The Investors Guide to

EVA and PRVit

Backtest Analysis

September 2004 by Bennett Stewart, Senior Partner Ling Yang, CFA, Vice President Monica Nica, Vice President

Contents
The Problem with Backtesting ................................................................................... 1
Models Fitted to Data.............................................................................................................1 Testing for Only Currently Listed Companies........................................................................1 The PRVit Backtesting Process.............................................................................................2

PRVit Backtesting Results.......................................................................................... 3

Overall Results.......................................................................................................................3 Results by Industry Sector.....................................................................................................4 Results by Company Size......................................................................................................5

Next Steps .................................................................................................................... 7

Complete Investors Guide

The complete Investors Guide to EVA and PRVit is available for download at www.sternstewart.com/prvit/investorsguide.

Notice
COPYRIGHT 2004 STERN STEWART & CO. NO PART MAY BE TRANSMITTED, QUOTED OR COPIED WITHOUT EXPRESS WRITTEN CONSENT OF STERN STEWART & CO. FOR INFORMATIONAL PURPOSES ONLY. ALL INVESTMENT COMMENTARY AND RATINGS CONTAINED HEREIN ARE FOR ILLUSTRATION ONLY AND ARE NOT INTENDED AS BUY/SELL RECOMMENDATIONS. INVESTMENT ADVICE POWERED BY PRVIT IS AVAILABLE FROM MATRIX INVESTMENT RESEARCH, LLC, THE EXCLUSIVE LICENSEE OF STERN STEWARTS PRVIT AND EVA METHODOLOGIES FOR INVESTMENT ANALYSIS. FOR MORE INFORMATION ON THE INVESTMENT APPLICATIONS OF PRVIT, CONSULT WWW.MATRIXUSALLC.COM, OR CONTACT MATRIX INVESTMENT RESEARCH AT 212-220-5147. FOR MORE INFORMATION ABOUT THE CORPORATE MANAGEMENT APPLICATIONS OF EVA AND PRVIT, CONSULT WWW.EVA.COM, OR CONTACT STERN STEWART AT 212-261-0600.
The Investors Guide to EVA and PRVit : Backtesting Analysis

Page i

The Problem with Backtesting

As PRVit is a new stock rating system, it has not yet raked up an actual money-management track record. The best indicator of its potential for adding to investment returns other than its impeccable logic and economic credentials is to test its predictions against historical data in what is known as a backtest. results. Recalling the old adage, there are lies, damn lies and statistics, two potential pitfalls should be kept in mind, however, when evaluating backtest

Models Fitted to Data

For one thing most back tests arent. Most quantitative models are fitted to historical data rather then being tested by it. The parameters of the model, and often the key variables, are determined by running statistical regressions that are designed to produce the tightest fit between the model and historical shareholder returns. This is like watching a basketball game on tape and making up the rules after the fact to ensure your team wins. It is not cricket, and it is certainly not the way to discover which team really is better and to predict which one will win under a fixed set of rules. The so-called backtests reported for models like those are not tests but just confirmations that the model has been well fitted to the historical data, because it was derived from it. The trouble is, future markets never resemble past ones, and models never produce the stellar returns going forward they seemed to earn in the past. PRVit does not fall into this trap because it was not fitted to or shaped by historical data. It

was shaped, rather, by the seminal work of two eminent financial economists, the Nobel Laureate Merton Miller and Franco Modigliani1. They were the first to set forth three entirely equivalent and wholly rational models of corporate valuation. They demonstrated, for instance, the complete equivalence between a model of projecting and discounting cash flow and one based on projecting and discounting excess earnings or residual income what we have chosen to call EVA. We developed PRVit to be consistent with M&Ms fundamental model of valuation, with a sense that a firm had a true intrinsic value, and a belief that share prices would gravitate toward that value over time. We also applied judgment shaped by our years of experience as consultants on questions of corporate value. Only after we had developed the model and set its parameters (such as placing a greater weight on growth for Gamble and Growth companies in the P score) did we test it against actual data.

