In a previous post, we highlighted an article that showed how useful accounting numbers are. In this post, we will present a concrete example of an application of accounting numbers in portfolio management.
Reference [1] showed that the Price-to-Earnings ratio is a mean-reverting process, and it can be accurately estimated by AR(1), an econometric model. Earnings, on the other hand, follow a trend process and can be modeled by a first-order integrated process with a constant factor that captures relative earnings growth.
I propose a model of expected returns by decomposing stock price into two constituents: earnings and price-to-earnings (PE) ratio. The PE ratio is a mean-reverting process that can be forecasted for short to medium horizons. On the other hand, earnings follow a trend process and can be characterized by a first-order integrated process. Growth in earnings is responsible for the growth of stock prices, but the cyclical nature of the PE process imparts time-series predictability to prices.
After calibrating the models, the author constructed a long-only investment strategy that switches between stocks and bonds.
Using the expected return model, I propose a portfolio switching strategy where investor switches between stocks and bonds based on current expected returns on market-wide stock index and risk-free government bond yields. My strategy provides better risk-adjusted returns by avoiding equity investments in periods of low expected returns. The strategy is suitable for retail investors because it only involves market-wide stock index and bond yield. Moreover, my strategy does not require short-selling of stocks which can be difficult for retail investors.
In short, accounting numbers can be used in econometric models in order to develop an asset allocation strategy that offers better risk-adjusted returns.
The article showed that Earnings and Price-to-Earnings ratio have practical and useful applications. In our opinion, revenue and revenue growth are also important accounting numbers that can be used effectively in portfolio management.
References
[1] N. Vidhani, Return Predictability using Price-to-Earnings Ratio, 2021, https://ssrn.com/abstract=3910641
Further questions
What's your question? Ask it in the discussion forum
Have an answer to the questions below? Post it here or in the forum
SoftBank is close to a deal to sell the U.S. investment manager to Mubadala Investment for more than $2 billion.
LONDON — Stocks edged up, oil prices recovered and bond yields fell on Wednesday after data showed U.S. consumer prices rose at a slightly slower-than-expected pace last month, evidence that the Federal Reserve was succeeding in its fight against inflation. MSCI’s gauge of global equity…
Ukraine said troops pushed back Russian forces near Bakhmut in the eastern Donetsk region, though the Russian Defense Ministry said its units were advancing in the west and northwest of the devastated town.
Wall Street’s main indexes were set to open higher on Wednesday as U.S. consumer prices rose at a slightly slower-than-expected pace last month in a sign that the Federal Reserve’s rapid interest rate hikes were yielding result. The Labor Department’s Consumer Price Index (CPI) rose…
