I shall be discussing some practical investment strategies which an individual investor can use easily here.
Today we shall discuss this strategy: Combined price/earnings ratio and combined price/book value strategy. This is adapted from the paper- Returns to buying earnings and book value.
1. To carry out this strategy we have to use a broad market index, like S&P 500. I am presenting it in an Indian context. So we shall use the NSE 500.
2. I am going to include companies which have a positive P/E ratio and a positive P/B ratio. As of 19/12/2012, there were 447 companies with a positive P/E ratio and a positive P/B ratio in the NSE 500
3.The first sort is dividing the companies into five groups or quintiles based on the P/E ratio. So the first group will consist of 90 stocks which have the lowest P/E ratio, the second group will consist of 90 stocks which have the second lowest P/E ratio, and so on. So we will have four groups of 90 stocks each and one group of 87 stocks( since we have only 447 stocks and not 450 stocks)
4.The next sort is to take each of these four groups and divide them into five groups or quintiles based on P/B ratio. So we shall take the first group of 90 stocks with the lowest P/E ratio and divide them into 5 groups of 18 stocks each based on P/B ratio. The first group will consist of 18 stocks with the lowest P/B ratio, the second group will consist of 18 stocks with the second lowest P/B ratio and so on. So each of the groups containing 90 stocks is divided further into five groups( each containing 18 stocks). So totally we will have 25 groups.
5.Within each P/E group, we shall only select the stocks with the lowest P/B ratio in each group. So we shall select the 18 stocks with lowest P/B ratio in each group.
6. So we shall have 18 stocks from the first four groups and 17 stocks from the last group( because the last group has only 87 stocks).
7.We shall invest equal amounts of money in these stocks
8.We shall hold them for a year.
9.We shall repeat the process again after a year.
We shall repeat this process every year.
The whole process is explained in this spreadsheet.
The mean annual returns of buying the lowest P/B stocks in all the P/E groups was 23.86% per year.The mean annual return of buying the lowest P/B stocks in the lowest P/B group was 30% per year. These are good returns. The data is summarised in Table 4 in the article. However this data is based on including all stocks and not only 500 large stocks. The returns may be lower or it might not outperform at all.
But it makes sense from a value investing perspective.
So, we shall track the returns in real-time each year and see how it performs in the Indian context.