Contrarian Investment , Extrapolation , and Risk

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. FORMANY 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 (19771, 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) 'Lakonishok is from the University of Illinois, Shleifer is from Harvard University, and Vishny is from the University of Chicago. We are indebted to Gil Beebower, Fischer Black, Stephen Brown, K. C. Chan, Louis Chan, Eugene Fama, Kenneth French, Bob Haugen, Jay Ritter, Rene Stulz, and two anonymous referees for helpful comments and to Han Qu for outstanding research assistance. This article has been presented at the Bcrlrcley Program in Finance, University of California (Berkeley), the Center for Research in Securities Prices Conference, the University of Chicago, the University of Illinois, the Massachusetts Institute of Technology, the National Bureau of Economic Research (, New York University, Pensions and Investments Conference, the Institute for Quantitative Research in Finance (United States and Europe), Society of Quantitative Analysts, Stanford University, the University of Toronto, and Tel Aviv University. The research was supported by the National Science Foundation, Bradley Foundation, Russell Sage Foundation, the National Bureau of Economic Research Asset Management Research Advisory Group, and the National Center for Supercomputing Applications, University of Illinois. The Journal of Finance 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"' 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 bookto-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 'What we call "naive strategies" are also sometimes referred to as "popular models" (Shiller (1984)) and "noise" (Black (1986)). Contrarian Investment, Extrapolation, and Risk 1543 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. We examine the most obvious implication of the contrarian model, namely that value stocks outperform glamour stocks. We start with simple onevariable classifications of glamour and value stocks that rely in most cases on measures of either past growth or expected future growth. We then move on to classifications in which glamour and value are defined using both past growth and expected future growth. In addition, we compare past, expected, and future growth rates of glamour and value stocks. Our version of the contrarian model predicts that differences in expected future growth rates are linked to past growth and overestimate actual future growth differences between glamour and value firms. We find that a wide range of value strategies have produced higher returns, and that the pattern of past, expected, and actual future growth rates is consistent with the contrarian model. The second question we ask is whether value stocks are indeed fundamentally riskier than glamour stocks. To be fundamentally riskier, value stocks must underperform glamour stocks with some frequency, and particularly in the states of the world when the marginal utility of wealth is high. This view of risk motivates our tests. We look at the frequency of superior (and inferior) performance of value strategies, as well as at their performance in bad states of the world, such as extreme down markets and economic recessions. We also look at the betas and standard deviations of value and glamour strategies. We find little, if any, support for the view that value strategies are fundamentally riskier. Our results raise the obvious question of how the higher expected returns on value strategies could have continued if such strategies are not fundamentally riskier? We present some possible explanations that rely both on behavioral strategies favored by individual investors and on agency problems plaguing institutional investors. The next section of the article briefly discusses our methodology. Section I1 examines a variety of simple classification schemes for glamour and value stocks based on the book-to-market ratio, the cash flow-to-price ratio, the earnings-to-price ratio, and past growth in sales. Section I1 shows that all of these simple value strategies have produced superior returns and motivates our subsequent use of combinations of measures of past and expected growth. Section I11 then examines the performance of value strategies that are defined using both past growth and current multiples. These two-dimensional value strategies outperform glamour strategies by approximately 10 to 11 percent per year. Moreover, the superior performance of value stocks relative to glamour stocks persists when we restrict our attention to the largest 50 percent or largest 20 percent of stocks by market capitalization. Section IV provides evidence that contrarian strategies work because they exploit expectational errors implicit in stock prices. Specifically, the differences in expected growth rates between glamour and value stocks implicit in their 1544 The Journal of Finance relative valuation multiples significantly overestimate actual future growth rate differences. Section V examines risk characteristics of value strategies and provides evidence that, over longer horizons, value strategies have outperformed glamour strategies quite consistently and have done particularly well in "bad" states of the world. This evidence provides no support for the hypothesis that value strategies are fundamentally riskier. Finally, Section VI attempts to interpret our findings.