by David Dreman
The landmark 1992 paper by Eugene Fama and his coauthor Kenneth French showed that the lowest price-to-book-value ratios, lowest price-to-earnings ratios, and small-capitalization stocks provide the highest returns over time.14 Figure 10-2 provides Fama and French’s price-to-book-value results. The sample used an average of 2,300 companies annually from the Compustat North America database. Stock returns are shown in quintiles by price-to-book-value ratios (P/BV), which are recast annually. The highest-price-to-book-value stocks are in column 3 and the lowest, or most unpopular, in column 1. As the figure indicates, low price to book value (20.5 percent) provides more than double the annual return of high P/BV for the entire sample through the life of the study. Low P/BV outperforms the market by 4.6 percent annually on average, while high P/BV underperforms by 5.7 percent.
Fama downplayed the low-P/E effect in an interview, saying the reason low-P/E stocks do well is that so many of them are the same stocks as are in the price-to-book-value sample. One could say precisely the opposite and be just as correct. As Fortune concluded, “Some might call that academic hairsplitting.”15 Since Fama had resisted the low-P/E effect for almost thirty years, another not unreasonable conclusion is that it may be a symptom of academic face-saving.
Let’s go back briefly to Basu’s Table 10-3. In the last column he adjusted his table for risk (beta) and found that volatility was actually lower for low-P/E stocks than for higher P/Es. EMH theory states definitively that low-P/E betas, or risk, must be higher than those of higher-P/E stocks. This has to be the case because these out-of-favor stocks provide higher returns than high-P/E stocks. Remember, the crucial premise of the capital asset pricing model, Fama and colleagues’ three-factor model, and all the other EMH risk-return models we saw in chapter 6 is based on the professors’ emphatic pronouncement that higher returns can be achieved only by taking greater risk (volatility), which we left them still trying to find proof for in that chapter.
But to move on. The blessing of contrarian strategies by the high priests at Chicago now allowed the investment world to eat what had been forbidden fruit. Value strategies were looked at with new reverence, and value indexes were introduced by Standard & Poor’s, Frank Russell, and scads of other consultants. Fortified by Professor Fama’s findings, other researchers now found the courage to spring boldly into the past.
In “Contrarian Investment, Extrapolation, and Risk,” Josef Lakonishok, Andrei Shleifer, and Robert Vishny measured the performance of the three important value strategies we’ve looked at and came up with similar results.16 These pesky contrarian strategies, then, have proved watertight for a lot longer than the efficient-market hypothesis. In fact, they have been getting stronger with each passing year.
The good news for you is that this wave of discoveries provides strong evidence that there are consistent, high-odds ways to beat the market. The methods also protect your capital in a bear market, as I’ll demonstrate shortly. It sounds a little like having your cake and eating it, too, but there are strong reasons why these strategies continue to work for disciplined investors. (That’s why I’ve included Psychological Guidelines—all based on investors’ psychological failings—throughout the text as a critical reminder.)
The Last Nail
As we have seen, there are a number of contrarian strategies besides low P/E that work just fine. Low price-to-cash-flow and low price-to-book-value ratios are both potent tools for beating the market. Some of my more recent work demonstrates that buying stocks with high dividend yields has been successful in outperforming the averages, as has buying the stocks with the lowest P/Es in any industry (the industry-relative strategy). Beating the market isn’t easy. According to Vanguard’s John C. Bogle, whom we met earlier, only about 10 percent of managers are able to accomplish this in any ten-year period. But someone may ask a pointed question here: “True, you might say the numbers on low-P/E returns are impressive going back to the 1930s and up to 1990, but a lot of water has flowed under the bridge since then. How have contrarian strategies done in more recent times?”
The answer is “Just fine,” as we’ll see next, and in much more detail in the investment strategy section of the next chapter. All five contrarian strategies we looked at outperformed the market in the 1970–2010 period, which saw the two worst market downturns in our history other than 1929–1932.
Figure 10-3 shows how effective contrarian value strategies have been for the forty-one years ending December 31, 2010. The study measures the Compustat 1500. Four separate value measures were used: low P/E, low price to book value, low price to cash flow, and highest yield. The stocks were divided into quintiles according to these four criteria, and the results were calculated annually throughout the study. The chart shows the returns against market using each of these strategies for this forty-one-year period. The methodology is almost identical to that explained for my chart shown earlier.
Value strategies work with a vengeance! All four outperform the average, and the returns of three of the strategies are outstanding. Ten thousand dollars invested in the bottom 20 percent of P/Es in the Compustat 1500 in 1970 would now be worth $3,274,000 at the end of December 2010 (all figures assume reinvestment of dividends), about four times the market’s cumulative value of $913,000 for investing the same $10,000 for the entire period. Looking at it another way, $10,000 in 1970 increased 327-fold!
Low price to book value, a favorite of Benjamin Graham, trailed low P/E but was ahead of the other two strategies for the period and almost triple the return for the market over these four decades. Low price to cash flow, taken from the statistics available from Compustat (thus excluding all the high-octane adjustments claimed to soup up performance), also worked just fine.
