*As well as similar outperformance by price-to-cash flow and price-to-book value groups, although not shown.

lowing five years, lagging the market by 44.7% for the full period. As we can see, the differential between these two groups continues to increase significantly through the five years measured.

Is the entire difference in performance between the two types ol event triggers caused by earnings surprises? Did the original 8 18 8 change investor perceptions permanently? These questions are impossible to answer statistically at this time. We do know that investors were far too confident of their prognostications for both "best" and "worst" stocks, which led to best stocks being significantly overvalued and worst stocks being undervalued. When the dark or rose-colored glasses were removed, perhaps they were swapped for each other. As was also noted earlier, not one but a series of su rises may occur, some in later quarters, including 8 8 8 other than analysts forecast errors, that continue to reinforce the price revaluations.

What we can say, however, is that the enormous market outperformance by the low P/E group,* and the unde erformance by the highest quintile, indicate that there certainly had to be an event or a series of events that changed investor perceptions of what were "best" and "worst" stocks.

We also see the effects of reinforcing events. "Worst" stocks with negative su rises (low P/E negative) consistently outperform after the su rise quarter and for the next 19 quarters, while "best" stocks with positive su rises (high P/E positive) just as consistently unde erform. Although the differences are not as large as for "best" and "worst" stocks that experienced an event trigger in the 8 8 quarter, they are still major. "Best" stocks unde erformed the market by 27.1% in the full 5-year periods, while "worst" stocks outperformed by 18.2%. (The results for the other two value measures, price-to-cash flow and price-to-book, are again similar.)

The middle group is not shown. However, the long-term findings differ little from those at the end of the first year. Su rise has a major effect only in the quarter the news is announced. After that they perform in line with the market. Overall, positive and negative 8 8 8 cancel out, which is pretty much what we should expect, since being in the middle group shows that these stocks are not overvalued or undervalued by much.

A Surprising Opportunity

Contrarian investment Rule 10 positioned us in out-of-favor stocks to take advantage of analysts forecast errors and other 8 18 8. We can now go further in delineating the effect of surprises, which will prove an essential tool for the strategies to be oudined shortly. Rule 12 summarizes our findings on surprise:

RULE 12

(A) Surprises, as a group, improve the performance of out-of-favor stocks, while impairing the performance of favorites.

(B) Positive surprises result in major appreciation for out-of-favor stocks, while having minimal impact on favorites.

(C) Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.

(D) The effect of an earnings surprise continues for an extended period of time.

In this chapter, we have examined the role of su rise and have found that it consistendy favors stocks that investors believe have poor outlooks and just as consistently works against those believed to be la creme. Because of the frequency of earnings 8 8 8 demonstrated in die last chapter, we know it is a powerful force acting to reverse previous over- or undervaluations of stocks.

Just how important su rise and the resulting change in investor expectations are in developing powerful investment strategies will be shown front and center in the next chapter. Its time to roll up our sleeves and sit down at a table in the green wing.

part iii

THE WORLD OF

CONTRARIAN

INVESTING