Earlier this week, we examined a recent study contributing to the literature that supports a behavioral-based argument for the value premium, in particular that investors persistently overvalue the earnings prospects of growth (“glamour”) stocks.
The study—“Glamour, Value and Anchoring on the Changing P/E”—posits that the differing experiences of glamour and value investors could be explained by the well-documented behavioral bias of anchoring, specifically that investors may anchor on the price-to-earnings (P/E) ratio of a stock when they initially invest in it.
As we discussed, anchoring is a form of cognitive bias in which people place an inordinate amount of importance on certain values or attributes, which go on to act as a reference point, and the influence of subsequent data is weighted to support their initial assessment.
The authors of the study, Keith Anderson and Tomasz Zastawniak, concluded that, taken together, their findings support the thesis that “glamour investors anchor on the high P/E value for glamour shares, while ignoring the high likelihood of future changes to the P/E ratio.”
Explaining The Appeal Of Glamour
Today we will look at a possible explanation that Anderson and Zastawniak offer to account for an investor preference for growth stocks, as well as some other evidence in the academic literature that supports their findings.
Investors appear to ignore the evidence showing that value stocks provide higher returns than growth stocks. Anderson and Zastawniak provide a possible explanation for investors’ preference for growth stocks: They will anchor on the current P/E of glamour stocks instead of considering the high likelihood that the P/Es of value and growth stocks exhibit a strong tendency toward mean reversion.
Anderson and Zastawniak concluded that investors tend to consider the current P/E of a potential investee firm to be more permanent than it actually is. In an uncertain world, many investors anchor on the current P/E. The result is that, “far from the 37.25% returns they expect to get through their share remaining a glamour share next year, they end up with average returns of only 10.91% and are beaten in their endeavours by value investors.”
There’s strong academic research supporting Anderson and Zastawniak’s findings. For example, in a February 1999 study, “Forecasting Profitability and Earnings,” professors Eugene Fama and Kenneth French tested whether the theory of profitability reverting to the mean stood up to the historical data. They examined the profits from an average of 2,304 firms per year for the period 1964 through 1995. Their conclusions: