much more reasonable.) In addition, its price-to-cash-flow ratio (75.1 vs. 26.1 industry median) and price-to-sales ratio (4.1 vs. 2.0 industry median) are equally as rich compared to the industry norms.

    When confronted with such disparity, it is always a good idea to examine the underlying data. Symantec acquired Veritas Software Corp. in a stock swap that led to the company issuing almost 531 million new shares. As a result, the company’s common equity jumped from $3.7 billion in 2005 to $13.7 billion in 2006 (fiscal-year ending March 31) and its book value per share (common equity divided by shares outstanding) rose from $5.61 to $13.69, thereby lowering Symantec’s price-to-book ratio. The increase in the number of shares outstanding has outpaced the growth in sales, earnings, and cash flow, thereby raising each of the respective price multiples to their current levels. Simply buying an out-of-favor stock is a risky endeavor, as there is a chance that the company will never rebound or, worse yet, that it will die altogether. Therefore, Lakonishok looks for value companies that appear to be making a resurgence in terms of stock price.

    The AAII Lakonishok screen requires a stock to have outperformed the S&P 500 over the last 26 weeks and have a 13-week relative strength index that is equal to or greater than its 26-week relative strength index. Over the last 13 weeks, Forest Laboratories, a manufacturer and marketer of branded and generic prescription and over-the-counter drugs, has performed the best of the Lakonishok stocks relative to the S&P 500. On July 14 of this year, the company announced that a U.S. District Court determined that the company’s patent for one of its drugs was enforceable and that it was being infringed upon by Ivax/Teva. The company’s stock jumped over 15% on the news.

    Another way Lakonishok gauges whether a company’s prospects are improving is by examining analyst sentiment, as measured by consensus estimate revisions.

    In order to pass the AAII Lakonishok screen, a company cannot have any downward revisions to its current fiscal-year earnings estimate over the last month and must have at least one upward revision over the same period. Furthermore, the screen requires that the company’s consensus estimate for the current fiscal year has increased over the last month. Intuitively, you may expect that if there has been at least one upward revision and no downward revisions, the consensus estimate would automatically increase. However, this is not always the case, as analysts may drop coverage, which could lower the consensus estimate without an actual downward revision.

    Lancaster Colony Corp., a diversified manufacturer and marketer of consumer products, and Blyth, Inc., a home expressions company offering home fragrances and decorative accessories, have both seen their current fiscal-year consensus estimates increase by 9.6% over the last month. Both companies have only had two upward revisions over the last month, but since they have a small number of analysts tracking them—two for Lancaster and three for Blyth—the impact on the overall consensus estimates was greater. In contrast, venerable Hewlett-Packard, which is tracked by over a dozen analysts, has had 27 upward revisions to its current fiscal-year estimate over the last month, but has seen the estimate increase by “only” 4.8%. Interestingly enough, however, Hewlett-Packard has outperformed both Lancaster and Blyth over the last 13 weeks.



    No matter how well a stock screening methodology has performed (or how badly it has underperformed) over the long term, stock screening is only the first step in the stock selection process. The stocks passing the AAII Lakonishok screen do not represent a “recommended” or “buy” list. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

       What it Takes: Josef Lakonishok Criteria
    • Market capitalization for the last fiscal quarter (Q1) is greater than or equal to $500 million;
    • Companies that trade on the over-the-counter (OTC) market are excluded;
    • Companies that trade as ADRs are excluded;
    • Companies in the miscellaneous financial services and real estate operations industries are excluded;
    • The price-earnings ratio, price-to-book-value ratio, price-to-cash-flow ratio, OR price-to-sales ratio is lower than the respective industry median value (a company only needs to satisfy one of these “value” criteria);
    • Relative price strength over the past 26 weeks is greater than zero;
    • Relative price strength over the past 13 weeks is greater than or equal to the relative price strength over the past 26 weeks;
    • No downward revisions in estimated earnings for the current fiscal year (Y0) over the last month;
    • At least one upward revision in estimated earnings for the current fiscal year (Y0) over the last month;
    • Consensus earnings estimate for the current fiscal year (Y0) is greater than it was one month ago.
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