It might seem obvious that having some perspective on the current relative value of a sector would potentially add value to your investment, but confirming this thesis actually proves to be rather difficult. According to a July 24th report from research firm Source, sector valuation ratios do add value when assessing potential investments, but only under specific circumstances. In other words, having knowledge about the current value of a sector you are considering investing in relative to historical values (“starting point value”) actually only leads to greater returns in some cases.

Sector Valuation Ratios

Report authors Paul Jackson (Source Head of Research) and András Vig (research associate) explain their findings: “Our investigation into the predictive power of sector valuation ratios in the US and Europe suggests some ability to add value. However, the best results accrue over multi-year investment horizons and valuations alone cannot suffice.”

More on sector valuation ratios

Sector Valuation Ratios

The Source study determined that “valuations can help but not as much as we had expected and that what works in the US does not necessarily work in Europe.” Of note, modeling using a process of cyclical adjustment does improve the results in most cases. However, quite surprisingly, reference to historical norms actually worsens investment outcomes. By the same token, reference to market norms also does not boost returns.

However, one trend was clear —  the greater the investment horizon, the better the results (ie, the value added is greater over five years than over one year).

Jackson and Vig say if they ” had to pick a single indicator to allocate across sectors in each region it would be the cyclically adjusted dividend yield in Europe and the cyclically adjusted price/cash-flow in the US.” That said, there is no single indicator that works best for all sectors in predicting the future returns of any given sector.

Sector Valuation Ratios

Some key conclusions from the research include:

  • Patience is a virtue in sector investment like elsewhere – and the predictive power is notably stronger over 5 years than over 1 year
  • Safety is the primary concern – sector valuation ratios help more in avoiding losses than producing high returns
  • Cyclical adjustment does improve results in most cases
  • Comparisons to market averages do not add value in most cases
  • Comparisons to historical norms worsen results in most cases
  • The best indicator for Europe is cyclically-adjusted dividend yield
  • The best indicator for the U.S. is cyclically-adjusted price/cash-flow.

Sector valuation ratios do have predictive power

Sector Valuation Ratios

The correlations in Figure 4 make a strong case that that sector valuation ratios do offer some predictive power, although the predictive power is clearly stronger for some sectors than for others. Of interest, the sectors for valuation ratios appear to work best in both the US and Europe are healthcare, food & beverage, personal & household goods and travel & leisure. Technology, on the other hand, is the sector where valuation ratios have historically had the weakest predictive power. Other sectors with minimal correlations and relatively weak predictive power include the insurance, telcos and basic resources sectors.