Utah State University

Thoughts from the Bullpen

Investment Performance and Price-Earning Ratios

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In “Investment Performance and Price-Earnings Ratios: Basu 1977 Revisited” I reexamined Basu’s 1977 work “Investment performance of common stocks in relation to their price-earnings ratios: a test of the efficient market hypothesis.” Basu examined data on common stock returns during the period September 1956 – August 1971, included an average of 500 assets for each of the 14 years, and found that the returns on common stocks were inversely, linearly, and statistically significantly related to their price-earnings (P/E) ratios. To put it another way, low P/E ratios predict future higher than normal returns; this suggests that an investor could follow Basu’s methodology to get high returns. To do so, the investor would need to group stocks into five portfolios based on the P/E ratios of those firms, then purchase the portfolio with the lowest P/E. By rebalancing this strategy at given intervals (monthly, quarterly, or annually as in Basu’s work) an investor could consistently out-perform the market average rate of return.

In my paper I used data on assets selected from the 2012 Russell 3000 list covering the period November 2002 – December 2012; the selection process, while introducing some degree of across-the-board upward bias on returns, ensured that assets included in the sample would appeal to a rational investor, and excluded those which would not. Ultimately, once firms which did not exist for the entire period, or failed to report financial data were removed, the assets of 1671 firms were included in the final dataset with data for every month in the dataset. While monthly returns in the dataset closely followed a normal distribution, typical in stock returns this dataset exhibited a slight degree of negative skewness (-0.3623) and some excess kurtosis (1.4496). These deviations from a standard normal distribution are assumed to be minor enough in degree to treat the data as normal, and therefore, standard errors are used throughout the study. Characteristics of the data also follow previous studies including Fama and French’s 1993 work, “Common risk factors in the returns on stocks and bonds.

I examined the data in a similar fashion to Basu, adhering as closely as possible to his methodology albeit with a more frequent (monthly) portfolio rebalance. This required ranking assets by P/E ratio and creating 5 portfolios, or quintiles, for each month of the sample. My work revealed a statistically significant non-linear relationship between P/E ratio portfolio and asset returns, with return generally increasing as P/E ratio increases. To put it another way, in the period 2002 – 2012, higher P/E ratios can be seen as predicting higher returns to a degree. The non-linearity of the relationship suggests that there is some optimal P/E ratio, and that to obtain the highest predicted return an investor should invest in the second highest P/E portfolio.

My work contradicted Basu, finding not only an essentially opposite relationship between price-earnings ratios and common stock returns, but a non-linear relationship as well. Assuming that the data from these two periods are not, in some way, vitally abnormal, the conclusions which can be reached from these results are:

1)     Stock returns during the period 2002-2012 can be predicted by price-earnings ratios

2)     In general, predicted stock returns are higher for higher price-earnings ratios, however, that relationship is non-linear in nature

3)     The highest asset returns are displayed in 2nd highest quintile (by P/E) ratio firms

In short, were an investor during the period of 2002-2012 to have followed the methodology outlined in this study, following Basu’s 1977 work, using price-earnings ratio quintiles to determine investments, that investor would have earned a monthly average of 0.505% (1.345% excess of risk-free rate) more than the market monthly excess rate of return (0.839% in excess of the risk-free rate).

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This represents the thoughts and assertions of the author.  It does not represent any position taken by Strata or it’s affiliates.


Investment Performance and Price-Earning Ratios

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Last summer I worked for a company named Agri-Concrete, owned by a man named John Ravsten.  John’s business is a small company specializing in building foundations, and retaining walls.  It was hard work, but I worked with great people and had experiences that I will be grateful for the rest of my life.  

John is currently trying to sell his business.  He can’t make money doing concrete anymore due to increasing cost.  John’s business was jokingly called ‘the unemployment office’ of the small town I lived in.  I know that bills were paid and families fed, that wouldn’t have been, because of Agri-Concrete.  On Labor Day I want to talk about why I think that Agri-Concrete is going out of business, and what affect it has on John Ravsten, a true laborer.

 There is a problem in America today.  Okay, there are many problems in America, but I want to discuss is cronyism.  Cronyism is defined as: the practice of favoring one’s close friends, especially in political appointments.  I defined it a bit wider: giving a group of people or businesses an artificial advantage.

