We did a recent internal simulation study on the performance of cheap and expensive stocks based on a variety of valuation metrics. We looked at all our favorites from our Journal of Portfolio Management paper, “Analyzing Valuation Measures: A Performance Horse Race over the Past 40 Years:”
- Gross Profits / TEV
- FCF / TEV
How Does Our Simulation Work?First, break stocks down into different valuation deciles from 1963 to 2013 based on EBIT/TEV (we only focus on US mid/large cap to avoid weird micro/small cap outlier effects).
- For example, if there are 1000 stocks, stocks 1-100 go in the first decile; stocks 101-200 go in the second decile, etc.
- For example, simulation #1 draws 30 random stocks each month from the top and bottom decile from 1963 to 2013. This is the rough equivalent of saying, “we are going to have a monkey throw 30 darts,” every month during the 50 year period, to establish in each month separate 30 stock portfolios. Once our monkey has thrown his 30 darts in each month, we will then have 600 separate monthly portfolios (12 months * 50 years) and will have made 18,000 (30 stocks * 600 months) individual stock picks. This represents one simulation. We do 1000 simulations for the top decile and 1000 simulations for the lowest decile.