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:
- 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.