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Learning outcomes.

After watching this video, you will be able to understand the economic

intuition Behind the signals used in the G score strategy.

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This strategy is based on a paper written by Professor Partha Mohanram.The

title of the paper is, Separating Winners from

Losers among Low Book-to-Market Stocks using Financial Statement Analysis.

In this strategy, Professor Mohandram modifies the traditional fundamental

analysis to suit global to market funds.

So the signals he sues in the strategy,

even though they are similar used in financial statement analysis, and

are based only on the information contained in the financial statements,

do not conform to the traditional notions of financial statement analysis process.

Before we started finding the signals,

let us try to understand how he had come up with these signals.

If you look at the local market firms, they can be split into three categories.

First, firms that really are low book to market firms.

Second firms that are low book to market because they are overvalued in the market.

Third, firms that are low book to market because of temporary book.

Professor Mohandram in this strategy accounts for

all these three cases and comes up with eight signals to separate low book

to market faults into potential winners and potential losers.

these eight signals are divided into three groups.

Each group of these signals takes care of one of the three categories of low booked

market firms that we spoke about previously.

Now the first group of signals is defined by keeping in mind

the firms that are actually low book-to-market.

These signals try to separate the low book to market firms into potential winners and

potential losers based on the modified financial statement measures

of profitability.

Before we proceed any further, I would like to take you through fractions 101.

Now I have a fraction numerator denominator

If I want to reduce the value of this fraction, I can do so

by decreasing the numerator or increasing the denominator.

Now, I hope you are clear with what I'm doing here.

You need this to understand our next two categories.

The second group of signals are defined

keeping in mind the firms that are low book-to-market.

Because of overvaluation in the market.

Now, book-to-market ratio is book value of the firm

above the market value of the firm.

If the firm is overvalued in the market, then it is increasing

the denominator of the ratio and this reduces the overall ratio and

makes the firm fall into the low book-to-market category.

Please note that all evaluation is a temporary thing and

when the form returns to its correct value then this

firm make no longer follow the low book-to-market category.

The main reason for this over valuation is that

markets mainly interpolate future values from current fundamentals.

The signals in this category are defined to take care of this problem.

The signals.

The signals is different.

Keeping in mind the firms that have low book-to-market because of

temporary reduction in book value due to accounting roots.

How does temporary reduction in book value make the firm a low book-to-market firm.

We have the book-to-market value.

The book value of the firm s reduced thereby decreasing the numerator,

in turn reducing the entire ratio.

Our quintile of low book-to-market firms may have some faults

which fall into this category because of conservatism in accounting rules.

I will explain the conservatism in accounting rules part shortly.

There are chances that these firms might perform well in the future.

So we will separate them from the true low book-to-market firms,

which as a whole underperform.

Doing this will strengthen our investment strategy.

So this is how the signals are classified.

Now, let us discuss each group of signals in detail.

Before we start, one thing I'd like to tell you.

Similar to Petrosky F score, if the signal is favorable we will assign it a value 1.

If it is not favorable, we will assign it a value 0.

First, we'll start off with the group of signals that are based on the traditional

financial statement measures of profitability.

The logic here is very simple.

Firms that are profitable now are likely to be firms with strong fundamentals.

And these firms might be fundamentally strong in the future also.

We want to separate these strong ones from the weak ones.

For this, we use the profitability measure.

Profitably can be measured in terms of earnings or cash flows of the firm.

This brings us to our four signal.

The first signal G1 is based on earnings measure of profitability.

G1 also known as earnings return on assets.

Is defined as the ratio of net income before extraordinary items

scaled by average total assets.

If you recollect, in case of Petrosky, we checked if the regional assets is positive

or negative, and then assign a value to the.

Here in this strategy, we follow a different procedure.

We compare the earnings returns assets of the firm with median

earnings return of assets of all the to market forms in the same industry,

at the same time as the firm.

Now same industry is different in terms of two digit SIC code.

It is SIC, I don't want you to go around calling it sick code, all right?

Now how do assign a value to G1?

The first group signal G1 is set equal to one.

