There’s extensive literature documenting that value stocks (the stocks of companies with low prices relative to a valuation metric, such as earnings, book value, cash flow or sales) possess a strong, persistent and pervasive tendency to outperform growth stocks.
While there’s no debate about the existence of the value premium, there’s a major debate about the source of the return differential. Some argue that returns reflect compensation for risk; others argue for mispricing.
The mispricing explanation for the value premium is that investors are systematically too optimistic in their expectations for the performance of growth companies, and too pessimistic in their expectations of value companies. Ultimately, prices correct when these expectations aren’t met.
Value And Mispricing
Joseph Piotroski and Eric So, authors of the study “Identifying Expectation Errors in Value/Glamour Strategies: A Fundamental Analysis Approach,” which was published in the September 2012 issue of The Review of Financial Studies, tested the mispricing hypothesis by identifying potential ex-ante biases and comparing the expectations implied by pricing multiples against the strength of firms’ fundamentals. Value strategies would be successful if prices don’t accurately reflect the future cash flow implications of historical information in a timely manner, resulting in equity prices that temporarily drift away from their fundamental value.
Piotroski and So classified and allocated firm-year observations into value and glamour (growth) portfolios on the basis of each firm’s book-to-market ratio. Because a firm’s book-to-market ratio reflects the market’s expectations about future performance, sorting by this metric will group firms on the basis of future performance expectations embedded in prices. Thus, book-to-market ratios serve as an empirical proxy for the relative strength of the market’s expectations about future firm performance.
The authors classified the strength of a firm’s recent financial performance trends using the aggregate statistic F-Score, which is based on nine financial signals designed to measure three different dimensions of a company’s financial condition: profitability, change in financial leverage/liquidity (capital structure) and change in operational efficiency.
Firms with the poorest signals have the strongest deterioration in fundamentals and are classified as low F-Score firms. Firms that receive the highest score have the strongest improvement in fundamentals and are classified as high F-Score firms.
Prior research shows that F-Score is positively correlated with future earnings growth and future profitability levels. Low F-Score firms experience continued deterioration in future profitability, and high F-Score firms experience overall improvement in profitability.
Study Results
Following is a summary of the authors’ findings, which cover the period 1972 through 2010:
- Among firms where the expectations implied by their current value/glamour classification were consistent with the strength of their fundamentals, the value/glamour effect in realized returns is statistically and economically indistinguishable from zero.
- The returns to traditional value/glamour strategies are concentrated among firms where the expectations implied by their current value/glamour classification are ex-ante incongruent with the strength of their fundamentals.
- Returns to this “incongruent value/glamour strategy” are robust and significantly larger than the average return generated by a traditional value/glamour strategy.
