When ever you go about reading or researching companies at different websites, they always offer some sort ratio analysis. When a stock selling cheap relative to its book value, it seems like a good buy. Some screen for stocks based solely on them. But has the “intelligent” investor ever thought if they actually have sort of predictive power for future return?
In this post, I take the popular valuation ratios and see how they perform. My experiment will be simply screening and buying stocks that are in the top percentile. I believe that it is more robust to use percentiles than hard fixed thresholds as stocks in different industries have different threshold that characterize their value.
The ratios I will be testing are Price To Sales Ratio, Price to Earnings Ratio, Price to Book Value, and Price to Free Cash Flow. The backtest will start from 2001 and end in 2012 and positions are rebalanced quarterly. When I am referring to top 20th percentiles, I am referring to stocks that have the “lowest” ratios in their respective universe of stocks. My universe contains 3647 stocks that are liquid and have market capitalization of 50 million or more; no ADR are included. All data are adjusted for survivor-ship bias. Below are the equity curves.
From the above you can see that compared to buy and hold, if the investor were to buy stocks with lowest respective ratios, they would outperform the market in the last decade.
But looking at the raw numbers, the investor would’ve have to put up with much higher drawdowns. In the upcoming weeks, I will come back in the future with a rolling return graph to show the consistency of these ratios performance over time.