Value Strategies: Contrarian Investment, Extrapolation, And Risk

Josef Lakonishok, Andrei Shleifer, and Robert W. Vishny*

December 1994

Abstract

For many years, scholars and investment professionals have argued that value strategies outperform the market. These value strategies call for buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value. While there is some agreement that value strategies produce higher returns, the interpretation of why they do so is more controversial. This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.

Value Strategies: Contrarian Investment, Extrapolation, And Risk – Introduction

FOR MANY YEARS, SCHOLARS and investment professionals have argued that value strategies outperform the market (Graham and Dodd (1934) and Dreman (1977)). These value strategies call for buying stocks that have low prices relative to earnings, dividends, historical prices, book assets, or other measures of value. In recent years, value strategies have attracted academic attention as well. Basu (1977), Jaffe, Keim, and Westerfield (1989), Chan, Hamao, and Lakonishok (1991), and Fama and French (1992) show that stocks with high earnings/price ratios earn higher returns. De Bondt and Thaler (1985, 1987) argue that extreme losers outperform the market over the subsequent several years. Despite considerable criticism (Chan (1988) and Ball and Kothari (1989)), their analysis has generally stood up to the tests (Chopra, Lakonishok, and Ritter (1992)). Rosenberg, Reid, and Lanstein (1984) show that stocks with high book relative to market values of equity outperform the market. Further work (Chan, Hamao, and Lakonishok (1991) and Fama and French (1992)) has both extended and refined these results.

Finally, Chan, Hamao, and Lakonishok (1991) show that a high ratio of cash flow to price also predicts higher returns. Interestingly, many of these results have been obtained for both the United States and Japan. Certain types of value strategies, then, appear to have beaten the market.

While there is some agreement that value strategies have produced superior returns, the interpretation of why they have done so is more controversial. Value strategies might produce higher returns because they are contrarian to “naive”1 strategies followed by other investors. These naive strategies might range from extrapolating past earnings growth too far into the future, to assuming a trend in stock prices, to overreacting to good or bad news, or to simply equating a good investment with a well-run company irrespective of price. Regardless of the reason, some investors tend to get overly excited about stocks that have done very well in the past and buy them up, so that these “glamour” stocks become overpriced. Similarly, they overreact to stocks that have done very badly, oversell them, and these out-of-favor “value” stocks become underpriced. Contrarian investors bet against such naive investors. Because contrarian strategies invest disproportionately in stocks that are underpriced and underinvest in stocks that are overpriced, they outperform the market (see De Bondt and Thaler (1985) and Haugen (1994)).

An alternative explanation of why value strategies have produced superior returns, argued most forcefully by Fama and French (1992), is that they are fundamentally riskier. That is, investors in value stocks, such as high book-to-market stocks, tend to bear higher fundamental risk of some sort, and their higher average returns are simply compensation for this risk. This argument is also used by critics of De Bondt and Thaler (Chan (1988) and Ball and Kothari (1989)) to dismiss their overreaction story. Whether value strategies have produced higher returns because they are contrarian to naive strategies or because they are fundamentally riskier remains an open question.

In this article, we try to shed further light on the two potential explanations for why value strategies work. We do so along two dimensions. First, we examine more closely the predictions of the contrarian model. In particular, one natural version of the contrarian model argues that the overpriced glamour stocks are those which, first, have performed well in the past, and second, are expected by the market to perform well in the future. Similarly, the underpriced out-of-favor or value stocks are those that have performed
poorly in the past and are expected to continue to perform poorly. Value strategies that bet against those investors who extrapolate past performance too far into the future produce superior returns. In principle, this version of the contrarian model is testable because past performance and expectation of future performance are two distinct and separately measurable characteristics of glamour and value. In this article, past performance is measured using information on past growth in sales, earnings, and cash flow, and expected performance is measured by multiples of price to current earnings and cash flow.

Value Strategies Contrarian Investment

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