Fundamental Fundamental Valuation: A Hunt for Abnormal Returns

Abstract: We set out to develop a valuation model and two trading strategies with the aim to generate abnormal returns. The data sample consists of the shares currently constituting the S&P100 over the time period 1988 to 2007. The model is specifically designed to avoid problems of endogeneity and circularity hitherto found in previous research. We take a new approach in identifying buy and sell candidates where we wish to find a better theoretically founded way of quantifying discrepancies between fundamental values as calculated from our model and the current share price. After controlling for survivorship and selection biases we find that we are able to generate significant abnormal returns with our trading strategies using both the CAPM (7.5% & 6.0%), the Three-Factor-Model (7.0% & 5.8%) and a 36-Month Market Adjusted Buy and Hold net zero hedge portfolio (26.3% & 40.3%). We find small or no similarities between our sell candidates and traditional “Value-Growth” characteristics while slightly larger for buy candidates. Contrary to previous research, our short portfolios are consistently generating strong returns to our hedge portfolios. Our results indicate that fundamental valuation has not been fundamental enough.