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This is the final paper I’ll summarise before continuing the analysis of Company B.
Written by Lakonishok, Shleifer and Vishny, henceforth LSV, in 1994, this paper should, together with the last few Newsletters, convince you of the possibility of a human tendency to under-weight the phenomenon of mean reversion – a common cognitive error.
The phenomenon might lead to problems in many walks of life; but of especially interest to us as investors, is the under-pricing and over-pricing of certain types of share.
Method
All the shares on the NYSE and the American Stock Exchange were included, with portfolios formed each year at one year intervals, the first being in April 1968 and the last in April 1989.
For each of the Aprils it was imagined that the shares were placed into ten portfolios (‘deciles’) based on their PERs using the previous year’s earnings per share.
The top decile (number 1) contained the 10% of companies with the highest PERs labelled ‘glamour’. The bottom decile (number 10) contained the 10% of shares with the lowest PER, labelled ‘value’.
(Only companies with positive earnings were included).
Performances were followed for each of the following five years (the paper shows each of the individual post-formation year’s performances, but I’ll just show the five year performance here).
These performances were then averaged over the 22 years of portfolio formations.
Results
We can see from the figure that value portfolios out-perform glamour portfolios (with statistical significance): Over five years value portfolios average returns of 139%, whereas the glamour portfolio achieve only 72%.
Why does the value strategy work?
LSV suggest that value strategies work because they are contrary to the following:
•Extrapolating past earnings growth too far into the future
•Assuming a trend in share prices
•Overreacting to good or bad news
•Equating a good investment with a well-run company irrespective of price
‘some investors tend to get overly excited about stocks that have done very well in the past and buy them up, so these “glamour” stocks become overpriced……similarly, they overreact to stocks that have done very badly, oversell them, and these out-of-favor “value” stocks become underpriced’.
Evidence on reversion to the mean
The over-extrapolating of past growth rates hypothesis is supported by LSV statistical evidence. It’s unfortunate that they only had space in the paper to report on portfolios formed on a different definition of value (using cash flow to price and growth in sales), but the insights are still useful for our thinking…….
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