If it forms a return on assets based on earnings is greater than the medium return

on assets for order book-to-market forms in this same industry, and zero otherwise.

Let us try to understand what this means.

Let us concentrate only on the intuition part.

If the forms earnings return on assets is greater than the industry median value.

It means that the form is profitable compared to many forms in the industry and

this is a favourable signal.

That is why we assign the value of one to the signal G1.

Please note that in the strategy we will be comparing all the signals with

industry median values, and

the industry classification is done based on SIC two digit code.

I'm sure all of you remember this point and I need not say this again.

Now coming back to the first group of signals,

earning may be less meaningful than cash flows for early stage forms.

Among the low book-to-market firms,

most of the firms will be firms in their early stages.

So we calculate profitability based on cash flow also.

This is the second signal G2.

The second signal G2, which is cash flow later on assets,

is defined as the ratio of cash flow from operations scaled by average total assets.

The second signal G2 is equal to 1.

If your firm's cash flow return on assets exceeds the median for

all low book-to-market firms in this same industry and 0 otherwise.

The intuition is similar to what we did for G1.

Please pause the video and think.

I'm sure you'll be able to figure it out on your own.

Return signal in this group is based on accruals.

You have studied about accrual concept in detail in the accrual strategy.

I won't be discussing it here again.

We have seen that forms with greater accrual component in their earning

generally underperform in the future because of the low

quality of the earnings.

So if the firms cash flow from operations exceeds net income

it is favorable to the firm and we assign a value one to the [INAUDIBLE] G3.

If the cash flow from operations does not

exceed net income then we assign a value of 0 to G3.

This brings us to the end of the first group of signals.

We now move over to the second group of signals.

This group of signals is used to take care of firms, overvalued in the market.

Let me quote an example given in the paper.

There are two firms, firm A and firm B.

In the current year, both of them have similar earnings.

Then the market values both of the firms equally.

But firm A has been a consistent performer and has stable earnings.

But firm B has good earnings only this year.

So you do think both of them should have same value?

No.

In comparison to firm A, firm B is over-valued.

The good performance of firm B in this year maybe attributed to good luck, and

next year it might go down.

The markets might not look at all these details, and

they mainly extrapolate the period performance to next period.

To avoid such situations, Professor Mohandram

defines the second group of signals based on availability of performance.

In case of local to market funds,

stability of earnings may help distinguish between forms with solid prospects and

forms that are overvalued because of hyper glamor.

The signals that we are going to define reflect this idea.

G4 is the first signal in this group and is based on stability of earnings.

Stability of earnings is also called earnings variability.

It is calculated as variance of firms.

Quarterly earnings return on assets over the last four years.

If the firms earnings variability is less than the median average

earnings variability of all the low book-to-market firms in the same industry

then it is favorable to the firm and we assign a value of one to G4.

Let us try to understand this.

If the earnings variability of the firm is less than the industry median,

this means that there is less variation in its earnings.

In other words, the earnings of the firm are much stable than the earnings

of most of the other firms in the particular industry, which is a good sign.

If the earnings variable p is more than industry median, it is unfavorable.

And we assign the value of 0 to G4 in that case.

Now in the case of low book-to-market firms,

most of the firms have negative earnings.

In such cases, calculating the earnings variable might not make sense.

Do we account for this problem?

We have the second signal in this group.

It's G5.

In the signal, you use sales quote as opposed to earnings quote.

Sales quote variability is defined as

variance of a firm's quarterly growth of sales over the last 4 years.

Earned, this is your signal G5.

If the firm's sales growth variability

is less than the medium sales growth variability for all the low book-to-market

firms in the same industry then it is favorable to the firm.

We assign a value of one to G5.

Otherwise we assign a value of 0 to G5.

The interpretation of the signal is same as previous one.

If the sales growth variability is less,

it means the sales are more stable and this is favorable for us.

I am sure you'll be able to figure out the remaining intuition

behind this on your own.

We are done with the second group of signals also.

We now come to the third and the last group of signals.

