Evaluating an annual valuation rank rotation

A signed residual as the membership rule

ABR was defined as the gap between a stock's earnings-yield and a required-return. Earnings-yield was the inverse of the price-to-earnings ratio, taken from a consensus earnings-per-share estimate in the illustrated case. Required-return was the sum of a 10-year government bond yield and an equity risk-premium estimate.

A positive ABR was treated as an undervaluation signal relative to that required-return hurdle. The signed gap was then used to rank names into positive and non-positive portfolios.

An annual sort across three market states

The same ABR sort was applied every February to 19 large names from the Nasdaq OMX Helsinki list over 2011-2013. The universe was split by the sign of ABR, and each bucket's subsequent annual total return was recorded.

Comparison series reported with those ABR buckets were a portfolio of all 19 names and the Nasdaq OMX Helsinki index. The window was chosen because it included a bear market, a turnaround year, and a bull market.

The 19-name set was described as challenging because the stocks tended to fall with the market and then lag during the later turnaround and bull phases. ABR was used to identify which names to keep out of the long book.

Entry, exit, and abstention in one rotation

Each February, names were resorted by ABR and held for the following year's total-return window.

A long-short variant that owned positive-ABR names and shorted non-positive-ABR names was tabulated beside the long-only buckets and the index. Abstention meant leaving non-positive ABR names out of the long book, or using them only on the short side, as part of the same rotation rule. Entry, exit, and abstention therefore sat inside one annual rotation.