Premium Payback Period Model and its Application in Stock Investment

Abstract

A simple and effective investment strategy has always been the pursuit of both academicians and practitioners. This thesis introduces for the first time the concept of Premium Payback Period (PPP), the time required to earn back the premium paid for an asset. PPP is a powerful stock valuation model, which takes into account the company’s current accounting information and future earning ability. In the stock market, a stock’s PPP can be computed from its PB and ROE. In the real economy, a company’s PPP can be observed from the date of establishment to IPO. As a rule of thumb, stocks with PPP < 5 years are undervalued and stocks with PPP > 9.5 years are overvalued, where the threshold PPP is obtained from observation in real economy.
PPP is proved to be an effective investment strategy in terms of stock selection as well as market timing. A pilot empirical study in Chapter 2 shows that a portfolio of stocks with PPP lower than 5 years can achieve excess return. In Chapter 3, I attempt to demonstrate the power of PPP model in selecting undervalued stocks. The size effect and PPP effect are incorporated in one framework and investigates both bull and bear market conditions. Investment recommendation is to invest in firms with small size and low PPP. When the indicators conflict, PPP criterion is the priority in the bear market and size criterion is the priority in the bull market. In Chapter 4, I endeavor to extend the application of PPP model to market timing. Both Treynor and Mazuy Model and Henriksson and Merton Model confirm the poor market timing performance of 10 Chinese equity-type funds. PPP model can help improve market timing significantly by adjusting position in stock market in line with PPP value of stock index. This research thus provides strong evidence that the PPP model performs as an effective investment strategy by selecting undervalued stocks and entering or exiting the stock market at appropriate timing.