Using fundamentals to identify value opportunities - earnings amp; cash flow-based investing

In the previous article in this series, I described how an analysis of the assets on the balance sheet may reveal a company that is trading for less than its worth. However, there are a few issues with relying on assets alone for investing decisions. Firstly, the asset values may be overstated or the liabilities understated. Secondly, the strategy involves harnessing the power of capitalism to make unproductive assets productive again, and not every asset can be made so, nor is every management team committed to doing so. Finally, in investing, it is not enough simply to generate a positive return. To make it worthwhile to pursue an active strategy, an investor should generate a market-beating return. There is strong evidence that buying the set of lowest price-to-book stocks indeed beats the market. However, the outperformance seems to have weakened over time, and it is not the best performing of the purely quantitive strategies a value investor could pursue.

The question of which was the best-performing value strategy was a question that started to be addressed by the early quant investing practitioners in the 1970s amp; 80s. Perhaps the best-known of these are David Dremen and James O'Shaughnessy. In 1980,...