How a good valuation model can help you decide your asset allocation

A well-documented and practical quantitative valuation model can assess investment opportunities more objectively than relying solely on subjective judgments. These models can be beneficial when making investment decisions across multiple asset classes, such as Domestic Equities, Fixed Income, Gold, Foreign Equities, etc. Using a checklist while investing in the market can effectively reduce the impact of cognitive biases, ensure essential factors are not overlooked, promote consistency, and help stay disciplined.

There are several widely used valuation parameters such as the Price-to-earnings ratio (P/E ratio), Price-to-book ratio (P/B ratio), Bond Equity Earning Yield Ratio (BEER), Market Cap to GDP ratio, Gold to Dollar Ratio, Developed Market to Emerging Market Valuation Premium/Discount, etc.

A detailed primer of some of the essential prerequisites of a good quantitative valuation model is mentioned below:

Model Parameters should be Mean-reverting

In finance, mean-reversion refers to the idea that, over the long term, asset price ratios tend to move towards their long-term averages or means. Mean-reverting ratios can be helpful in asset allocation decisions because they can help identify potential under-valued asset classes.

For example, commonly used P/E Ratio, P/B Ratio, BEER, etc., are mean-reverting investing ratios. This means that if these ratios are above their historical average, they are more likely to decrease in the future and vice versa.

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Model Parameters should complement each other and provide a comprehensive picture

Each of the complementary parameters provides unique information about the attractiveness of the asset class, and by combining them, the model can provide a more accurate and complete picture of the asset class valuation.

For example, while accessing the over or under-valuation of an Equity Market (say via P/B Ratio), it is important to analyze Fixed Income Market valuation and, thus, relative attractiveness between these two asset classes (say via BEER ratio).

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Model should be reviewed periodically to incorporate only the “Structural Changes”

Structural change refers to a long-term shift in the underlying structure of an economy. For example, in 2019, the government reduced the corporate tax rates after many years, which eventually will improve the post-tax profitability of the companies (keeping all other things constant). Hence, it becomes important to review model parameters and rebalancing ranges used, to incorporate any new “Structural Changes” in it.

Should be adjusted for non-recurring or/and special events

These are typically one-time or infrequent occurrences that require adjustment. For example, Lockdown has adversely impacted many companies’ profitability for brief period. It thus becomes important to adjust for these non-recurring events while using financial ratios to give a more accurate picture.

Model results should be tested on non-sample (outside sample) data as well

Out-of-sample data refers to a set of data that is separate from the data that was used to develop a quantitative model. This data is typically used to test the accuracy and generalizability of the model.

In other words, out-of-sample data is a way to evaluate how well a model can predict outcomes on new, unseen data based on its performance on the back-tested data.

Should incorporate Regime Change

Regime change refers to a significant shift in the governing system, a new constitution, a new legal framework, or the political structure of a country. Working with raw data as input in a model that involves two completely different regimes (for example; pre and post-liberalisation period) can make the model results irrelevant or biased.

The overlay used should be logical besides helping in improving the results

An overlay factor is an additional variable or set of variables added to a model to improve its accuracy. None of the valuation tools is flawless, so checking one valuation against another is helpful. For example, it’s beneficial to consider P/B ratio evaluation with ROE (Return on Equity Ratio). A high P/B ratio with a low ROE usually indicates overvalued securities and vice versa.

Each Market Cycle can be different from the previous one

Not all market cycles are the same. Historical trends suggest that the market can remain Expensive or Cheap (over or under-valued) for a more extended period. Also, what is Expensive or Cheap today, can become even more Expensive or Cheaper tomorrow. One of the ways to deal with this issue is to reduce the speed of asset allocation during strong trending (upward/downward) market.

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Dynamic Asset Allocation should be gradual (and not abrupt)

Sudden and significant changes in a portfolio’s asset allocation (possible signs of overconfidence and human biases) can result in unintended consequences and may not achieve the desired results.

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To sum up

While selecting a DAAF/BAF or Multi-Asset Fund category scheme, which uses Quantitative Valuation Models to decide asset allocation within various asset classes, investors can study the process followed by the investment team and make a better-informed decision based on their long-term investing goals.

The author, Manuj Jain is Associate Director, Co-Head Product Strategy at WhiteOak Capital Management