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Relevance of Popular Financial Ratios (and Update to DUMAC) Quantitative Stock Selection Finance 491 Prof. Campbell Harvey. Eugen Nuri. Introduction. The purpose is to test whether the universal and indiscriminate us of several popular ratios to gauge firms’ future performance is warranted
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Relevance of Popular Financial Ratios (and Update to DUMAC)Quantitative Stock SelectionFinance 491Prof. Campbell Harvey Eugen Nuri
Introduction • The purpose is to test whether the universal and indiscriminate us of several popular ratios to gauge firms’ future performance is warranted • The introduction of significant restrictions in the universe of securities warrants a return to our previous analysis of the dual simple moving average crossover
Sample Industries • Non-energy Minerals • Manufacturing • Technology • Consumer Durables • Consumer Non-durables • Consumer Services • Finance
Sample Financial Ratios • Book to Price • Dividend Yield • Consumer Services
Findings on Ratios • Book to Price carries significant information, mainly in long positions, in almost all analyzed sectors with the exception of Consumer Services • Dividend Yield seems to carry information for most sectors, but ambiguous or opposite signals in some • Return on Equity is weak in most sectors with the exception of Technology
Findings on Industries • Non-Energy Minerals • Dividend yield is the more consistent factor, but generally all ratios are weak • Manufacturing • Book to Price is the most powerful factor by far, in both the long and short portfolios. • High D/Y ratio deciles tend to outperform lower deciles • ROE signal is weak
Findings on Industries • Technology • Book to Price and ROE are potentially good factors for both long and short portfolios • Dividend Yield seems irrelevant • Consumer Durables • Book to Price is the most powerful factor by far, in both the long and short portfolios. • Lower D/Y ratios seem to indicate better performance • ROE deciles would perform better if clustered
Findings on Industries • Consumer Non-Durables • All long deciles seem to outperform significantly, but lowest deciles have positive non-zero alphas as well • Consumer Services • None of the ratios are reliable predictors • Finance • Book to Price has highest long alphas and displays consistent diminishing returns • The other two ratios carry little information, except that lowest deciles seems to underperform, yet, positive alphas
Best Factor/Industry Combos • Book to price - Manufacturing
Best Factor/Industry Combos • Book to price - Technology
Best Factor/Industry Combos • Book to price – Consumer Durables
Best Factor/Industry Combos • Book to price - Finance
Best Factor/Industry Combos • Dividend Yield - Manufacturing
Best Factor/Industry Combos • Return on Equity - Technology
Back to DUMAC • Dual Simple Moving Average Crossover: • Designed to smooth out temporary fluctuations and reveal the true path of trends. • Best performance in broad, trending markets • Easy to use (simple math) For more details look at “The Dual Simple Moving Average Crossover” by Emerging Investors, 2005
Back to DUMAC • Used “ratio before crossover” method • Long positions only
Back to DUMAC • Result: 1990 – 2000 Period Note: Lower deciles are long positions.
Back to DUMAC • Result: 1990 – 2005 Period Note: Lower deciles are long positions.
Note on Restrictions • The model tests build in the restrictions introduced by Fuqua Investors Analytics with regard to minimum capitalizations and exclusion of specific securities • No limits on trading volumes
Next Steps • Refine sector definition or look at sub-sectors for local relevance • Expand the number of ratios analyzed • Test variations of the ratios or tweak to gouge optimal performance • Test whether moving average crossover concepts could be applied to ratios as well to eliminate securities in upper deciles but that display a lower ratio than their historical level, capturing trend information