In market crashes (such as the one we are currently in), the Price:Book ratio becomes even more important a selector. This is because markets tend to over-react (both on the up and on the down) and when panic ensues, prices have the tendency to go way below fair value.

Benjamin Graham said that stocks selected with low Price:Book ratios in a crash can form very defensive stocks, since the underlying value of the stock is normally far higher than what you paid for it. Over time, after one or two interims or finals, after the market has picked up, everyone will quickly realise this and the stock will rise accordingly.

Just about every value investment book mentions this, but nobody has ever tested this theory on the JSE. We set out to do just that and at the very bottom of the last JSE crash we ranked the JSE by Price/Book ratios and calculated their subsequent 5 year growth to the peak of the last bull market in May 2008. We compared this growth to the ALSI (a market cap weighted index) and also an equal weighted index of the JSE called GROUP.

Sure enough, we are presented with an astounding vilification on the JSE of Graham's sage advice. There is a remarkably clear and distinct correlation between low Price:Book ratios at the trough of a bear market, and their ability to outperform the rest of the market in the ensuing 5 years. We can look at the above graph and state that historically, Price:book ratios of less than 1 will significantly outperform those with a value greater than 1, with spectacular out performance demonstrated by issues worth less than 50% of net asset value.

The above backtest is to demonstrate the use of Price/Book in an extreme market condition such as a crash. If you would like to see more comprehensive tests of the Price/Book ratio, over 8 years spanning a variety of market conditions (booms and busts) then go to our research page and GO BACKTESTS.

Make a Free Website with Yola.