In their March 2012 paper, “Analyzing Valuation Measures: A Performance Horse-Race over the past 40 Years,” Wes Gray and Jack Vogel asked whether the business cycle should affect our choice of price ratio:
For example, cash-focused measures, such as free-cash-flow, might perform better during economic downturns than accounting-focused measures like earnings. Or perhaps a more asset-based measure, like book value, will outperform when the economy is more manufacturing-based (‘70s and ‘80s), and struggle when the economy is more human capital and services oriented (therefore making asset-based measures less relevant).
Gray and Vogel analyze the returns of different price ratios over economic expansions and contractions defined by the National Bureau of Economic Research.
Economic Expansions and Contractions
(Click to enlarge)
The first panel presents the returns for different price ratios during economic expansions. Gray and Vogel observe:
B/M enjoys periods of relative out-performance in the early ‘70s, early ‘80s, and in late 2009. The B/M performance pattern lends weak evidence to the hypothesis that balance-sheet-based value measures perform better than income or cash-flow statement value metrics when the economy generates more returns from tangible assets (e.g., property, plant, and equipment) relative to intangible assets (e.g., human capital, R&D, and brand equity). Overall, there is no strong evidence that a particular valuation metrics systematically outperform all other metrics during expanding economic periods.
The second panel presents the returns for different price ratios during economic contractions. Gray and Vogel observe:
[The] results in Panel B suggest there is no clear evidence that a particular value strategy systematically outperforms all other strategies in contracting economic periods. For example, during the July 1981 to November 1982 and March 2001 to November 2001 contractions GP/TEV shows strong outperformance, but this same metric has the worst performance in the December 2007 to June 2009 recession.
Gray and Vogel conclude:
[There] is little evidence that a particular value strategy outperforms all other metrics during economic contractions and expansions. However, there is clear evidence that value strategies as a whole do outperform passive benchmarks in good times and in bad. The one exception to this rule is during the April 1975 to June 1981 business cycle, a time when a passive small-cap equity portfolio performed exceptionally well.