Risk, Mispricing, and Value Investing
Rent the article at a discountRent now
* Final gross prices may vary according to local VAT.Get Access
We evaluate the stock return performance of a modified version of the book-to-market strategy and its implications for market efficiency. If the previously documented superior stock return of the book-to-market strategy represents mispricing, its performance should be improved by excluding fairly valued firms with extreme book-to-market ratios. To attain this, we classify stocks as value or glamour on book-to-market ratios and accounting accruals jointly. This joint classification is likely to exclude stocks with extreme book-to-market ratios due to mismeasured accounting book values reflecting limitations underlying the accounting system. Using both 12-month buy-and-hold returns and earnings announcement returns, our results show that this joint classification generates substantially higher portfolio returns in the post-portfolio-formation year than the book-to-market classification alone with no evidence of increased risk. In addition, this superior stock return performance is more pronounced among firms held primarily by small (unsophisticated) investors and followed less closely by market participants (stock price <$10). Finally, and most importantly, financial analysts are overly optimistic (pessimistic) about earnings of glamour (value) stock, and for a subset of firms identified as overvalued by our strategy, the earnings announcement raw return, as well as abnormal return, is negative. These last results are particularly important because it is hard to envision a model consistent with rational investors holding risky stocks with predictable negative raw returns for a long period of time rather than holding fT-bills and with financial analysts systematically overestimating the earnings of these stocks while underestimating earnings of stocks that outperform the stock market.
- Ali, A., L. S. Hwang and M. A. Trombley, “Arbitrage Risk and the Book-to-Market Anomaly.” Journal of Financial Economics (2002) (forthcoming).
- Basu, S., “Investment Performance of Common Stocks in Relation to Their Price to Earnings Ratios: A Test of The Efficient Market Hypothesis.” The Journal of Finance 32, 663–682 (1977).
- Beaver, W., “The Information Content of Annual Earnings Announcements.” Journal of Accounting Research 6, 67–92 (1968).
- Brown, L. D. and M. S. Rozeff. “The Superiority of Analyst Forecasts as Measures of Expectations: Evidence from Earnings.” The Journal of Finance 33, 1–16 (1978).
- Brown, L. D., P. A. Griffin, R. L. Hagerman and M. E. Zmijewski. “Security Analyst Superiority Relative to Univariate Time Series Models in Forecasting Quarterly Earnings.” Journal of Accounting and Economics 9, 61–88 (1987).
- Chan, K., Y. Hamao and J. Lakonishok. “Fundamentals and Stock Returns in Japan.” The Journal of Finance 46, 1739–1764 (1991).
- Doukas, J. A., C. F. Kim and C. Pantzalis. “A Test of the Error-Expectations Explanation of the Value/Glamour Stock Returns Performance: Evidence from Analysts' Forecasts.” The Journal of Finance 57, 2143–2166 (2002).
- Fama, E. F. “Efficient Capital Markets: II.” The Journal of Finance 46, 1575–1617 (1991).
- Fama, E. F. and K. R. French, “The Cross-Section of Expected Stock Returns.” The Journal of Finance 47, 427–465 (1992).
- Griffin, J. and M. Lemmon. “Book-to-Market Equity, Distress Risk, and Stock Returns.” The Journal of Finance 57, 2317–2336 (2002).
- La Porta, R., J. Lakonishok, A. Shleifer and R. Vishny. “Good News for Value Stocks: Further Evidence on Market Efficiency.” The Journal of Finance 52, 859–874 (1997).
- Lakonishok, J., A. Shleifer and R. Vishny, “Contrarian Investment, Extrapolation, and Risk.” The Journal of Finance 49, 1541–1578 (1994).
- Mulford C. W. and E. E. Comiskey, The Financial Numbers Game: Detecting Creative Accounting Practices. New York: John Wiley & Sons, Inc. 2002.
- The New York Times. Cheap Stocks: Undervalued? June 8 (1978).
- O'Brien P. C. “Analysts' Forecasts as Earnings Expectations.” Journal of Accounting and Economics 10, 53–83 (1988).
- Piotroski, J. D., “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers.” Journal of Accounting Research 38, 1–41 (2000).
- Rosenberg, B., K. Reid and L. Ronald, “Persuasive Evidence of Market Inefficiency.” Journal of Portfolio Management 11, 9–17 (1985).
- Shumway, T., “The Delisting Return Bias in CRSP Data.” The Journal of Finance 52, 327–340 (1997).
- Sloan, R. G. “Do Stock Prices Fully Reflect Information in Accruals and Cash Flows About Future Earnings?” The Accounting Review 71, 289–316 (1996).
- Vassalou, M., “Default Risk in Equity Returns.” Working Paper. Columbia University (2001).
- The Wall Street Journal, Leading the News: AT&TCorp. Resorts To Unusual Motion: Reverse Stock Split-Market Capitalization Stays Constant, but Measure Would Boost Share Price. April 11 (2002).
- Risk, Mispricing, and Value Investing
Review of Quantitative Finance and Accounting
Volume 23, Issue 4 , pp 353-376
- Cover Date
- Print ISSN
- Online ISSN
- Kluwer Academic Publishers
- Additional Links
- market efficiency
- Industry Sectors