Many people believe that our current economic system is one of capitalism and free markets.  This just isn’t true.  Capitalism benefits consumers, and will only help a business if that firm help consumers.  This is achieved when we have truly free markets that are without government intervention.  When government regulates and subsides business it changes the incentives and signaling that the free market provides, and creates protections for certain businesses.  This is crony capitalism. A LearnLiberty video featuring Dr. Jeff Miron of Harvard University, explains capitalism well and is worth the 3:28 it takes to watch it. (Link at the bottom)

Crony-capitalism arbitrarily increases costs for businesses, and small businesses can’t cover these costs.  Current business owners don’t want competition, and in order to discourage competitors they look to government to place barriers to entry. These barriers range from required business and professional licenses, to banning certain goods and requiring the use of others.  Another LearnLiberty video shows this well. (Link at the bottom)

John’s costs of doing business were made higher because of the government regulation and subsidies.  Every job that is poured is required to be inspected, to make sure it is up to building code.  An inspector from the governing agency would come to the job site and make sure that all the reinforcing bar (rebar- steel bar that strengthens concrete) was where it should be and tied right.  One of the last projects that I worked on was for a sewage pit at a pig farm. This pit used twice as much rebar as a home foundation of the same size.  Because it’s more important for pig excrement to be protected than human lives.

This increase in the raw materials used increased John’s costs. Add this to the other costs imposed by government (taxes, licensing, ect) and John can’t be competitive. I asked Daniel Ashcroft, the foreman of Agri-Concrete, how the other crews in the area were able to cut cost, and he said that some paid people under the table, and some had lower quality work.

I’m not trying to say that there aren’t other concerns that we need to take into consideration when looking at this case and others like it. What I am saying is that government intervention into the market does change things and has a real cost that affects real human lives. If we want to celebrate laborers and what they do for us, we need to talk about what these costs.





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The opinions expressed in this blog are solely the opinions of the writer and in no way represent those of Strata itself.


Investment Performance and Price-Earning Ratios

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In 2007, the eloquent Miss Teen South Carolina brought to our attention the tragedy that “some people out there in our nation don’t have maps.” Miss Caitlin Upton’s rambling mess of an answer, however, is less cause for concern than the question she was asked: “Recent polls have shown a fifth of Americans can’t locate the U.S. on a world map. Why do you think this is?” I’ll tell you why. It’s because we don’t care.

Technology journalist Clive Thompson tried to stress that we should care by saying, “it’s a civic virtue to be exposed to things that appear to be outside your interest.”  In other words, it’s important to society as a whole for every individual to see, read, and hear information and views that contradict or widen their own, so that maybe one day we’ll be able to locate the U.S.—and every other country in the world—on a map (when we have enough maps, that is). Not that maps aren’t a great resource but thankfully as technology has advanced, we can look to the “Internet” six years later. When the World Wide Web was just getting big, people thought one day every North American citizen would be discussing mind-blowing ideas with their peers in China, speeding up and widening the amount of information shared. In fact the opposite is sadly happening more often; as author Eli Pariser illustrates, “our virtual next-door neighbors look more and more like our real-world neighbors, and our real-world neighbors look more and more like us.” Rather than connecting the citizens of the world in a network of varying and competing ideas, the Internet has become a mirror of our personal interests and views. We’re steadily spiraling into a never-ending merry-me-go-round reflecting ourselves and Kimye. If being exposed to ideas outside our interests is a “civic virtue” as Thompson stated, then it can be said that Internet users have a civic duty to seek out those views and information that challenge their opinions. What do we care about virtue and duty these days? We can do what we like, when we like, and how we like. We can’t stop. Am I right, Miley? (ilysm, if you’re reading this, I don’t mean any of it.)

Here’s why we should care: being creatures of habit, we regularly frequent specific websites of preference. These habits can stunt our growth and learning process. Our Facebook news feed and Twitter feed get more hits than any other source of news, like the Washington Post, NPR, and the New York Times. Illustrating the danger of this fact, Facebook founder, Mark Zuckerberg frankly stated, “A squirrel dying in front of your house may be more relevant to your interests right now than people dying in Africa,” or, if I might add, people dying in Syria. While most would balk at the debasement of human life by such a statement, few could legitimately deny the truthfulness of Zuckerberg’s painfully blunt assessment of human nature. “Americans seem to know less and less about the world around them” and more and more about the “squirrel dying” in their front yard. The habitual nature of our Internet use becomes harmful when we realize how little we actually educate ourselves about what is going on in the world and how much we concern ourselves with what we like, what our friends like, and what our neighbors would like to tell their unborn daughters about Miley Cyrus (sorry, bb).

