- There is a strong tendency for profits to revert to the mean.
- Reversion to the mean is strongest when profits are highest (also the point at which the incentive for competition to enter an industry is greatest) and lowest (the point at which the incentive to leave an industry and reallocate assets, thereby reducing competition and restoring profits, is greatest).
- Abnormally low earnings tend to revert even faster than abnormally high profits.
- Reversion to the mean occurs at a rate of about 40% per year.
- Real-world forecasts tend to underestimate the speed at which reversion to the mean in profitability occurs.
Fama and French offered a possible behavioral-oriented explanation for the finding that abnormally low earnings revert faster than abnormally high earnings. They hypothesized that when reporting bad news, companies often become very conservative and try to get all the bad news out of the way at one time (possibly blaming previous management). On the other hand, they tend to spread out good news over time.
If, in fact, reversion to the mean occurs faster than the market is anticipating, this may help explain why growth stocks underperform value stocks. The market may simply be overestimating the amount of time that growth firms would generate abnormal profits. Ultimately, earnings expectations are not met, and this fact gets reflected in lower equity returns.
The reverse is true of value firms. The market appears to overestimate the time it takes for abnormally low profits to revert to the mean. Ultimately, earnings expectations are exceeded, and this is reflected in higher returns.
The Bottom Line
It’s likely that Anderson and Zastawniak’s findings won’t settle the debate about whether the value premium is risk- or behavioral-based (if the latter is the case, the value premium is a free lunch). Keep in mind that the answer to the question doesn’t have to be black or white. Perhaps the value premium, while not being a free lunch (there’s plenty of evidence supporting a risk-based explanation) is at least a free stop at the dessert tray.
The bottom line is that value stocks historically have outperformed growth stocks, and if you think the explanation is risk-based, then you should expect this outperformance to continue. If you think the explanation is behavioral-based, then—unless you expect investor behavior to change—you should expect value stocks to outperform as well.
Also remember that the outperformance of value stocks has been in the academic literature for many decades, and legendary investor Benjamin Graham was advocating the purchase of value stocks 80 years ago.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.