Testing for Only Currently Listed Companies

A second ploy that some model builders use to inflate backtest returns is to test the model only for currently listed companies, leaving out firms that went belly-up or were acquired or de-listed for whatever reason over the historical test period. Thats like trying to find predictors of health by only examining people who are still alive today and ignoring all those died for some reason

Three papers form the backbone of the modern theory of intrinsic valuation: (1) "The Cost of Capital, Corporation Finance and the Theory of Investment," by Merton Miller and Franco Modigliani, American Economic Review, June 1958; (2) "The Cost of Capital and the Theory of Investment: A Reply," by Merton Miller, American Economic Review, September 1959; and (3) "Dividend Policy, Growth and the Valuation of Shares" by Merton Miller and Franco Modigliani, Journal of Business, October 1961. The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 1

or other along the way. The trouble is, at the time the historical data is available, it is not clear which people will live a long healthy life and which will not. We had first hand experience with this so-called survivor bias when we first ran our backtests. We had not yet received the delisted company data file from our source, Standard&Poors, but on a lark we decided to press ahead and undertake a preliminary run on the surviving firms. We found that companies with a higher set of risk factors earned higher shareholder returns, when our intuition (and economic theory) told us that investors should discount value for risk. When we included the defunct companies in the test and eliminated the survivor bias, the sign on the risk factor turned negative, just as our original PRVit model held it should be. The risk factor was capturing something significant about firms that never make it to the end of the game, but that wasnt noticeable without including those companies in the test.

The PRVit Backtesting Process

The backtests we undertook spanned the nine-year period from 1995 to 20032 and covered the Russell 3000, non-financials3, approximately 2,300 stocks. with several leading quantitative money management firms: Firms that did not have at least the 9 trailing quarters of financial data that are needed to compute the PRVit measures were excluded. Start-up Gambles were excluded (in this case, defined as firms with sales growth > 12% and EVA/sales < -1%, but also firms where future growth reliance, the percent of the firms value dependent on future growth in EVA, was > 90th percentile). Illiquid stocks that sold for under $5 a share were excluded. Outlier stocks with monthly returns > 100% were excluded. From that list each month we eliminated other stocks that did not meet certain criteria that were established in conversations

The qualifying stocks were divided each month into 20 sectors corresponding to the four-digit level GICS code4. Portfolios were formed by dividing the stocks in each sector into 5 quintile groups according to their PRVit scores, and then aggregating the quintiles across all the sectors. That way, each of the portfolios had the same exposure to all of the industry sectors, and their returns would be attributable solely to their PRVit scores and not to sectors shifting in and out of favor.

2 3 4

1995 data starts with February 1995 due to data constraint from the data source. st It is expected that PRVit will cover financial institutions as of no later than December 1 , 2004. The backtests were repeated using the 54 non-financial 6-digit GICS sectors and were found to be substantially the same.

The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 2

PRVit Backtesting Results

Overall Results
The cumulative returns for the five sector-neutral portfolios from 1995 through 2003 are presented in Exhibit 1.

Exhibit 1: Top-Rated, Sector-Neutral PRVit Portfolios Beat the Market

250%

Portfolio returns

200%

150%

T op quintile
100%

2nd quintile 3rd quintile 4th quintile Bottom quintile

50%

0%
Feb-97 Feb-99 Feb-01 Jun-98 Jun-00 Jun-96 Feb-03 Feb-95 Feb-00 Feb-02 Feb-96 Feb-98 Oct-95 Oct-97 Oct-99 Jun-03 Jun-95 Jun-97 Jun-99 Jun-01 Jun-02 Oct-96 Oct-98 Oct-00 Oct-01 Oct-02 Oct-03

-50%

The top rated PRVit portfolio produced a cumulative return of 193.4% versus only 37.8% for the lowest rated portfolio. Moreover, the portfolio returns were all in order of their PRVit scores. These results strongly suggest that PRVit has information content in distinguishing the relative value of stocks within industry sectors. PRVit also fared well on a yearly basis against its Russell benchmark, as shown in Exhibit 2. The top portfolio beat its Russell non-financial benchmark by a cumulative total of 70.7% over the nine year period, and fell short in only one calendar year out of nine, in 1999, by 15.9% versus 17.1%, a year when new economy buzz was putting low PRVit rated stocks out of alignment with their fundamental value.

