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50

I Low P/BV □ Middle P/BV □ High P/BV □ Market

Source of data: E.Faina and K. French, "The Cross-Section of Expected Stock Returns, Journal ofFinance, 47 (June 1992): pp. 427-465.

gies beat the market if they were not risky, regardless of the fact that said risk could not be detected)? Circular and fallacious reasoning, yes, but Ball, Fama, et al. used precisely this logic to defend EMH. In both cases, the theorists defend themselves against phenomena they cannot explain through the creation of ingenious fudge-factors. (The efficient market hypothesis, as we will see in the final chapter, has a grab bag full of these defenses.)

The landmark 1992 paper by Eugene Fama, coauthored with Kenneth French, showed that the lowest price-to-book value ratios, price-to-eamings ratios, and small capitalization stocks provide the highest retums over time.* Figure 7-2 provides Fama and Frenchs price-to-book value results. The sample used an average of 2,300 companies annually from the Compustat tapes. Stock retums are shown in quintiles by price-to-book value (P/BV), which are recast annually. The highest price-to-book value stocks are in column 3 and the lowest or most unpopular in column 1. As the figure indicates, low price-to-book value (20.5%) provides more than double the annual retum of high P/BV for the entire

Figure 7-2

Fama & French 1992

CRSP & Compustat Data 1963-1990 Price/Book Value



* We will look at the question ofhow to assess risk in more detail in chapter 14.

sample through the life of the study. Low P/BV outperforms die maricet by 4.6% annually on average, while high P/BV unde erforms by 5.7%.

Fama downplayed die low P/E effect in an interview, saying the reason low P/E stocks do well is that so many of them are die same stocks as are in the price-to-book value sample. One could say precisely the opposite and be just as correct. As Fortune concluded, "Some might call that academic hairsplitdng." Since Fama had resisted the low-P/E effect for almost thirty years, another not unreasonable conclusion is, it may be a symptom of academic face-saving.

What about beta, the "phlogiston factor" used to discredit the higher retums of low P/E and low price-to-book value? Beta was no longer defensible. Fama and French found no reladonship between beta and retum. EMH gospel asserted that a stock with a higher beta should provide higher retums; it did not. Nor did lower-risk stocks provide inferior results. According to Fama and French, beta did not account for the disparity in retum between favored and unfavored stocks.*

The blessing of contrarian strategies by the high priests at Chicago now allowed the investment world to eat what had been forbidden fmit. Value strategies were looked at with new reverence, and value indexes were introduced by Standard and Poors, Frank Russell, and scads of other consultants.

Fortified by Professor Famas findings, odier researchers now found the courage to spring boldly into the past. Lakonishok, Shleifer, and Vishny, in late 1994, went a step further and "discovered" contrarian strategies in an article published in the Journal of Finance, "Contrarian Investment, Extrapolation, and Risk." The three professors used the thousands of companies on the Compustat tapes (the CRSP tapes were used for pricing) from April 1968 to April 1990, selecting only stocks on the NYSE or the AMEX to help correct for stock selection bias.

Lakonishok et al. measured the performance of the three important value strategies weve looked at and came up with similar results. Figure 7-3 shows the annual performance of stocks as measured by their P/E ratios. The results were calculated by recasting the retums of the large sample annually. Low P/Es significantly outperform high P/Es and the market averages. The same is tme for the retums of price-to-cash flow, and price-to-book value (not shown). This all adds up to an overwhelming case for the superior performance of contrarian strategies.



S 15%

17.8%

12.4%

I Low P/E Middle P/E □ High P/E □ Market

Source: Adapted from J. Lakonishok, A. Shleifer, and R. Vishny, "Contrarian Investment,

Extrapolation and Risk," Journal ofFinance, 49 (December 1994), pp. 1541-1578.

The Last Nail

These pesky contrarian strategies, then, have proved watertight for a lot longer than the efficient market hypothesis. In fact, they have been getting stronger with each passing year.

The good news for you is that this wave of discoveries provides strong evidence that there are consistent, high-odds ways to beat the market. The methods also protect your capital in a bear market, as Ill demonstrate shortly. It sounds a little like having your cake and eating it, too, but there are good reasons why these strategies continue to work for disciplined investors. (Thats why the Hst of 41 rules-all based on investor psychological failings-is a critical reminder.)

As we have seen, there are a number of contrarian strategies besides low P/E that work just fine. Low price-to-cash flow and low price-to-book value are both potent tools for beating the market. Some of my recent work demonstrates that buying stocks with high dividend yields has been successful in outperforming the averages. Beating the market

Figure 7-3

Lakonishok, Shleifer, and Vishny 1994

CRSP and Compustat Data 1968 - 1990 Price/Earnings



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