Industry group impact on stock valuation precision and contrarian strategy performance
o Introduction
§ Stock Valuation and portfolio construction are two core activities for active equity investment managers
§ Portfolio construction is studied from the point of view of efficient diversification of risk, individual stock of return, return standard deviations and return correlations
§ Stock valuation → analyzed in absolute terms → various multiple → company’s standing among comparable firms
§ Portfolio construction → rank on Market Cap. → Large, mid, small → as value, blended, or growth
§ Investment strategies that favor portfolio over-weighted in → value stocks as opposed to Growth stocks.
§ Practitioner used the ratio for individual company valuation
§ Academics used portfolio constructions concerns the universe of stocks considered
§ Testing for the effectiveness of contrarian portfolio strategies:
Þ Academics sort over universe of all listed stocks → defined by market capitalization
Þ Practitioners generally focused on narrow group of firms drawn from the same industry
§ On one level → test whether the peer group perspective actually improves upon assessments of relative values
§ First examine the usefulness of → book-to-market, cash flow-to-market, earnings-to-market ratios → in explaining the cross-section of observed individual stock values
§ Second, In particular → estimate how quickly individual firm value ratios correct themselves back toward the peer group median
§ Finally → specifically highlight industry effects on portfolio design and returns to contrarian strategies.
o Literature Review
§ Lie & Lie → apply the multiples-based firm valuation model in a peer group setting → determined by SIC groupings → examine the explanatory power of both assets-based multiples → in company valuations → enterprise value and equity value
§ Dremen and
o Data and Peer Group Construction
§ Kim and Ritter → bankers use valuation via median peer group characteristic multiples for prospective IPO
§ Typical investment banker’s peer group definitions for multiple-based valuation analysis seems quite useful
§ Median multiple level → differ significantly across industry peer groups at any given time
o Using Characteristic Multiples to Value Stocks
§ Lie and Lie (2002) → presuming → forming industry peer groups improves valuation precision
§ Industry-based median ration approach → significantly reduces stock pricing error → compared → aggregated single median ratio approach
§ Current median multiple for industry peer group → used as a forecast of the fair multiple → for soon-to-be-listed firms
§ Relative stock valuations within a peer group appear sticky at the one-year horizon → currently observed differences in individual firm book-to-market ratios appear → to reflect firm-specific factors → that tend to persist
§ Both equations tell a consistent story → current observed stock price cheapness or richness based on peer group ratio analysis tends to persist over a one-year horizon
o Ranking Produce Excess Returns in Hedge Portfolios
§ Test for the contribution of industry-based peer group valuation analysis in terms of the risk-adjusted returns to contrarian strategies
§ Generic contrarian strategies → constructed without regard to industry exposures based on relative value ranking across the full universe of firms
§ Create a second net return series → (Rich stock return – Cheap stock return)
§ This net return series → return on quasi-arbitrage strategy → purchases the portfolio of the cheapest stocks & sell the richest stocks
§ Excess returns to contrarian strategies persist
§ Estimates imply → annual returns to contrarian strategies are even higher in year 2 and 3
§ Average return on the industry-neutral version → could be higher / lower → depend on valuation ratio used and the particular forward period considered
§ Identification appropriate peer group → crucial first step in the company valuation process
o Result from Deciles Portfolios
§ Our two key equal-weighted portfolios have been created by drawing the cheapest and richest stocks in each industry
§ This hedge portfolio has no net exposure to industry effects
§ Average net of return between these richest and the cheapest portfolio equals zero
o Conclusion
§ Peer pressure is a term describing the pressure exerted by a peer group in encouraging a person to change their attitude, behavior and/or morals, to conform to
§ Company affected by peer pressure may → or may not want to → belong to these groups
§ They may also recognize dissocialize groups with which they would not wish to associate → thus they behave adversely concerning that group's behaviors
§ Two types of peer pressure → positive and negative.
§ Positive peer pressure → tries to help a company change → better
§ Negative peer pressure → tries change a company → worse
§ Contrarian Strategy → approach based on the idea that the market will eventually rediscover out-of-favor stocks and bring the high-flyers back down → it looks for medium to large cap stocks with low price / earnings ratios and a potentially strong financial condition
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