CHAPTER 11 Profiting from Investor Overreaction

1. David Dreman, "A Bemard Barach Kind of Maricet," Forbes, August 30, 1982.

2. David Dreman, "The Buy of a Lifetime?" Forbes, June 7, 1982.

3. David Dreman, "The Setting Sun," Forbes, August 24, 1987.

4. W. Braddock Hickman, Corporate Bond Quality and Investor Experience (Princeton, N.J.: Princeton University Press for NBER, 1958).

5. Addnson, Thomas R., Trends in Corporate Bond Quality, NBER (New York: Columbia University Press, 1967).

6. The original Investor Overraction Hypothesis was updated in David Dreman and Michael Berry, "Overreaction, Underreaction and the Low P/E Effect," Financial Analysts Joumal (July/August 1995), pp. 21-30.

7. David Dreman, Eric Lufkin, and Nelson Woodard, "The Dark Side of the Moon," Dreman Foundation Working Paper, 1998.

8. The study also uses 10 years of prior data, so the statistical measurements commence in 1963, because 1963 is the first year data are available on the Compustat Monthly file.

9. We use medians rather than averages for profit margins, retum on equity, and the three growth rates within each quarter to avoid the problem of distorted numbers resulting from oudiers or negative numbers. The medians for each quarter, however, are averaged over each 5-year timespan.

10. We use 77 five-year periods between 1973 and 1996. A five-year portfolio is formed in each quarter between 1973Q1 and 1992Q1. We start in 1973 to allow for 10 years of back data to 1963, the first year data are available on the Compustat Monthly file.

11. As noted, we ran the same tests for price-to-eamings, price-to-cash flow, and price-to-dividends with reasonably similar results.

12. David Dreman and Michael Berry, op. cit.

13. Statistically diese figures are significant at die 0.1% level, which means there is less than a 1 in a thousand possibility they are chance.

14. R. Fuller, L. Huberts, and M. Levinson, "Retums to E/P Stoategies, Higgledy-Piggledy Growth, Analysts Forecast Errors, and Omitted Risk Factors," Joumal of Portfolio Management, Winter 1993, pp. 13-24.

15. This is not the same thing as fine-tuning eamings estimates quarter to quarter. Growth will not be in a straight line. A company growing at 15% over 5 years will have quarters of 5% growth and others of 25% growth. The heuristic biases we looked at in the last chapter, however-the inputs matching outputs, the failure to understand regression to the mean, etc.- make us unable to accept the unpredictability of analysts quarterly estimates. This is the reason I recommended in chapter 8 to look only at an approximate growth rate rather than attempting to fine-tune forecasts, because of the disastrous consequences of incorrect forecasts.

16. Academics have, I believe, unintentionally muddled the issue by confusing the fact that regression to the mean as contrarian stocks rise and fa-

vorites drop doesnt occur instantaneously, but over a time period of as much as 9 years, as was shown in chapters 8 and 9.

17. The information comes from a working paper I am currentiy completing in collaboration with Nelson Woodard (formerly of James Madison University) and Dr. Eric Lufkin.

18. We used all four contrarian measures to see if this effect worked in all cases-which it did.

19. Werner P.M. DeBondt and Richard H. Thaler, "Does die Stock Market Overreact?," Joumal of Finance 40 (1985), pp. 793-805. Wemer RM. DeBondt and Richard H. Thaler, "Further Evidence on Investor Overreaction and Stock Market Seasonality," Joumal of Finance 42 (1987), pp. 557-580.

20. Benjamin Graham, David Dodd, Sidney Cottie, and Charles Tatham, Security Analysis, 4th ed. (New York: McGraw-Hill, 1962), p. 179.

CHAPTER 12 Crisis Investing

1. As measured by the Keefe Bruyette Bank Index, a major research house specializing in banking and other financial stocks.

2. Money center banks seemed to us to have too many other unquantifiable bad loans in addition to those of real estate. We played it safe-perhaps too safe-because on tiie recovery many of the money centers, including Citibank and Chemical, went up as much as tenfold or more.