The returns shown in the small box near the top of the chart are worth looking at. After both the dot-com crash and the meltdown of 2007–2008, the average annual return over this forty-one-year period was 15.2 percent for low P/E, more than 14 percent for low price to book value, and 14.0 percent for low price to cash flow. This compares with a long-term rate of return for common stocks of 9.9 percent since the mid-1920s. Contrarian strategies outperformed the long-term rate of return of common stocks, 37 to 54 percent, through this forty-one-year period. I think we can safely say the sky is not falling on these strategies in spite of the horrendous markets of the the last decade.
Next let’s move on to the high-yield investment strategy. This value method is a little different from the other three. Normally, high dividend yields are found in utilities and other industry groups, which are not expected to have rapid appreciation. On the opposite side of the scale, stocks that pay small dividends or none at all are usually found in rapidly growing industries. Instead of paying dividends, companies hold the money back to finance growth. There has always been a good deal of controversy about whether stocks with high dividend yields even come close to the appreciation of the averages.
The answer is surprising. Although trailing the other three value measures, high-yield stocks outdistanced the market by 105 percent (all strategies include reinvested dividends). Ironically, though large numbers of investors buy large dividend payers for income, this method is probably most suitable for tax-free accounts. In a high tax bracket, the performance advantage over the market will decline fairly significantly, because a large part of the return is dividends, which go to Uncle Sam.
Another reasonable question is: how did the favored stocks perform by the same yardsticks? Badly. Regardless of which measure I used, none of the favorites came close to beating the market over the forty-one-year period. Ten thousand dollars invested in the highest-P/E group would have been worth $259,000 at the end of 2010, less than 30 percent of the $913,000 ending value of the market. The same amount invested in highest-price-to-book-value stocks grew to only $242,000, and invested in the highest-price-to-cash flow category, it grew to $209,000: 27 percent and 23 percent of the cumulative market return, respectively. Unexpectedly, the best performer in the “best sector” w
as the low-yield, no-yield group, which accumulated a dismal 33 percent of the market’s value at the end of 2010.
Strikingly, then, four of the most commonly used valuation ratios when applied to out-of-favor stocks resulted in their all significantly outperforming the market, while the same four metrics, when applied to favored stocks, resulted in their all significantly underperforming the market over the length of the study.
Unhappily for believers in growth, the long-term drubbing does not stop here. Although there is constant debate in the financial press and the investment media, as well as in Morningstar and other advisory services, about whether value or growth performs better over time, the results of this study are clear-cut. First, contrarian strategies outperform growth strategies regardless of the metric chosen. Next, the margin of outperformance over time is enormous. Low-P/E stocks outperform their high-P/E brethren by close to thirteenfold. Ten thousand dollars initially invested in these stocks in 1970 became $3,274,000, versus the $259,000 invested in high-P/E stocks at the same time. Similarly, $10,000 invested in low-price-to-book-value stocks would have grown to $2,425,000 against the $242,000 that the initial $10,000 would have increased to in high-price-to-book-value stocks. The comparisons of price to cash flow are similar. It’s clear that contrarian strategies outperform favored stocks by a country mile. What is also demonstrated is that contrarian strategies have performed very well, increasing initial capital by up to 327 times, from 1970 through 2010, and this after the worst market downturn since the Great Depression.
But the story is still not over. Most investors want more than just to increase their nest egg in a rising market. Just as important, they would like to keep it intact when the bear growls. We’ve seen the intensity of this goal after the 2007–2008 bear market. Morningstar, Lipper, and the Forbes Annual Mutual Funds Survey, among others, rank mutual funds on how they have performed through several bear markets.
To find out how our contrarian strategies worked in down markets, we took the returns of the value stocks in each of the four categories for all fifty-two down quarters in the study and averaged them. As Figure 10-5a shows, the value strategies all did better than the market average in the down markets through the same period (1970–2010). While the market dropped 7.6 percent in the average down quarter, low-P/E, low-price-to-cash-flow, and low-price-to-book-value stocks all fell less, as the figure shows. The best performers, as you might expect, were the high-yield stocks, declining only 3.8 percent, or half as much as the market.
As you have also probably guessed, the high-P/E, high-P/CF, high-P/BV, and low-yield stocks were hit hard. As Figure 10-5b shows, all four strategies were down more than the market average, dropping between 9.5 percent and 10.8 percent and significantly more than the low-value metrics*59 versus a 7.6 percent drop for the market. Value stocks, then, not only provide higher returns in a rising market but also star on the defense. The value strategies originally presented by Ben Graham and other market pioneers played out at least as well as, and perhaps better than, they would have imagined.
Obviously, very few individuals can or need to hold funds in stocks for this period of time. But for those institutions, pension funds, and other long-term buyers who are once again fleeing stocks to buy Treasuries and other bonds at tiny yields, it’s a proven strategy that, when folks stop running away from stocks, they should definitely consider.
Summing It All Up
The consistency of these studies is truly remarkable. Over almost every period measured, the stocks considered to have the best prospects fared significantly worse than the contrarian stocks, using the same criteria. This leads us to another Psychological Guideline:
PSYCHOLOGICAL GUIDELINE 22: Buy solid companies currently out of market favor, as measured by their low-price-to-earnings, low-price-to-cash-flow, or low-price-to-book-value ratios or by their high yields.
