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The relevancy of 6 valuation ratios is evaluated in the S&P 500 universe on a 17-year period. The idea is to measure the performance of the 20% of stocks with the lowest price-to-something. Such filters may improve the total return, but sometimes degrade the risk-adjusted performance. Many seasoned investors use valuation fundamental factors as filters before going further in stock analysis. The most popular factor is certainly the Price/Earnings ratio. This article evaluates the relevancy of 6 valuation ratios available in most financial websites and in good stock screeners. The methodology is to compare the historical performance of the 20% stocks in the S&P 500 universe with the lowest valuation ratios. In every case, it is a set of 100 stocks, updated and rebalanced in equal weight every week to take into account the latest earnings reports, companies entering and exiting the index, M/A and liquidations. The period of comparison covers 2 market cycles: 1/2/1999 to 9/2/2015. SPY is usually taken as a benchmark for the S&P 500 universe, but for this study it is more accurate to take all S&P 500 companies in equal weight and rebalanced weekly, as for the 20% sets. For all the following simulations, dividends are accounted and reinvested. All S&P 500 stocks, equal-weighted rebalanced on weekly opening: (click to enlarge) This index returned 325% on the period, almost tripling SPY’s total return and doubling its annualized return. The excess return of our benchmark over capital-weighted SPY has two reasons: Size effect: lower-range large caps usually perform better than mega-caps. Weekly rebalancing: rebalancing frequently a big set of stocks is a kind of simplistic “buy-low-sell-high” strategy. Simplistic, but not stupid. This benchmark index is impossible to implement as a strategy for an individual investor because of the capital needed to absorb transaction costs. Moreover, there is an ETF for that: the Guggenheim S&P 500 Equal Weight ETF (NYSEARCA: RSP ). Since inception on 4/24/2003, it has an annualized excess return of 2.1% over SPY, making it a better instrument of passive index investing. On the same period, the annualized excess return of my benchmark index is 3.5%. The difference can be explained by trading costs, management fees, rebalancing frequencies. Now that the benchmark is defined, it’s time to examine the “best 20%” sets, ratio by ratio. 20% S&P 500 companies with the lowest P/E: (click to enlarge) 20% S&P 500 companies with the lowest Forward P/E: (click to enlarge) 20% S&P 500 companies with the lowest PEG: (click to enlarge) 20% S&P 500 companies with the lowest Price to Sales: (click to enlarge) 20% S&P 500 companies with the lowest Price to Book: (click to enlarge) 20% S&P 500 companies with the lowest Price to Free Cash Flow: (click to enlarge) Summary: Annualized Return % Max Drawdown % Benchmark 9.08 -59.29 20% lowest P/E 11.77 -64.14 20% lowest forward P/E 12.82 -69.43 20% lowest PEG 9.90 -63.63 20% lowest Price to Sales 11.94 -68.43 20% lowest Price to Book 9.12 -76.98 20% lowest Price to FCF 14.03 -67.65 Interpretation : Filtering the 20% lowest valuations using any ratio increases the return, but also the downward risk. The Price to Free Cash Flow gives the highest excess return and risk-adjusted performance (Sharpe and Sortino ratios). P/E, Forward P/E and Price to Sales also increase significantly the return and risk-adjusted performance. The Price to Book, used by a lot of investors to limit the downward risk, unexpectedly gives the highest downward risk when used alone. The excess return given by the Price-to-Book and PEG ratios, used alone, is very weak. For both of them, the Sharpe ratio is inferior to the benchmark. It doesn’t mean that PEG and Price to Book are bad ratios, just that they don’t work very well alone on the broad market. They may be more useful in combination with other factors, and they are more relevant in specific sectors like energy (this assumption is not justified here, maybe in a future article – some statistical evidence is in my book “The Lazy Fundamental Analyst”). The purpose of this article is not only to show the most useful valuation factors, but also to justify my choice of using the best 4 in my next series of articles. In this series I plan to give a valuation score of every sector in the GICS classification relative to its historical averages, and update it every month. I may also go deeper at the industry level in some cases. This series aims at improving the dashboard of investors who want a top-down vision of the S&P 500 universe and the stock market in general. If you are interested in the idea, you can click on the “follow” link at the top of the article, then tell me in a comment what you think and which other information specific to every sector’s fundamental status you would like to read in this series. Data and charts: portfolio123 Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I short the S&P 500 index for hedging purposes Scalper1 News
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