The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 3

Exhibit 2: Annual Returns Are Attractive, Too

Annual Total Returns Top Portfolio 1995 1996 1997 1998 1999 2000 2001 2002 2003 Cumulative Total Returns Average 26.9% 24.5% 33.2% 15.3% 15.9% 14.5% 29.4% -10.5% 44.2% Russell Benchmark 24.1% 17.0% 23.9% 6.8% 17.1% 4.1% 12.1% -23.1% 40.6%
250.0%

Russell 3000 29.5% 19.0% 31.7% 23.9% 20.9% -7.5% -10.5% -22.8% 27.8%

S&P 500 24.0% 16.0% 24.8% 12.3% 10.6% 8.7% 0.1% -18.7% 34.2%
200.0% 193.4% 150.0% 122.7%

100.0%

112.1%

111.9%

50.0%

193.4% 21.5%

122.7% 13.6%

112.1% 12.5%

111.9% 12.4%

0.0% Top Portfolio Russell Benchmark Russell 3000 S&P 500

Not surprisingly, the results are even more dramatic when the returns are compounded, as opposed to just summed. The top rated portfolio produced a total compound return of 489.8% versus the Russell non-financial benchmark return of 188.2%.

Exhibit 3: Compound Returns are Even Better

Annual Total Returns Top Portfolio 1995 1996 1997 1998 1999 2000 2001 2002 2003 Cumulative Total Returns Average 30.1% 26.5% 37.3% 12.6% 15.8% 14.1% 30.2% -11.9% 52.9% Russell Benchmark 26.5% 17.5% 25.4% 3.7% 17.3% 2.7% 8.9% -22.8% 47.4% Russell 3000 33.7% 21.6% 31.6% 24.1% 20.9% -7.4% -11.4% -21.5% 30.9% S&P 500 26.5% 16.5% 26.7% 10.4% 10.2% 7.6% -1.9% -19.4% 38.7%
600.0% 500.0% 489.8% 400.0% 300.0% 200.0% 188.2% 100.0% 0.0% Top Portfolio Russell Benchmark Russell 3000 S&P 500 170.0% 168.3%

489.8% 21.8%

188.2% 12.5%

170.0% 11.7%

168.3% 11.6%

Results by Industry Sector

Superior PRVit performance extends to 19 out of 20 industry sectors. The one exception is Energy, where the top quintile PRVit portfolio under-performed the sector average return, but only just by a cumulative shortfall of 3% over the 9 year test period. PRVit performed best in Retailing, Household and Personal Products, Healthcare Equipment and Services, and Technology Hardware and Equipment. The top PRVit portfolios beat the average by more than 100%, cumulatively, in those sectors.

The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 4

Exhibit 4: Excess Return by Sector (TSR Top Rated TSR Sector Average)
Energy Utilities Food Beverage & Tobacco Food & Staples Retailing Automobiles & Components Materials Capital goods Media Hotels Restaurants & Leisure Pharmaceuticals & Biotechnology Softw are & Services Transportation Semiconductors & Semiconductor Equipment Telecommunication Services Consumer Durables & Apparel Commercial Services & Supplies Retailing Household & Personal Products Health Care Equipment & Services Technology Hardw are & Equipment -20% 0% 20% 40% 60% 80% 100% 120% -3% 9% 23% 25% 29% 36% 41% 52% 72% 73% 77% 78% 87% 90% 95% 100% 103% 108% 110% 132% 140%

Hypothetical cumulative returns that could have been achieved by buying the PRVit rated top 20 percentile companies in each sector versus the sector average return over 1995 2003, with portfolio rebalanced monthly

Results by Company Size

Unsurprisingly, PRVit works better for smaller cap stocks than larger ones. To study the effect of size, stocks in each sector were divided into three market capitalization groups designated large cap, medium cap, and small cap. The stocks in the three groups were divided into quintiles according to their PRVit scores, and the quintiles were aggregated across all the sectors. The central three columns in Exhibit 5 display the results for the top and bottom PRVit-rated quintile portfolios for each market cap category. It shows that the spread between the top and bottom rated portfolios grows wider as market cap grows smaller (the spread is 92.4% for the large caps, but 232.8% for the small caps!).

