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Fundamental Stock Market Anomalies

Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC


     Value investing is probably the most publicized anomaly and is frequently touted as the best strategy for equity 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 (of LSV Asset Management) 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

     In Value and Growth Investing: Review and Update (or in the Financial Analysts Journal here January/February 2004) Louis K.C. Chan and Josef Lakonishok reviewed and updated the literature regarding the performance of value versus growth strategies through 2001 and provided some new results based on an updated and expanded sample. They concluded that common measures of risk do not support the argument that the return differential is a result of the higher riskiness of value stocks, but rather, in their opinion, is due to behavioral considerations and the agency costs of delegated investment management.

     Eugene Fama and Ken French (DFA) argue that Value strategies are riskier. See their The Anatomy of Value and Growth Stock Returns in the Financial Analysts Journal (November/December 2007) for more on the discussion (earlier version). Value versus Growth: The International Evidence also from Eugene Fama and Ken French in the Journal of Finance (December 1998) focuses on the international evidence. James L. Davis wrote in 2001 "The issue of whether the value and size premiums are caused by risk or inefficiency may never be resolved to everyone's satisfaction. Feelings run strong on both sides of the argument." (See Explaining Stock Returns: A Literature Review.)

     Meir Statman states "There are enough papers now that show risk is not what underlies outperformance . . . It is emotion; it is sentiment." in Using Behavioral Finance to Better Understand the Psychology of Investors (May 2010) from II.

     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.

     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. James L. Davis, Eugene Fama and Ken French documented 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 (or here).

     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.

High Dividend Yield

     Numerous studies have concluded that high yielding stocks tend to outperform. In High Yield, Low Payout, Pankaj N. Patel, Souheang Yao, and Heath Barefoot of Credit Suisse (2006) found that while high dividend yield stocks did indeed outperform their lower yield counterparts, the 8th decile stocks produced the best returns. The Dow Dividend Strategy has received a great deal of attention over the years, but also has it's critics (see Dow Dogs & the Foolish Four) and is a very limited data set.

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.)

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.

     But more recently, in A Great Company Can Be a Great Investment Jeff Anderson and Gary Smith (Abstract - Financial Analysts Journal, July/August 2006) studied Fortune's ten "most admired companies in the US from 1983-2004 and they outperformed. They concluded that a portfolio consisting of the stocks identified annually by Fortune magazine as America’s most admired companies outperformed the S&P 500 even with various lags after publication date, representing a clear challenge to the efficient market hypothesis since Fortune’s picks are readily available public information and they found no compelling explanation for this anomaly. On the opposite side, in In Search of Distress Risk John Y. Campbell, Jens Hilscher, Jan Szilagyi found that since 1981, financially distressed stocks have delivered anomalously low returns, which is inconsistent with the conjecture that the value and size effects are compensation for the risk of financial distress (also here Journal of Finance, December 2008).

International Value Studies

     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 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.

     More recently in Value and Momentum Everywhere (older version via AQR), Cliff Asness, Tobias J. Moskowitz, and Lasse Heje Pedersen find that "value and momentum ubiquitously generate abnormal returns for individual stocks within several countries, across country equity indices, government bonds, currencies, and commodities." They find that in the US, UK, Continental Europe, and Japan, Value and momentum work in combination even better than either alone.

After Transactions Costs

     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.

     Todd Houge and Tim Loughran in Do Investors Capture the Value Premium?, Financial Management, Summer 2006 (At SSRN) question whether investors can expect to profit from value strategies. They conclude "We propose that the value premium is simply beyond the reach of investors...The bid-ask spread, transaction costs, and the price impact of trading likely work against capture of the value premium in small-cap stocks. Hence, investors should harbor no illusion that pursuit of a value style will generate superior long-run performance.

"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.

1. Josef Lakonishok, Robert W. Vishny, and Andrei Shleifer, "Contrarian Investment, Extrapolation and Risk" Working Paper No. 4360, National Bureau of Economic Research, May 1993. Also here in The Journal of Finance, December 1994.

2. Eugene Fama and Kenneth R. French, The Cross-section of Expected Stock Returns Journal of Finance, June 1992.

3. Werner F.M. DeBondt and Richard Thaler, Does the Stock Market Overreact? Journal of Finance, July 1985.

4. Michelle Clayman, In Search of Excellence: The Investor's Viewpoint, Financial Analysts Journal, May/June 1987.

5. Carlo Capaul, Ian Rowley, and William Sharpe, International Value and Growth Stock Returns, Financial Analysts Journal, January/February 1993.

6. Lewis A. Sanders, CFA, "The Advantage to Value Investing," Value and Growth Styles in Equity Investing, Association for Investment Management and Research, 1995.

7. John R. Chisolm, "Quantitative Applications for Research Analysts," Investing Worldwide II, Association for Investment Management and Research, 1991.

8. A. Michael Keppler, The Importance of Dividend Yields in Country Selection, Journal of Portfolio Management, Winter 1991.

9. Sandip Mukherji, Manjeet S. Dhatt, and Yong H. Kim, A Fundamental Analysis of Korean Stock Returns, Financial Analysts Journal, May/June 1997.

10. Patrick Dennis, Steven B. Perfect, Karl N. Snow, and Kenneth W. Wiles, The Effects of Rebalancing on Size and Book-to-Market Ratio Portfolio Returns, Financial Analysts Journal, May-June 1995.

This page is not a stand-alone page and should not be read or used without first viewing the main Anomalies page which includes important information and warnings about interpreting historical stock market anomalies.

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