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49

Whatever Took So Long?

Given the weight of the evidence, youd think that contrarian value approaches would have captured the imagination (and wallets) of investors long ago. By the 1990s, perhaps we should have been looldng back at the golden age, when only a handful of pioneers reaped the rewards and

Table 7-5

Performance of Stocks According to P/E Ranking April 1957-March 1971

Average Annual

BETA

Quintile

Return (%)

(systematic risk)

A (highest)

1.1121

1.0579

1.0387

11.7

0.9678

13.6

0.9401

E (lowest)

16.3

0.9866

a = highest P/E quintile

a* = highest P/E quintile, excluding stocks with negative eamings

•Source: Sanjoy Basu, "Investment Performance of Common Stocks in Relation to Their 1rice/Earnings Ratios: A Test of the Efficient Market Hypothesis," Journal of Finance, 32 (June 1977) p. 67.

companies that had year-ends of December 31 and tumed over the portfolios annually, using prices on April 1 of the following year. Like most of the previous studies, he divided the stocks into quintiles according to P/E rankings. The results (again using total retum) are shown in Table 7-5.

Basus conclusions were similar to all the others: "The average annual rates of retum decline (to some extent monotonically) as one moves from low P/E to high P/E portfolios."

Basu found, as we did, that the low P/E stocks provided superior retums, and were also somewhat less risky. Again, using his words: "However, contrary to capital market theory, the higher retums on the low P/E portfolios were not associated with higher levels of systematic risk; the systematic risks of portfolios D and E [the lowest] were lower tiian those for A, A* and [the highest] ."

This and subsequent work, updated and adjusted for previous criticisms through the mid-1980s, added many links to a chain extending over 40 years, documenting the superior performance of low P/E issues.



only the favored few knew what a powerful tool these strategies were. But thats not the case. Even today, contrarians are a distinct minority- and, remarkably, are likely to remain so.

One reason for the situation is historical. Youll remember how EMH swept the land and banished the heathen from Wall Street. As the new orthodoxy, EMH had everything to gain from a long and prosperous reign. Not to mention a good deal to lose if competing ideas shouldered their way onto the Street. That, of course, is as much innate human psychology, as any of the other crowd reactions we will examine.

In the late 1970s and through most of the 1980s this work did not stand tall with efficient market advocates, particularly those residing at the high shrine of market fundamentalism, the University of Chicago. As a leading heretic, I often experienced the wrath of the true believers. My work came under sharp attack, and my Forbes columns even had the distinction of being assigned to classes of students to hammer apart. On several occasions my unfortunate editors had sets of twenty or more letters attacking the work, which they on occasion good-naturedly published.

With the publication of my books and additional articles the barrage intensified. Letters attacked every part of the findings, saving some choice remarks for the author.

None found any statistical fault with the work, but questioned the Neanderthal beliefs of a writer who couldnt understand the overwhelming sweep and beauty of efficient market thinking.

When I submitted a paper reporting the findings to the Financial Analysts Journal, it was not accepted or rejected, but left in some purgatory reserved for ideas that dont fit the prevailing paradigm.

I presented a low P/E paper at a 1984 conference of leading psychologists and economists, only to watch a leading exponent of EMH slam my paper on the table and bark that "these results are impossible." (The slammer is now writing a paper on contrarian strategies.)

The low-P/E anomaly was large enough to continue to attract attention from academe and Wall Street. In academe the work was also dismissed using the old academic standby, risk measurement. Low-P/E stocks might provide higher retums, but they were far more risky, said the critics. Rational investors accepted the higher risk only by demanding higher retums.



The Great Discovery

Through the 1980s, Wall Street became increasingly interested in contrarian investment strategies. With continuing improvements in databases, confirmation that these sti-ategies worked grew sti-onger. And stronger yet.

In 1983, two researchers wrote a low P/E article, similar to my paper that the joumal refused to publish. The academics did not reference my work (possibly to avoid controversy with the efficient market theorists), although they consulted me on numerous occasions in writing their paper. The tide continued to gain strength. Dennis Stattman and Rosenberg, Reid, and Lanstein, for example, found that low price-to-book value outperformed high price-to-book value and the market. At the same time, the evidence mounted that beta had no value as a predictor of stock prices. Though the economic fundamentalists attempted to rationalize away their existence for almost three decades, these exasperating methods just did not have the good manners to disappear. That contrarian strategies worked and beta did not was a death knell for efficient markets.

What was a poor aposde of the new religion to do? Since neither of these results could be denied, the answer of course was to be the first to discover them. That is exactly what Eugene Fama, the apostle of efficient markets, did. In the 1990s, academics firmly planted their own flag on the newfound world of contrarian strategies.

In a revolutionary paper-that boldly thmst thirty years into the past-Professor Fama discovered precisely what Francis Nicholson, other researchers of the 1960s, Sanjoy Basu, Stattman, Rosenberg, et al., and I had found in the seventies and eighties: contrarian strategies worked. Worse yet, beta didnt. The three decades of stating that contrarian strategies provided better retums because they were rislder were swept away by the discovery that beta, the risk measure the apostle and his disciples used, was valueless.

To be fair, Fama and French do reference Basu, Stattman, and Rosenberg, et al., in passing, as well as Ball," who argued low P/E is a catchall for all risk that cannot be explicidy separated or even found. Balls explanation was widely accepted by efficient marketers for years.

Balls paper is not unlike the phlogiston theory of heat popular in the eighteenth century. According to the theory, some elements are more combustible than others because they contain more phlogiston, while others are less so because they contain smaller amounts. Phlogiston was weightless, odorless, and could not be detected, but nevertheless it was there. How else could combustion occur (or how could low P/E strate-



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