Toute la Difference

Figure 6-lb looks at the effects of 8 18 on stocks measured by price-to-cash flow. The chart is nearly identical to Figure 6-la for the 8 8 quarter and the full year. The lowest price-to-cash flow group again strongly outperforms the market in both cases. Similarly, the favorite stocks, the 20% of highest price-to-cash flow issues, significantly un-de erform the average in both periods, while the middle group is almost unaffected by 8 8 . By this value measurement, 8 8 8 in analysts forecasts once again work powerfully in favor of the most unwanted group and against the most highly regarded stocks.

Figure 6-1 demonstrates the effects of 8 8 measured by price-to-book value. Remember, the higher the price-to-book value ratio, the more popular a stock is, and vice-versa. Again, the results are similar. Favorite stocks unde erform in the 8 18 quarter (-0.7%) and do even worse for the full year (-3.0%). Stocks that are unpopular outperform in the quarter (+1.0%) and take off nicely over the full year (+4.0%). Once more, the middle 60% of stocks are minimally affected by eamings 8 8 8.

What is remarkable is not only that out-of-favor stocks outperform by all three measures, but how similar the performance is regardless of the value measure we choose. We thus begin to see a path to making money in the stock market. Eamings 8 18 8, whether positive or negative, affect favored and out-of-favor stocks very differently. $ 18 consis-

quarter, and that differential increases to 3.5% for the full year, some 22% under the market.

Surprise does not have much effect on the 60% of stocks that make up the middle grouping. These stocks are not normally over- or undervalued much. As chart 6-1 a shows, the stocks are down by less than one quarter of 1 percent in the 8 18 quarter. A year after the 8 18 there is a small negative (-0.5%) effect.

However, the difference in the effects of 8 18 on "best" and "worst" stocks is large and increasing over time. Worst stocks outperformed best stocks by 2.5% in the 8 18 quarter, then steadily rose to 7.7% by the end of the year.

To summarize. Figure 6-1 a reveals that earnings 8 18 8 do not affect the retums of the various P/E groups the same way. $ 8 works to the benefit of low P/E stocks and against the high P/E group, while it has a nominal effect on stocks in the middle group. Is there any difference in how 8 8 affects stocks ranked by the other value measures?

tently results in above-average performance for out-of-favor stoclcs and below-average performance for favored stoclcs. Has the lightbulb gone on? We can find illumination in Contrarian Investment Rule 10:

RULE 10

Take advantage of the high rate of analyst forecast error by simply investing in out-of-favor stocks.

Conversely, buying favorites and being exposed to the frequent surprises will cost you money. How much money? A look at the magnitude of this surprise effect is a sobering experience, as Ill demonstrate shortly.

The Effect of Positive Surprises

Examine Figure 6-2. It shows the effects of positive 8 8 5 on stocks in our high, low, and middle groupings, by P/E. As you can see, posidve su rise galvanizes the lowest 20% of stocks. In the su rise quarter, they outperform the averages by 3.6%, or two and a half times the quarterly retum of the market over almost 80 years. For the full year, the lowest P/E quintile charges ahead of the market by a remarkable 8.1%. Think about this for a moment. Since the late 1920s, stocks have returned about 10.5% annually. Owning out-of-favor stocks that have positive su rises will fetch you almost double the market retum over time. Well look at the reasons for this astonishing increase in return shortly.

Positive su rise also has a noticeable, but more subdued effect on stocks in the middle quintiles. The middle group outperforms the market by 2.3% in the quarter. But the above-market retum increases by less than 1% forthe remaining nine months. They dont continue to steadily appreciate. Their reaction to positive su rise is moderate, probably because they are the least under- or overvalued.

Finally, positive su rises have far less effect on favorite stocks. Stocks that receive positive su rises outperform the market by 1.7% in the 8 8 quarter. The "best" stocks do not keep improving, however, as with the case of the low P/E group. Rather, they decline slightly over the next nine months.

Although not shown, the lowest 20% of stocks ranked by price-to-cash flow or price-to-book value are remarkably similar. Both 8 1 outperform the market for 8 8 quarter and for the full year, and rout the most favored stocks for the two periods. The result for the 60% of

10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0%

Figure 6-2

Price/Earnings Positive Surprises

Compustat 1500 1973 - 1996

8 8 Quarter

Full Year

I Low P/E Quintile Middle Quintiles □ High P/E Quintile

0% = Market Return (3.6% quarterly, 15.6% annually) All figures are market adjusted.

Stocks in middle quintiles is close to that of the middle group of P/Es in Figure 6-2.

Why do positive 8 18 8 for "best" stocks cause only a moderate rise in the 8 18 quarter? Since analysts and investors alike believe they can precisely judge which stocks will be the real winners in the years ahead, a positive 8 18 does little more than confirm their expectations. Its no great shakes-the top companies should have rapidly growing revenues, market share, and eamings. By the end of the year, therefore, the effect of the 8 18 almost disappears.

Investors react very differently to positive 8 18 8 for out-of-favor companies, however, no matter which of the three value yardsticks by which we measure them. Investors put these stocks into the lowest category precisely because they expect them to continue to mope. These are the dogs of the investment world; they deserve minimal valuations. A positive eamings 8 18 for a stock in this group is an event. Investors sit up and take notice.