Not only are we biased and narrow minded in the news we seek out, but news sites that report information about the world around us (i.e. CNN and Fox News) are often also biased. To add to the slant of information we receive, these sites attempt to cater to users by offering a “personalized” version of the news, in which one is served an appealing array of news hand-selected by the viewer. We’re given the option of choosing which news will be sent to us via whichever social media outlet we prefer, thus, narrowing the outside news we might otherwise receive. Convenient, if one doesn’t care what team has the best chance of winning the NCAA Championship, but constricting in the availability of information and knowledge we might gain through exposure to all news rather than a slender selection. Web creator, Nicholas Negroponte predicted this very phenomenon in 1994, when he wrote, “Imagine a future, in which… a personalized summary [of news]… is printed in an edition of one… Call it the Daily Me.” A quick look at the top hits on social media reveals the US’s edition of the “Daily Me” is primarily concerned with cats, twerking, Project Runway, banning One Direction fans from Twitter, and football.

Avoiding being consumed by the riveting cat videos on Youtube is key to truly developing our opinions and choosing in which way to live our lives. Yochai Benkler stresses the importance of learning and reading about a variety of diverse beliefs and news in order to truly be free to “be the authors of our own life choices in some meaningful sense.” We owe it to ourselves and to the rest of humanity to educate ourselves about what’s going on in the world rather than living in our own house of mirrors, stuck in a perpetual reflection of trivialities, like social media, celebrity news, and sports. While Miss Upton was very sincere in her concern that we don’t have enough maps in the States, it really isn’t about the maps. It’s about caring enough to know what’s going on in the world and using the available knowledge and resources to make our lives meaningful.  Find something that you can’t get enough of, learn about it, and use that knowledge to better the world. Make your grandma proud.

Justine Larsen

Works Cited

  • Benkler, Yochai. The Wealth of Networks: How Social Production Transforms Markets and Freedom. New Haven and London: Yale University Press, 2006. Print.

  • Miller, Alisa. The news about the news. TED.com. TED Talks, 27 May 2009. Web. 9 Apr. 2013.

  • Pariser, Eli. The Filter Bubble: What the Internet is Hiding from You. New York: The Penguin Press, 2011. Print.

  • Huffington Post. Caitlin Upton, Miss Teen South Caroling, Learns Where Babies Come From. Retrieved from: http://www.huffingtonpost.com/2009/11/14/caitlin-upton-miss-teen-s_n_357843.html

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The opinions expressed in this blog are solely the opinions of the writer and in no way represent those of Strata itself.


Investment Performance and Price-Earning Ratios

In Caracas, Venezuela an abandoned skyscraper has become a prime example of the power of spontaneous order.


Intended as a temple of white-collar affluence (the roof has a helipad for executives), the Centro Financiero Confinanzas was abandoned in 1994 when the government took it over after a banking crisis. Several years later as Hugo Chavez increased the government’s control over the Venezuelan economy, Caracas experienced a worsening housing crisis. In 2007 the city’s poor took over the building. Now known as the Tower of David, the skyscraper houses over 700 families.

Not only are thousands of people making new homes for themselves, many are finding the demands of the market and responding accordingly. Shops dot the 28 inhabited stories, including a beauty salon, a dentist, and several grocery stores. My economist-in-training side sees a fascinating example of how market forces make can make a bad situation better. Those who live in this tower are certainly better off than they would be in the hillside slums, otherwise they wouldn’t have moved here.

Especially interesting are the interviews with some of the residents.  While many claim that the tower is a hotbed of drugs, gangs, and violence, the people moving here often have no other option except homelessness or even worse slums, and both options are more dangerous than the Tower. And the residents themselves tell a different story. As Daisy tells the documenters, “in reality, me, I’ve lived alone here and nothing has ever happened to me. Never ever.”

Another resident, Hipolito, has an apartment as nice as anything you’d find in the states. “I got here three years ago,” he says, “There was nothing but mountains of dirt. There were no walls like the ones you see now.”

Guillermo Barrios, a professor of architecture at the Central University of Venezuela has different vision for the Tower:

“The right path would be to relocate these families into adequate residences, adequately planned around a vision of habitat, of housing with integrated public services. And then return that tower to its original use. That is what is really needed.”

What Barrios fail to understand, is that the Tower is demonstration of both the failure of governments and the success of markets. Failure, because without the Venezuelan government acquiring private housing there wouldn’t be a housing crisis in the first place (if you know the government can take your new set of apartments you won’t even build them). And success, because this is exactly what the market is: individual people bettering themselves in the face of scarcity. As Hipolito tells us, “A lot of people from different slums come here. Not because of the government, but because that’s the nature of life.”

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