By |Published On: October 1st, 2013|Categories: Research Insights|

On the Performance of Cyclically Adjusted Valuation Measures

Abstract:

We confirm the effectiveness of using cyclically-adjusted valuation metrics to identify high performing stocks. The Shiller P/E, or cyclically-adjusted price-to-earnings (CAPE) ratio, is not the optimal way to implement a cyclically-adjusted value measure. At the margin, the cyclically-adjusted book-to-market (CA-BM) is a better measure to predict returns. We find that more frequent rebalancing and momentum can enhance strategies based on cyclically-adjusted valuation metrics.

Data Sources:

CRSP/COMPUSTAT.

Alpha Highlight:

Cyclically-adjusted valuation metrics, or measures that sort stocks on 10-year average real earnings (or Book, EBITDA, FCF, GP, etc.) divided by the current real price (or total enterprise value in some cases), can be used to identify cheap securities. Annually rebalanced portfolios that purchase the top 10% cheapest securties based on these long-term valuation measures have outperformed the S&P 500 and the equal-weight S&P 500 over time.

cape1


[Click to enlarge] The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

How does the Shiller P/E stack up against other cyclically-adjusted measures?

cape2


[Click to enlarge] The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

All measures show an ability to identify cheap stocks that beat common market benchmarks over the long-term. At the margin, the cyclically-adjusted book-to-market ratio works better than the Shiller P/E, or CAPE.

Strategy Summary:

  1. Sort all stocks on your favorite cyclically-adjusted measure.
  2. Buy the cheapest 10%, equal-weight.
  3. Rebalance annually.

Commentary:

  • Many market commentators and participants are infatuated with cyclically-adjusted valuation metrics. There is no evidence that we are familiar with to suggest that these metrics are any better at sorting stocks than simple trailing twelve month measures.
  • Adding momentum and more frequent rebalancing can enhance these ratio’s ability to identify winners and losers.

Time to dump CAPE and fire up CA-BM?

About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.