You might wonder: if these strategies do so well, why doesn’t everyone use them? This lands us smack in the realm of investor psychology (or behavioral finance, as it is now called by economists).
Though the statistics drag us toward the value camp, our emotions just as surely tug us the other way. People are captivated by exciting new concepts. The lure of hitting a home run on a hot new idea, as chapter 2 made clear, overwhelms caution. The sizzle and glitz of an initial public offering such as LinkedIn, the Facebook of the professional world, which was issued at $45 and went to $122.70 the same day in May 2011, when it traded at a P/E of 548 times and price-to-book-value ratio of 134 times, or a RealD, in late May 2011 trading at a P/E of 170, are just too great.17
Though these are extreme examples of investor evaluation run amok, they show why value strategies have worked so well over the years. People pay for concept, whether in the absurd cases of LinkedIn or RealD or in consistently overpricing the trendy industries of the day. Investors just as surely want to stay well away from companies whose outlooks seem poor.
The favored stocks, on the other hand, present the best visibility money can buy. How, then, can one recommend such a reversal of course? The psychological consistency of the error is remarkable. There are, of course, strong stocks that justify their price-earnings ratios and others that deserve the slimmest of multiples. But, as the evidence indicates, the “best” are relatively few in number, and the chances of recognizing them are very small.
Contrarian strategies succeed because investors don’t know their limitations as forecasters. As long as investors believe they can pinpoint the future of favored and out-of-favor stocks, you should be able to make good returns on contrarian strategies. Human nature being what it is, this edge should continue for a few years longer—unless contrarians have a few million new readers sooner. (I’m sure my publisher and I would be delighted to deal with that problem, though.)
We have seen how consistently contrarian strategies have worked for investors over the years. The good news for you is that this wave of discoveries in new psychology and in contrarian strategies is harmonious. This is in strong contrast to EMH and MPT, where psychology exposes their basic assumptions. The research data of stock performance over the years provide strong evidence that there are consistent high-odds ways to beat the market. Next let’s extend the explanation to how we can use these strategies to both survive in and crank up our returns in the difficult markets we are likely to face.
Chapter 11
Profiting from Investors’ Overreactions
IN THE PRECEDING CHAPTER we surveyed the four important contrarian strategies that will let us not only survive but be successful in today’s markets, and we’ve seen the spectacular results they provide over time if used properly. In this chapter we’ll introduce a new investment hypothesis that seems to explain markets and investors’ behavior, as well as risk, far better than does EMH. Now, how can we put its findings to work?
Disproving an old hypothesis and bringing out a new one in its place is always difficult for the proponents of the new one. Though advocates won’t be burned at the stake or be under house arrest for the rest of their days, you can be sure that their work will be scrutinized by legions of graduate students all attempting to find even the slightest flaw, down to the punctuation marks. The old theory is the security blanket for the reputations and work of distinguished academics who have devoted their lives to researching, expanding, and broadening the ideas of the accepted hypothesis, the large number who have been taught its efficacy, and the many thousands who work with it almost daily in the investment field because they believe in its validity, as well as the millions of people who depend on its findings to improve their portfolios’ results.
Whether the new challenger in the field works or not has almost no significance to the believers in the prevailing theory—at least for the first fifty years or so. But for the reader there’s a very different possibility. You don’t have to stand on a soapbox and declare that you’re a contrarian. All that’s required is to reinvest your capital according to the contrarian strategies laid out and w
ithdraw the gains when the time is right.
From the previous chapters, you know that our new hypothesis is built on a considerable amount of evidence in hand and a substantial amount of investigation already carried out. But it remains what it is declared to be, a hypothesis.
That is why research continues and why we cannot “close the books” on investing strategies or portfolio approaches. Even though the results have been so encouraging along the way, more work lies ahead to open up new paths and strategies and to more closely link the contrarian findings to the powerful psychology that is responsible for them.
We’ve come a long way on the major causes of investment misfires in today’s markets. Very few investors will be successful in the contemporary environment without an understanding of how to handle these pitfalls. Now, with this knowledge of what we face, we are ready to move on to the rewards, which, if we stay within the guidelines of our new psychological knowledge, are there for the taking.
Sadly for many, this is the investment world we must deal with today. But as we know, it is often in times of turmoil that new ideas are looked at through new eyes and are accepted. Far from doom and gloom, I believe, we’ll see major opportunities ahead. But to reach them, it is important to know what we are fighting and the tactics that will give us the highest probabilities of success.
Section I: The Investor Overreaction Hypothesis
We have seen throughout this book that investors overreact to events and then correct their original reactions by causing major reversals in stock prices. In chapters 1 and 2, we repeatedly saw the enormous swings from frenzied overoptimism in bubbles and manias to the inevitable panic, when prices were often brutally knocked down by as much as 80 to 90 percent. Affect, sometimes accompanied by other cognitive heuristics, stands out as the most likely psychological force causing this investor behavior. But it is not only in manias, contagion, and panics that these predictable overreactions take place.