Portfolio Allocations Using Fundamental Ratios: Are Profitability Measures More Effective in Selecting Firms and Sectors?

Abstract

Our study assesses the performance of portfolios formed using out-of-sample sector forecasts and past firm fundamental ratios. Portfolio allocations based on profitability measures—gross profit, operating profit, and earnings before interest, taxes, depreciation, and amortization (EBITDA)—generate substantially better performance than the benchmark. Long/short portfolio allocations using these fundamentals possess alphas over 14% and increase Sharpe ratios by over 60%. A composite variable provides the highest payoff for firm allocations, whereas EBITDA produces the most profitable out-of-sample sector allocations. Profitability metrics are superior indicators of sustainable economic performance because these ratios are more strongly linked to future returns and cash flows than net income.

TOPICS: Accounting and ratio analysis, portfolio construction, performance measurement