3. Prices are adjusted for the merger with National Bank of Detroit in 1995.

4. Duane P. Schultz, Panic Behavior (New York: Random House, 1964), p. 49.

5. The treasuries are redeemed at face value thus ensuring the interest payments were reinvested at the same abnormally high rates in the future. The longer the period tiie greater flie discount. As an example, a 30-year Treasury yielding 15% would be discounted by 15% for each year the bonds are outstanding. In this case the bonds would be redeemed at $100 but only cost the investor $1.51.

6. The inflation rate at the beginning of each quarter is based upon the latest reported inflation figures (Consumer Price Index) for the previous 12 months.

7. M. Rothbart and B. Park, Joumal of Personality and Social Psychology 50 (1986), p. 131. Paul Slovic, James H. Flynn, and Mark Layman, "Perceived Risk, Trust, and die Politics of Nuclear Waste," Science 254 (Dec. 13, 1991), pp. 1603-1607.

8. Paul Slovic, "Perceived Risk, Trust, and Democracy," Risk Analysis 13 (1993), pp. 675-682.

CHAPTER 13 An Investment for All Seasons

1. The book is currentiy being updated. Siegel took the retums from 3 sources: 1802 to 1870 from William Schwert, "Indexes of United States Stock Prices from 1802 to 1987," Journal of Business 63 (1990), pp.

399-426; 1871 to 1996 from the Cowles Indexes as reprinted in Robert Shiller, "Market Voladlity" (M.l.T. Press, 1989); and die 1926 to 1995 period from the CRSP value-weighted indexes of all New York, American, and Nasdaq stocks. See Jeremy J. Siegel, Stocks for the Long Run (New York: twin, 1994), pp. 3-4.

2. Edgar L. Smith, Common Stocks as Long-Term Investments (New York: Macmillan, 1925).

3. Jeremy J. Siegel, op. cit., pp. 3-4.

4. Irving Fisher, Foreward to Kenneth F. Van Strum, "Investing in Purchasing Power," Barrons (1925), p. vii.

5. Forbes, November 15, 1976.

6. William D. Nordhaus, "The Flexibility of Wages and Prices," Inflation Theory and Policy issue, American Economic Review 66 (May, 1976), pp. 59-64.

7. A 50% tax bracket is used, which was the bracket on $70,000 in taxable income in 1965. Tax rates ranged as high as 90% for much of die postwar period, only dropping with the Tax Reform Act of 1985. Tax adjustment assumes the following: stock dividends and T-bill and bond retums are taxed as income at die 50% rate until 1988, and at die 35% rate diereafter. Stock appreciation is taxed at an assumed capital gains rate of 25%. Stocks are assumed to have a tumover rate similar to the major market averages, roughly 100% every 33 years. This is implemented by calculating the average gain over the previous 30 years (or ren-ospective to 1946, whichever is shorter) and taking 3% of that amount as the taxable appreciation each year. The capital gains part of the calculation is far smaller than the income tax. Inflation adjustment is calculated after adjusting for taxes.

CHAFFER 14 What Is Risk ?

1. Standard deviation measures the ups and downs of an assets retums, irrespective of what the market is doing. Either way, beta and standard deviation measure past retums and nothing else.

2. J. Michael , "Efficient Markets, Index Funds, Illusion, and Reality," Journal of Portfolio Management (Fall 1977), pp. 5-20.

3. Ibid. See also Shannon Pratt, "Relationship Between Variability of Past Retums and Levels of Future Retums for Common Stocks, 1926-60," in Frontiers of Investment Analysis, 2nd edition (Scranton, PA: Intemational Textbook Company, 1971); Fischer Black, Michael Jensen, & Myron Scholes, "The Capital Asset Pricing Model: Some Empirical Tests," in Studies in the Theory of Capital Markets (New York: Praeger, 1972); R. Richardson Pettit & Randolph Westerfield, "Using die Capital Asset Pricing Model and the Market Model to Predict Securities Retums," Journal of Financial and Quantitative Analysis (Sept. 1974), pp. 579-605; Merton Miller and Myron Scholes, "Rates of Retum in Relation to Risk: A Re-Examination of Some Recent Findings," in Studies in the Theory of Capital Markets (New York: Praeger, 1972); Nancy Jacob, "The Measure-