As I have been discussing in a series of articles (which you can find here, here and here), we now have a substantial body of evidence demonstrating that individual investors possess a preference for low-priced equities. This is anomalous behavior, because the level of a company’s stock price is arbitrary—firms can manipulate it by adjusting the number of shares they have outstanding.
The research from a trio of studies on the U.S. stock market has found that this irrational preference is explained by individual investors who are searching for a cheap bet, as with lottery tickets. Therefore, such investors find lower-priced stocks attractive. The research also confirms the view that individual investors may see low-priced stocks as being closer to zero and farther from infinity. Thus, they are perceived to have more upside potential and less to lose.
Summarizing the findings from these three recent papers, investor preferences and beliefs lead to the pricing anomaly in which low-priced stocks—especially those with higher betas, high idiosyncratic volatility and high skewness—show poor raw returns and very poor risk-adjusted returns.
The Out-Of-Sample Evidence
As noted, while the cumulative weight of the evidence is compelling, it’s all based on U.S. data. We would have more confidence in the authors’ findings if we had an out-of-sample test that produced similar results. Thanks to Ulrich Hammerich, Christian Fieberg and Thorsten Poddig, authors of the October 2016 study “Nominal Stock Price Investing,” we now have that out-of-sample evidence.
In their study, which covered the period 1990 through 2013, the authors investigated the relevance of nominal prices when applied as an investment style on the German stock market. They found that nominal prices explain portfolios’ excess returns (built via price deciles) when applying the CAPM (market beta), the three-factor model (market beta, size and value) and a four-factor model (adding momentum). Following is a summary of their findings:
- When moving from decile P1 to decile P10, returns increase virtually monotonically, while standard deviations basically decrease monotonically and Sharpe ratios basically increase monotonically.
- There is a significant return difference between the cheapest 10% of stocks (P1) and the most expensive 10% of stocks (P10).
- Although there only is a barely/marginally statistically significant difference in the returns in favor of high-priced stocks, the Sharpe ratios and the standard deviations show a very robust, significant difference concerning P1 and P10 (P10 has a lower standard deviation of returns than P1 and at the same time higher mean returns; thus, a much higher Sharpe ratio).
- If an investor scales up the volatility of P10 via the use of leverage to the same level as P1, the return difference in favor of P10 would be dramatically higher.
- Results from the CAPM and four-factor model show that the main differences between high-priced and low-priced stocks are that high-priced stocks are, on average, low-beta stocks and have positive and very significant coefficients on the momentum factor, while low-priced stocks likely are high-beta stocks and have a very significant negative factor loading on momentum.