Contrarian Strategies and Investor Expectations: The U.K. Evidence

The rationale for the superior performance of contrarian investment strategies remains a matter of lively debate. The orthodox view maintains that such strategies generate higher returns because they are fundamentally riskier, whereas the behaviorists suggest that the superior performance is a result of systematic errors in investors' expectations about the future. If the behavioral view is accepted, then the debate centers on what the underlying source(s) of such errors are—naive extrapolation of past performance or biased analysts' earnings forecasts. Using stocks listed on the London Stock Exchange, we found evidence consistent with the view that errors in expectations are more likely to be a result of biases in analysts' earnings forecasts than naive extrapolation of the past. We also found that positive and negative earnings surprises have an asymmetrical effect on the returns of low- and high-rated stocks. Positive earnings surprises have a disproportionately large positive impact on stocks that are priced low relative to four measures of operating performance; negative surprises have a relatively benign effect on such stocks. Evidence from the major stock markets suggests that over long time intervals, contrarian strategies have generated significant abnormal returns. Understanding the underlying drivers of such an apparently successful investment strategy is vital for designing appropriate processes to exploit it and for detecting any long-term behavioral changes that may influence its effectiveness. But in spite of the apparent robustness of contrarian strategies, the underlying rationale for their success remains a matter of lively debate, both in academic and practitioner communities. The orthodox view maintains that contrarian strategies generate higher returns because they are fundamentally riskier, whereas the behaviorists argue that the superior performance is a result of systematic errors in expectations about the future. The identity of the source(s) of such errors is the subject of a separate controversy. One source proposed in the literature is naive extrapolation of past performance; that is, investors base their decisions on extrapolations of companies' recent sales and earnings growth. The second source proposed is errors in analysts' forecasts of long-term earnings growth. We studied the drivers of the success of contrarian investing by using data on stocks traded on the London Stock Exchange in the past 30 years. First, we built portfolios based on five definitions of performance—book-to-price (B/P), earnings-to-price (E/P), cash flow to price (C/P), three years' past EPS growth, and three-year past cumulative rate of return—and examined the evolution of profitability and price performance around the time of portfolio formation. We tested the implication of the extrapolation hypothesis that the returns of stocks with low B/Ps, E/Ps, and C/Ps (growth stocks) and attractive past (three years) EPS growth will be lower than the returns of portfolios with similar valuation characteristics but poor past earnings performance (temporary losers). We also tested the related idea that if investors are naively extrapolating the past, the portfolios composed of stocks with high B/Ps, E/Ps, and C/Ps (value stocks) and low past-EPS-growth rates should outperform temporary winners (stocks with high B/Ps, E/Ps, and C/Ps but also high past EPS growth). We found that the market does not incorrectly extrapolate the past and that stock prices do not reflect the naive extrapolation of past earnings growth or returns. Second, we assessed the relationship between EPS forecasts, earnings surprises, and contrarian strategies. In contrast to previous studies of U.S. data, we did not attempt to investigate whether stock prices incorporate analysts' forecasts of long-term earnings growth. We concentrated on analysts' errors for high (low) -B/P, -E/P, and -C/P stocks immediately after portfolio formation as potential candidates for explaining their postformation return difference. Although we found larger average forecast errors for contrarian-based strategies, we nevertheless found more positive surprises, particularly among high-E/P and high-C/P portfolios. Third, we provide a direct test of the impact of earnings surprises on contrarian strategies. If investors are making systematic errors in their expectations, they are expecting growth stocks to do well in the future and value stocks to do poorly. Therefore, the market may regard a positive surprise to be good news for value stocks, and the surprise will have a more positive impact on value stocks' returns than on the returns of other stocks. Similarly, the market may consider a negative surprise to be bad news for growth stocks; thus, the surprise will have a negative impact on the growth stocks' returns while having only a minor effect on the returns of other stocks. Our regression results did indeed suggest that positive and negative surprises have asymmetrical effects on the returns of value and growth portfolios in favor of the value stocks in a fashion that is consistent with the errors-in-expectations hypothesis.