As I have mentioned previously,

that last group of signals is different to take care of the firms

whose book value has been temporarily supressed due to accounting rules.

Let us see how the book value of a firm can get temporarily supressed.

Spending on research and development, advertising, and

capital expenditure will lead to increase of future sales and

thereby future growth and earnings and also future growth of the firm.

I'm not saying this.

Research has shown that future excess returns of the firm

are associated with spending on research and development and advertising expenses.

Isn't this great then?

Firms should spend more on this three activities.

But according to accounting rules, the amount spent on research and

development, advertising, and capital expenditure has to be expensed.

This is the conservatism in accounting rules that I spoke of previously.

Now, expensing these items will decrease the current earnings and

suppress the book value of the firm.

So because of these accounting rules, some firms which have laid the foundation for

growth in the current period by spending on research and development, advertising,

and capital expenditure, so that they may meet the market expectations in the next

period, are wrongly classified as low bottom market firms.

Such firms are to be separated from the true low bottom market firms.

Let me take an example.

R&D intensive firms such as pharmaceutical firms

spend huge sums on research and development.

In the process these firms create intangible assets.

The same thing goes for firms spending a lot on advertising.

By spending on advertising the firm is causing consumers

to buy more of its product.

But this takes time and may not be visible immediately.

So in this case, the form is again creating intangible assets.

But based on the principles of conservative accounting, research and

development costs, and

advertising costs appear as expenses in the income statement.

This decreases the current earnings and suppresses the but

because of new products in advertising the earnings will increase in the next period.

Hope this makes it clear.

So real spending on research and development, advertising, and

capital expenditure could define this terrible group of signals.

Depending on the size of the firm,

the spending on the three activities will differ, so we will standardize

the spending by scaling the spending with the assets at the beginning of the year.

Again, why are we using assets at the beginning of the year.

Think of it, you have this many assets at the beginning of the year.

And you are spending this much in the year.

Having this many assets, you are able to spend this much.

So we are using this asset at the beginning of the year

to scale this expenses.

I hope that intuition is clear.

Now let us define the signals G6.

Signal G6 is called R&D intensity.

It is defined as amount spent on R&D scaled by beginning of year assets.

We calculate the R&D intensity measure for the firm and

compare it with the median R&D intensity value for

all the low book-to-market firms in this same industry.

Again, let me remind you, same industry based on the SIC Core.

If the R&D density measure is greater than the industry median, it means the firm

is spending more on R&D compared with most of the other firms in the same industry.

This is a good sign.

It is a favorable sign.

R&D intensity assigns a G8 value of one.

No.

Had it not been favorable?

That is, had it not been below the industry median?

We would have given data value of 0.

G7, capital expenditure intensity.

It is defined as amount spend on capital expenditure

scaled by the beginning of year assets.

Here again the procedure is similar.

We calculated the capital expenditure and density measure for the firm and

compare it with the median capital expenditure and

density value for all of the global market firms in the same industry.

If the capital expenditure and density measure is greater than the industry

median then it means the firm is spending more on capital expenditure.

Compared to most of the other folks in the same industry.

This is a good sign, it is a favorable sign.

And via signal G7, a value of one.

No, if the capital expenditure intensity measure were less than the industry

medium, yes, you guessed it right.

We would have a assesed G7 a value of 0.

G8, the last segment.

Advertising expense intensity.

It is different as amount spent on advertising

scaled by the beginning of year assets.

Same really, we calculate the advertising expense intensity measure for the firm.

Compare it with the median advertising expense intensity value for

all the low book-to-market firms in the same industry.

If the advertising expense intensity measure is greater than the industry

median, it means the firm is spending more on advertising expense compared to

most of the other firms in the same industry.

This is a good sign.

It is a favorable sign.

And we assign the signal G8 a value of one.

Had it not been favorable, that is, had it been below the industry median,

we would have given it a value of zero.

Please note that the signals we have developed are called growth fundamentals

because they measure the fundamental strength of these firms in a way

which is appropriate for the growth firms.

In the next video we will see these steps in this strategy.

G Score - Economic Intuition

Advanced Trading Algorithms

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