Peer Pressure

1. Introduction
§ Stock Valuation and portfolio construction → two core activities → active equity investment managers
§ Portfolio construction → studied from the point of view of:
i. efficient diversification of risk
ii. individual stock of return
iii. return standard deviations and return correlations
§ Portfolio construction → rank on Market Cap → as value, blended, or growth
§ Investment strategies → value stocks as opposed to Growth stocks
§ Academics used portfolio constructions concerns the universe of stocks considered
§ Testing for the effectiveness of contrarians portfolio strategies:
i. Academics sort over universe of all listed stocks → defined by market capitalization
ii. Practitioners generally focused on narrow group of firms drawn from the same industry
§ One level → test → peer group perspective actually improves upon assessments of relative values
i. Examine the usefulness of → book-to-market, cash flow-to-market, earnings-to-market ratios → explaining the cross-section of observed individual stock values
ii. Estimate how quickly individual firm value ratios correct themselves back toward the peer group median
iii. specifically highlight industry effects on portfolio design and returns to contrarians strategies

2. Literature Review
§ Lie & Lie
i. Apply the multiples-based firm valuation model in a peer group setting → determined by SIC groupings
ii. Examine the explanatory power of both assets-based multiples → in company valuations → enterprise value and equity value
§ Dremen and Lufkin
i. Analyze returns to contrarian strategies → using relative-value rankings and compare them to returns from corresponding rankings

3. Data and Peer Group Construction
§ Kim and Ritter → bankers use valuation via median peer group characteristic multiples → prospective IPO
§ Typical investment banker’s peer group definitions → useful multiple-based valuation analysis
§ Median multiple level → differ significantly across industry peer groups at any given time

4. Using Characteristic Multiples to Value Stocks
§ Lie and Lie (2002) → presuming → forming industry peer groups improves valuation precision
§ Industry-based median ration approach → significantly reduces stock pricing error ↔ aggregated single median ratio approach
§ Current median multiple for industry peer group → used as a forecast of the fair multiple → soon-to-be-listed firms
§ Relative stock valuations within a peer group appear sticky at the one-year horizon
i. Currently observed differences in individual firm book-to-market ratios appear → to reflect firm-specific factors → that tend to persist

5. Ranking Produce Excess Returns in Hedge Portfolios
§ Generic contrarians strategies → constructed based on relative value ranking across the full universe of firms
§ Create a second net return series → Rich stock return minus Cheap stock return
§ Net return series → return on quasi-arbitrage strategy → purchases the portfolio of the cheapest stocks & sell the richest stocks
§ Average return on the industry-neutral version → could be higher / lower → depend on:
i. valuation ratio used
ii. The particular forward period considered
§ Identification appropriate peer group → crucial first step in the company valuation process

6. Result from Deciles Portfolios
§ Our two key equal-weighted portfolios → created by drawing:
i. The cheapest stocks in each industry
ii. The richest stocks in each industry
§ This hedge portfolio has no net exposure to industry effects
§ Average net of return → between these richest and the cheapest portfolio equals zero

7. Conclusion
§ Peer pressure is a term describing the pressure exerted by a peer group in encouraging a person to change their attitude, behavior and/or morals, to conform to
§ Two types of peer pressure:
i. Positive peer pressure → tries to help a company change
ii. Negative peer pressure → tries change a company
§ Contrarian Strategy → approach based on the idea that the market will eventually rediscover out-of-favor stocks and bring the high-flyers back down
§ It looks for medium to large cap stocks with low price / earnings ratios and a potentially strong financial condition