Value investing is probably the most publicized anomaly and is frequently touted as the best strategy for investing. There is a large body of evidence documenting the fact that historically, investors mistakenly overestimate the prospects of growth companies and underestimate value companies. Professors Josef Lakonishok, Robert W. Vishny, and Andrei Shleifer concluded that "value strategies yield higher returns because these strategies exploit the mistakes of the typical investor and not because these strategies are fundamentally riskier." ¹

There are many criteria that fall within the value classification. A common technique is to divide an index into high price to book value (growth) stocks and low price to book value (value) stocks. In fact, many refer to these sub-indexes of the S&P 500 as the benchmarks for value and growth portfolios. Here is indexes information from BARRA.

Some proponents of growth stock investing take issue with how growth/value classifications are determined and how indexes choose to drop and add securities. In addition, there is some evidence that growth fund managers have been more successful at beating their benchmarks than value managers and in many cases have outperformed their value peers.

The following are anomalies based on fundamentals and value that have been documented to outperform the market in long-term studies. The effects are related to varying degrees and investors using the different techniques will commonly select many of the same stocks.

Low Price to Book

A classic study on the performance of low price to book value stocks was by Eugene Fama and Kenneth R. French ². It covered the period from 1963-1990 and included nearly all the stocks on the NYSE, AMEX and NASDAQ. The stocks were divided the into ten groups by book/market and were re-ranked annually. The lowest book/market stocks outperformed the highest book/market stocks 21.4% to 8% with each decile performing worse than the previous. Fama and French also ranked the deciles by beta and found that the value stocks had lower risk and the growth stocks had the highest risk. The study had a profound impact in the academic community and made headlines in part because Fama was a long-time champion of the Capital Asset Pricing Model. Some researchers now believe that "value" represents a risk factor that investors are compensated for (just as investors expect higher returns from stocks as opposed to bonds). The argument here is that value stocks are risky because they are down-and-out and in danger of getting worse, therefore investors need to be compensated with higher returns in exchange for accepting the risk of investing in value stocks. Others argue against the notion that value is a risk factor. In a forthcoming Journal of Finance article, James L. Davis, Fama, and French document the performance of low price to book value stocks in the out of sample period from 1929 to 1963. Characteristics, Covariances, and Average Returns: 1929 to 1997 also discusses the explanations for the value premium.

In his Forbes 5/6/96 column titled "Ben Graham was right--again," David Dreman discussed his study of the largest 1500 stocks on Compustat for the 25 years ended 1994. He found that the 20% lowest P/B stocks (quarterly adjustments) significantly outperformed the market which outperformed the 20% highest P/B.

Low Price to Sales (P/S)

A number of studies have concluded that stocks with low price to sales ratios outperform the market and stocks with high price to sales ratios. In What Works on Wall Street James P. O'Shaughnessy argues that Price/Sales is the strongest single determinant of excessive returns.

Low Price to Earnings (P/E)

Numerous studies have shown that low P/E stocks tend to outperform the market and high P/E stocks. In What Works on Wall Street, O'Shaughnessy found that the P/E ratio is particularly relevant with large stocks. However, he argued that Price/Sales is an even better indicator of excessive returns. (See also Interrelationships.)

High Dividend Yield

Numerous studies have concluded that high yielding stocks tend to outperform. The Dow Dividend Strategy, which has received a great deal of attention recently, consists of buying the ten highest yielding Dow stocks. See Dow Dogs & the Foolish Four.

Neglected Stocks

Neglected stocks commonly are selected by those that follow a contrarian strategy of buying stocks that are out of favor. Werner F.M. DeBondt and Richard Thaler ³ conducted a study of the 35 best and worst performing stocks on the New York Stock Exchange (NYSE) from 1932 through 1977. They studied the best and worst performers over the preceding five and three year periods. They found that the best performers over the previous period subsequently underperformed, while the poor performers from the prior period produced significantly greater returns than the NYSE index.

An interesting debate regarding value investing evolved from T. J. Peters and R.H. Waterman's "In Search Of Excellence: Lessons from America's Best-Run Corporations" (1982). They formed a list of "Excellent" companies based on a number of factors including asset growth, book value growth, and return on assets. Following up on their work, Michelle Clayman ⁴ studied the performance of the "excellent" firms and another group she termed "unexcellent" (by going "in search of disaster") and found that the characteristics of the excellent companies quickly reverted to the mean in the years following their excellent performance. The unexcellent companies also reverted to the mean and showed substantial improvement. The stocks of the unexcellent firms significantly outperformed the excellent companies over the years that followed.

Interestingly, numerous studies of foreign stock markets have come to similar conclusions regarding growth and value stocks. The implication is that investors worldwide (not only Americans) systematically misprice value stocks. Carlo Capaul, Ian Rowley, and William F. Sharpe ⁵ studied six countries from January 1981 through June 1992 and found that Value Stocks outperformed growth stocks on average in each country. Lewis A. Sanders, CFA ⁶ also studied six countries from 1980 through 1993 and also found that value outperformed the benchmark in each country. John R. Chisolm ⁷ studied stocks in France, Germany, Japan and the United Kingdom from 1974 through 1989. Stocks were divided into quintiles based on price to book value and adjusted annually. In each country the low price to book value quintile outperformed. The difference in annual compound returns in France and Japan was more than 10% for the period studied. Chisolm also divided stocks into quintiles based on P/E and found similar results with low P/E stocks outperforming, particular in the United Kingdom. A. Michael Keppler ⁸ studied the performance of 18 country indexes from 1969 through 1989. The indexes were grouped into quartiles based on dividend yield and adjusted quarterly. In both local currencies and dollars, the most profitable strategy would have been to own the highest yielding quartile of indexes. Researchers also recently came to similar conclusions regarding Korean stocks ⁹. From 1982 through 1993, book-market and sales-price ratios were positively related to performance.

One study followed up on the question of whether the value anomaly worked after transactions costs ¹⁰. The authors found that after adjusting for 1.0 percent transaction costs and annual rebalancing, investors would have outperformed the market by 4.82 percent over the 1963-1988 period if they had invested in securities from firms with high book to price and small size. They concluded that the optimal rebalancing period for long positions in these securities was two years.

"Value criteria act like a chaperon at a party, making sure you don't fall for some sexy stock with a great story."

James O'Shaughnessy in What Works on Wall Street

"You don't make money by investing in a good company . . . You make money by investing in a company that is better than the market thinks."

Robert Vishny, Institutional Investor, January 1997.