Swedroe: Glamour Can Distract Investors

March 28, 2016

There’s very strong historical evidence to support the existence of a value premium in equity markets. While there’s no dispute over the existence of the value premium (value stocks have provided an annual average return 5% higher than growth stocks over the long term), there is much debate over the cause of the difference in returns.

In one camp are financial economists who argue that the value premium is a risk story—value stocks are riskier than growth stocks. As a result, investors must be compensated in the form of higher expected returns. Others argue for an alternative explanation—there’s a persistent overvaluation of the earnings prospects for growth stocks. And what’s more, there’s a wealth of evidence on both sides.

The Allure Of Growth

Keith Anderson and Tomasz Zastawniak—authors of the October 2015 study “Glamour, Value and Anchoring on the Changing P/E”—contribute to the literature supporting the persistent overvaluation of the earnings prospects for growth stocks.

Their working hypothesis was that the differing experiences of glamour and value investors can be explained by the well-documented behavior of anchoring.

Anchoring is a form of cognitive bias in which people place an inordinate amount of importance on certain values or attributes, which then act as a reference point, and the influence of subsequent data is weighted to support their initial assessment. For example, some investors will tend to hang on to a losing investment because they’re waiting for it to break even, anchoring their investment’s present value to the value it once had.

Anchoring is such a powerful force that, even in experiments when subjects could plainly see the anchor and that it could not possibly be any sort of guide to an answer, the bias continued to play a role.

For example, in a famous experiment, Daniel Kahneman and Amos Tversky asked subjects to spin a roulette wheel rigged to stop at 10 or 65, and then asked them to estimate the percentage of African nations in the United Nations. Subjects who saw a result of 10 guessed 25% while those shown 65 guessed 45%.

Anchoring On The P/E Ratio

Anderson and Zastawniak hypothesized that investors may anchor on the price-to-earnings (P/E) ratio of a stock when they initially invest in it.

They write: “Given an observed high P/E of 25 [investors] may think (consciously or not), ‘Thousands of investors, some of whom are better informed than I am, already are paying $25 for each $1 of current earnings. This must be a valuable, high growth company to justify that.’”

The authors then posit that such investors “fail to adjust their future expectations sufficiently according to mean reversion.” Thus, having now bought the stock, investors “expect the P/E to change slowly, if at all. As time goes on, the P/E decile changes, and different prospects for returns attach to each decile. If there is a differential drift in the P/E and hence returns between value and glamour stocks that are not expected by investors, this could account for why glamour investors end up disappointed.”

Anderson and Zastawniak’s study covered the period 1983 through 2010. When ranking stocks and forming P/E deciles, they divided positive P/E companies into deciles and then added five more deciles to include the firms with losses (34.1% of the company/year data points represent losses), producing a total of 15 “bins.” They then used these 15 bins, as the loss-producing companies represented about one-third of the total.

They paired each year’s decile number with the decile to which the company moved in the following year. If no earnings were recorded the following year, decile “00” was coded, as the company went into administration, was taken over or otherwise ceased to be quoted. There are thus 15 bins in year 1 and 16 bins in year two, resulting in 240 (or 15x16) possible transitions from one year to the next. Finally, they calculated the equally weighted return from each of these 240 possible transitions.


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