The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (Sept. 3, 1997) -- Many readers ask about the Sharpe ratio, what it is and whether it's useful as a predictor of future high returns. I'm the first to admit I'm no expert in Modern Portfolio Theory or its many components, but basically, the Sharpe ratio is a mathematical measure of return and risk.

Specifically, it measures the amount of return per unit of risk. To calculate the ratio, divide the total return for a period by the standard deviation over the same period. I haven't spent much time playing with this ratio, but in my experiments with Value Line's screening software, I have looked at it briefly. Value Line calculates the Sharpe ratio for any particular stock by using the annualized rate of return divided by the annualized monthly standard deviation. Value Line doesn't make an adjustment for the risk-free return one could achieve in something like Treasury bills.

Whether the Sharpe ratio on individual stocks is useful as a forward-looking screen, I have no idea. I only have a single year's worth of data to examine, but in response to a recent question I received, I looked at the three-year Sharpe ratios for the field of large-capitalization stocks in the Value Line universe one year ago (some 330 stocks) and selected the top 15.

Over the twelve months, buying equal-dollar amounts of these 15 stocks would have generated a return of 89.8%. Obviously, a huge chunk of that is attributable to DELL COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>, but even without Dell, the other 14 stocks gained an average of 59.4%. Over the same period, the S&P 500 gained 40.1% (from the end of August 1996 through August 27, 1997).

Here are the 15 stocks with the highest 3-year Sharpe Ratios at the end of August 1996 and their 12-month returns since then:

38.89% 3Com (COMS)
100.42% Tellabs (TLAB)
516.22% Dell Computer (DELL)
41.64% McDonnell-Douglas (MD)
22.54% Nike (NKE)
48.79% Safeway (SWY)
53.74% Cisco Systems (CSCO)
56.76% Gillette (G)
139.87% Microsoft (MSFT)
85.22% Medtronic (MDT)
48.83% Coca-Cola (KO)
64.83% Monsanto (MTC)
24.40% Service Corp (SRV)
73.66% HealthSouth (HRC)
31.48% Johnson & Johnson (JNJ)

Now whether or not this terrific performance is a complete fluke is impossible to tell. I don't have the data needed to test this over many years, so any long-term conclusion is total speculation, an area I don't like to wander into too far. Nevertheless, I'm always interested in watching anything that seems effective.

If you're interested in following along, here's a list of large-cap stocks (over $5 billion market cap) with the highest 3-year Sharpe ratios now:

Dell Computer (DELL)
United Technologies (UTX)
Pfizer (PFE)
PeopleSoft (PSFT)
Coca-Cola (KO)
Tyco Int'l (TYC)
Eli Lilly (LLY)
Exxon (XON)
Merck (MRK)
Procter & Gamble (PG)
Monsanto (MTC)
Cisco Systems (CSCO)
Sun Microsystems (SUNW)
Coca-Cola Enterprises (CCE)
Ascend Communications (ASND)
Safeway (SWY)
Bristol-Myers Squibb (BMY)
Microsoft (MSFT)
General Electric (GE)
Warner-Lambert (WLA)

Fool on!

Monthly Growth Screens
(Jan. 3 to present)
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33.50% Investing for Growth 
24.05% S&P 500 Index 
22.73% Low Price/Sales 
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11.32% Formula 90 

Annual Value Screens
(Jan. 1 to present)
24.26% Dogs of the Dow 
22.43% Dow Jones Ind Avg 
19.57% Beating the S&P 
18.68% Dow Combo 
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17.94% Beating the Dow 
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