Stock Selection Criterion - Stock Selection Effectiveness

Stock Selection Effectiveness

In A Random Walk Down Wall Street, Burton Malkiel (b. 1932), an economist from Princeton University, argues that asset prices typically exhibit signs of random walk and that one cannot consistently outperform market averages. Random walk is a theory about the movement of stock and commodity futures prices hypothesizing that past prices are of no use in forecasting future price movements. According to the theory, stock prices reflect reactions to information coming to the market in random fashion, so they are no more predictable than the walking pattern of a drunken person. This book is frequently cited by those in favor of the efficient-market hypothesis, a theory that market prices reflect the knowledge and expectations of all investors.

However, there have been numerous studies indicating that some investment strategies have outperformed the market for long periods of time. For example, in 1986, Roger Ibbotson, a finance professor at the Yale School of Management, studied the relationship between stock price as a percentage of book value and investment returns in Decile Portfolios of the New York Stock Exchange, 1967–1984. His study reveals that stocks with a low price to book value had significantly better investment returns over the 18-year period than stocks priced high as a percentage of book value. During that period, the compound annual return for the market capitalization weighted NYSE Composite Index was 8.6%.

In 1987, Werner F.M. DeBondt and Richard H. Thaler, Finance Professors at the University of Wisconsin–Madison and Cornell University, respectively, examined stock prices in relation to book value in "Further Evidence on Investor Overreaction and Stock Market Seasonality", The Journal of Finance, July 1987. All companies listed on the New York and American Stock Exchanges, except companies that were part of the S&P 40 Financial Index, were ranked according to stock price in relation to book value and sorted into quintiles, five groups of equal number on December 31 in each of 1969, 1971, 1973, 1975, 1977 and 1979. The total number of companies in the entire sample ranged between 1,015 and 1,339 on each of the six portfolio formation dates.

The investment return in excess of or (less than) the equal weighted NYSE Index was computed over the subsequent four years for all of the stocks in each selection period. The four-year returns in excess of or (less than) the market index were averaged. The compound annual return (investment return, discounted retroactively from a cumulative figure, at which money, compounded annually, would reach the cumulative total) in excess of the market index from the lowest 20% of the stocks, in terms of price/book value, was 8.91%. For each $1,000,000 invested, the low price/book value stocks returned $407,000 more on average than the market index in each four-year period.

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