Peer Pressure: Industry Group Impacts on Stock Valuation Precision and Contrarian Strategy Performance

Abstract

Investment bankers focus on narrow, industry-based peer groups for individual stock valuation. And some market-neutral equity hedge fund managers restrict their portfolios to be sector-neutral as well. Yet, academic research into contrarian strategy investment performance has typically invoked full universe valuation and ignored industry effects. Here, we find in favor of the bankers’ and hedge fund managers’ approach. Industry effects matter. Narrow industry-based peer groups improve stock valuation precision for three key valuation ratios. While our analysis of the dynamics of these ratios indicates substantial inertia in relative value rankings, we find that average returns to industry-based contrarian portfolio strategies are positive, statistically significant, and persistent. And over a sample that extends through the “new economy/old economy” and boom/bust period of the late 1990s, contrarian strategies were particularly profitable for NASDAQ-listed stocks. Most importantly, using our full sample of stocks, we show that an industry-neutral strategy is far superior to an industry-exposed, full universe strategy in Sharpe ratio terms over every horizon for each valuation ratio. Thus, contrarian strategy portfolio performance is significantly improved in risk-adjusted terms when implemented in its industry-neutral hedging form.