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 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