Quantitative Value, + Web Site: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors

PART FOUR

The Secret to Finding Bargain Prices

In Part Four, we examine a variety of price ratios to determine which works the best. In Chapter 7, we use several statistical techniques to measure each metric's performance. First, we put the price ratios into a horse race, looking at raw, absolute compound growth over the full period. Next, we examine performance controlling for risk factors such as general market exposure. We also look at the risk profile of each price ratio, and its performance after adjusting for risk. Finally, we look at rolling performance statistics to ensure that the results are consistent over different subperiods of the sample time period. From these different analyses, we identify a winner.

Chapter 8 explores alternative and underresearched variations of price ratios. We examine longer-term price ratios. The price measures examined in Chapter 7 are all single-year metrics. There is some danger in using a single historical period of 12 months to calculate price. Such a thin slice of historical earnings data might cause our single-year price metrics to favor stocks that have had unusually good earnings in a 12-month period unrepresentative of the stock's typical earning power. Our price metrics might therefore select stocks at the peak of their business cycle, with the likelihood that earnings over subsequent periods revert down to at least their long-run average, and possibly lower.

We also research the use of composite price ratios. We investigate whether ...