Following is a summary of Anderson and Zastawniak’s findings:
- For all deciles, the most likely decile for a company to appear in the following year is the same decile as the current year.
- A glamour company has a 34% chance of becoming a loss-maker next year, compared with just 25% for a value company.
- Extreme loss-makers (decile 1) and value companies are most likely to remain in the same decile next year, at 32% and 34%, respectively. The deciles between them are much more likely to move, with the probability of remaining in the same decile only 15-20%.
- Extreme loss-makers find it particularly difficult to break out of the spiral. They have only a one-in-six chance of turning a profit in the next year, compared with a 27% chance of being delisted.
- Unsurprisingly, the worst loss-makers (decile 1) that either delist or stay in the first decile lose money for their investors. However, surprisingly, companies only have to make their losses less severe and excellent returns can be expected—an average gain of 131% for loss-makers that move from decile 1 to decile 5 (the least severe loss-makers).
- Glamour stocks that remain in the same decile provide three times the rate of return of value stocks that remain in the same decile (36% versus 12%). This could help explain the preference for glamour stocks. However, few companies stay in the same decile in the following year, and glamour stocks have a greater tendency to move deciles—roughly five-sixths of the time—and then give very poor returns. In addition, if glamour stocks start making losses, they suffer greatly. Glamour stocks that move from decile 6 to decile 1 lose on average 41%. On the other hand, value shares are much more likely to remain in or near the value P/E decile.
- Glamour investors appear to be underestimating the tendency of their preferred stocks to change decile, by at least 18%, and possibly much more. Additionally, the average change in P/E is large.
- Smaller companies, particularly small high-growth companies, are much more likely to move from the glamour deciles to the value deciles than large companies. These are exactly the sort of stocks that are most likely to be dominated by retail investors who are more prone to behavioral biases. I would add here as well that they are also exactly the type of stocks most difficult for arbitrageurs to short, thereby correcting mispricings.
- NYSE stocks are 28% more likely than Nasdaq stocks to move into the higher deciles next year, while Nasdaq stocks are 42% more likely than NYSE stocks to become loss-makers or delist.
- Shares in the extreme-loser decile have respectable mean returns, but the median returns are very poor and the standard deviation of returns is double what it is for the glamour and value deciles. Any good returns from an extreme-loser stock depend on the firm becoming profitable, or at least stopping such heavy losses, but each year there is an almost 60% chance of the firm either ceasing to be quoted or remaining a decile 1 stock.
- There was a 7.5% average annual difference in returns between decile 6 (glamour) and decile 15 (value).
- The returns for glamour investors are relatively poor whatever their time horizon. However, value investors can expect superior returns if they hold for two to three years (not just for one year) as recommended by Benjamin Graham. The returns to value stocks, while just 5% for the first year, were 21% for the second year and 15% for year three. After that, returns decline to little more than the returns on glamour shares.
- The value decile’s standard deviation of returns is only slightly greater than that of the glamour decile, and not enough to account for the higher returns.
When considered together, the authors write, the findings support their thesis that glamour investors anchor on the high P/E value for growth shares while ignoring the high likelihood that the P/E ratio will change in the future.
Later this week, we’ll take a closer look at a possible explanation Anderson and Zastawniak offer to account for investors’ preference for growth stocks, as well as some other evidence in the academic literature that supports their findings.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.