The benefits of adding a cost function to Tobin’s q as an investment style on the JSE

Abstract

Tobin’s q ratio employs a fundamental principle that enterprise values cannot deviate excessively from, namely the replacement value of the assets required to generate the future cashflow of the business. This ratio formed the cornerstone of this research that investigated whether an index based on the ratio would indicate time periods of market missed valuations; determined whether the q effect exists and the probability of its persistence over a 24 year period across different ranked quintile portfolios. Finally the research examined a new supply approach valuation technique that altered the q ratio, and could improve the spread in the q effect to improve investment yields. The Tobin’s q index was compiled using the most recent estimate and the index included the top 160 shares by market capitalisation, excluding the resources and financial sector for firms listed from 1990, to create a representative index for the Johannesburg Stock Exchange. Tobin’s q long term average was 1,83 at December 2013, indicating a consistent upward bias mainly due to share valuations. A time serious approach was followed to compare cumulative returns between different ranked quintile portfolios, ranked by Tobin’s q to analyse for style effects. Tobin’s q displayed style characteristics, although it was not as prominent as other value indicators. The adjustment from the supply approach could not improve investment yields.