The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 5

Exhibit 5: PRVit Works Best for Small Cap Stock

Cumulative return (1995 to 2003) Top Portfolio Average return Top Median return - Top Maximum monthly return - Top Minimum monthly return - Top STD (M) - Top 1995 - Top 1996 - Top 1997 - Top 1998 - Top 1999 - Top 2000 - Top 2001 - Top 2002 - Top 2003 - Top Cumulative return (1995 to 2003) Bottom Portfolio Average return Bottom Median return - Bottom Maximum monthly return - Bottom Minimum monthly return - Bottom STD (M) - Bottom 1995 Bottom 1996 Bottom 1997 Bottom 1998 Bottom 1999 Bottom 2000 Bottom 2001 Bottom 2002 Bottom 2003 Bottom Equal $ Weighted 193.4% 1.8% 1.8% 12.1% -16.6% 5.2% 26.9% 24.5% 33.2% 15.3% 15.9% 14.5% 29.4% -10.5% 44.2% Large Cap 159.2% 1.5% 1.9% 10.5% -13.9% 4.7% 29.9% 21.1% 29.9% 18.5% 12.3% 11.7% 18.1% -17.7% 35.6% Mid Cap 186.2% 1.8% 1.9% 13.2% -19.6% 5.6% 21.3% 23.2% 32.4% 5.7% 13.9% 25.6% 24.2% -8.9% 48.7% Small Cap 226.2% 2.1% 1.9% 16.8% -16.8% 6.0% 21.2% 28.9% 36.9% 12.4% 17.8% 8.5% 54.6% -3.1% 49.1% Market Cap Weighted 164.8% 1.5% 2.0% 10.8% -12.1% 4.9% 39.2% 24.7% 33.0% 40.1% 25.4% 3.7% -1.5% -25.7% 25.9%

37.8% 0.4% 1.5% 12.1% -20.7% 6.6% 17.4% 8.9% 12.5% -1.8% 25.2% -19.0% -2.9% -42.2% 39.7%

67.7% 0.7% 1.6% 11.2% -16.9% 5.8% 22.6% 13.6% 15.4% 11.7% 26.6% -14.3% -14.6% -31.1% 37.7%

58.7% 0.6% 2.0% 14.0% -20.7% 6.6% 20.6% 8.5% 14.2% -6.3% 34.6% -13.4% -5.9% -39.4% 45.7%

-5.6% 0.0% 1.7% 17.3% -23.5% 7.6% 19.1% 8.0% 11.8% -9.0% 9.5% -32.2% 7.0% -52.9% 33.1%

61.2% 0.6% 1.9% 13.0% -17.5% 5.9% 21.5% 15.3% 23.3% 19.5% 23.3% -30.3% -23.2% -23.0% 34.7%

For comparison, the left column presents the results already examined, from investing in the top and bottom PRVit rated portfolios cutting across all the sectors, and investing the same amount in each company regardless of size. The right-most column shows the same results but where the investment amount is proportionate to each firms market capitalization. Observe that the long-short spread is lower for the market cap weighted returns than for equal dollar weighed returns because, once again, PRVit doesnt find as much mis-valuation in large caps as it does in small caps. To put that into perspective, note that the market cap weighted portfolio returns are still quite attractive, with a cumulative 9-year long-short spread of 101% (top rated 167.8% - bottom rated 66.8%). The top rated portfolio is also less risky, with a monthly return standard deviation of 4.9% versus 5.9% for the bottom rated portfolio. A market-weighted long-short strategy would also have made money in 69 out of the 110 months studied (an equal weighted
The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 6

long-short strategy would have done even better, of course, making money in 80 of 110 months, although with higher transactions costs). The bottom line is that PRVit appears to have significant information content, especially when used to rate stocks within a sector and to construct sector-neutral portfolios or pair trades.

Next Steps
The complete Investors Guide to EVA and PRVit is available for download at www.sternstewart.com/prvit/investorsguide. Arrange a trial PRVit subscription at www.matrixusa.com. Visit www.sternstewart.com for corporate applications of EVA.

The Investors Guide to EVA and PRVit : Backtesting Analysis

Page 7