First published at ValueWalk.com
“What happens when value and glamour stocks miss earnings expectation targets? Although, as expected, prices for glamour stocks have historically fallen, prices for value stocks have gone up — even when business fundamentals deteriorated, based on results found in this study of global equities. These results suggest the superior returns delivered by value stocks may not be a result of positive developments relative to expectations, but instead are more likely due to a gradual and corrective reversal of earlier overreaction and mispricing. This augments research by select scholars and provides fresh evidence explaining why value investing historically has been a successful long-term strategy.” — The Brandes Institute: The Role Of Expectations In Value And Glamour Stock Returns
In this part of the timeless reading series I’m looking at a study published by the Brandes Institute titled, “The Role Of Expectations In Value And Glamour Stock Returns.”
The Brandes Institute is the research arm of Brandes Investment Partners and regularly produces comprehensive research reports and videos on the topic of value investing, to help investors improve their investment process.
The Role Of Expectations In Value And Glamour Stock Returns looks at the markets relationship with glamour stocks versus value stocks.. In particular, the study shows that, for the most part, investors tend to be overoptimistic when it comes to expectations for growth with glamour stocks while underestimating value stocks’ potential. For example, the chart below shows the earnings growth of ten different (#1 to #10) companies across three years. The blue line is the multiple of earnings the market is willing to pay for each company.
Company #10 is expected to earn $50,000 cumulatively over the next three years. Company #1 is only expected to earn $19,000 over the same period, but the market is willing to pay 2.7x for the stock. Why? The market is willing to pay a high premium for growth. Company #1’s earnings are set to jump for $4,000 to $8,000 over three years, if this growth continues, the company will earn an equivalent, if not greater level of earnings than company #10 at some point in the future.
Investors are willing to pay more for glamour stocks. However, the Brandes Institute has found that the value/glamour cycle has been surprisingly persistent and bordering on the predictable over the long-term:
“We find a manifest chronology of overreaction, revision, sentiment shift, and multiple expansion in value stocks. In glamour stocks, a similar record of overoptimism, revision, disappointment, and multiple contraction existed…the purchase of value stocks tends to exploit, rather than succumb to, behavioral biases such as overoptimism, overreaction, and anchoring. These biases tend to push prices for securities above or below their inherent worth.” — The Brandes Institute: The Role Of Expectations In Value And Glamour Stock Returns
The report notes that these biases, which push prices to extremes in the short-term, dissipate over the long-term, and security prices revert away from extreme levels.
“As prices make this reversion, we believe there are ample opportunities for profit-minded investors who can remain rational and patient.” — The Brandes Institute: The Role Of Expectations In Value And Glamour Stock Returns
Why has value investing worked?
There’s plenty of evidence that supports the conclusion that value investing outperforms over the long-term. Why this has been the case seems to have something to behavioral errors. It’s often the case that investors associate value stocks with companies that continually disappoint. As a result, there’s a perception that owning them is a direct path to poor returns. On the flipside, there are stocks that have exceeded expectations in the past, appear to offer promising results, and whose stock prices have leapt with each positive development. Such stocks bring investors comfort and confidence. Accordingly, many investors have high expectations for such stocks and, “sentiment that borders on adoration.”
The study from the Brandes Institute is over 20 pages long, so I have to summarize the argument here.
Nevertheless, it’s clear from the study that investors of both value and growth disciplines are affected by emotional biases that impact the returns on value and growth stocks. For value stocks, after the initial event that caused a sell-off, after an average “cool down” period of 12 months, investors reverted to a less emotional and behaviorally biased disposition. A more balanced assessment of fair value ensued, and sentiment began to shift.
“Most notably in this study, company fundamentals needn’t immediately improve for this progression to begin. The reappraisal was a slow progression with bumps along the way, amounting to years of subsequent outperformance delivered by value stocks.”
.With growth stocks, it was found that overoptimism set expectations for growth at unattainably high levels — required to sustain already elevated stocks prices. Eventually, it then becomes increasingly difficult for a company to meet growth targets. At some point in the future, eventually, growth expectations will be missed (typically by a wide margin), and expectations will be revised downwards. Investors then become rattled, and prices fall leading to multiple contraction.
The numbers in the table below really do sum up the argument nicely.