Mauldin relays this essay by Ed Easterling who writes about a study by Dreman and Lufkin. The work, entitled Investor Overreaction: Evidence That Its Basis is Psychological," is an analysis of investor behavior that illustrates that perceptions are more important than the fundamentals.
Dreman and Lufkin look at a database for 4,721 companies from 1973 through 1998. Each year, they divide the database up into five parts, or quintiles, based on the companies' perceived market valuations. They separately study price to book value (P/BV), price to cash flow (P/CF), and the traditional price to earnings (P/E). This creates three separate ways to analyze stocks by value for any given year so as to remove the bias that might occur from using just one measure of valuation.
The results? Almost immediately upon creating the portfolio, the price performance comparisons change, and change dramatically. The in-favor stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.
How much better did the well-performing stocks do than the poorly performing stocks in the 10 years prior to creating the portfolios? The highest P/BV (price to book value) stocks outperformed the market by 187 percent. The lowest stocks underperformed the market by -79 percent for a differential of 266 percent! If you look at the P/CF (price to cash flow), the differential between the two is 172 percent.
Yet in the next five years, the hot stocks underperformed the market by -26 percent on a P/BV basis and -30 percent on a P/CF basis. The out-of-favor stocks did 33 percent and 22 percent better than the market, respectively. This is a huge reversal of trend.
Much more in the article.
