Tom Max TMP, quantitative analyst, has developed a portfolio construction model about which he is excited. To create the model, TMP made a list of the stocks currently in the S&P 500 Stock Index and obtained annual operating cash flow, price, and total return data for each issue for the past five years. As of each year-end, this universe was divided into five equal-weighted portfolios of 100 issues each, with selection based solely on the price/cash flow rankings of the individual stocks. Each portfolio’s average annual return was then calculated. During this five-year period, the linked returns from the portfolios with the lowest price/cash flow ratio generated an annualized total return of 19.0 %, or 3.1 percentage points better than the 15.9 % return on the S&P 500 Stock Index. Max also noted that the lowest price-cash-flow portfolio had a below-market beta of 0.91 over this same time span.
a. Briefly comment on TMP use of the beta measure as an indicator of portfolio risk in light of recent academic tests of its explanatory power with respect to stock returns.
b. You are familiar with the literature on market anomalies and inefficiencies. Against this background, discuss TMP use of a single-factor model (price–cash flow) in his research