Purpose:

o This article provides evidence that value strategies yield higher returns because these
strategies exploit the sub-optimal behaviour of the typical investor and not because
these strategies are fundamentally riskier.

Themes:
 Value strategies outperform the market:
o These strategies call for buying stocks that have low price relative to earnings,
dividends, historical prices, book assets, or other measures of value
o Stocks with high earnings/price ratios earn higher returns
o Extreme losers outperform the market over years
o Stocks with high book relative to market values of equity outperform the
market

Why do value strategies produce superior returns?

 The interpretation of why they have done so is more controversial
 Some reasons include:
o They are contrarian to “naïve” strategies followed by other investors. Naïve
is also referred to popular models.
 Naïve strategies include:
 Extrapolating past earnings growth too far into the future
 Assuming a trend in stock prices
 Overreacting to good or bad news
 Equating a good investment with a well-run company
irrespective of price
 Because contrarian investors invest disproportionately in stocks that
are underpriced and underinvest in stocks that are over-priced, they
outperform the market.
 Exploit the mistakes of naïve investors.
o They are fundamentally riskier (Fama and French, 1992).
 Bear higher fundamental risk of some sort and their higher average
returns are simply compensation for this risk.
o This remains an open question

Two types of stocks:

 Growth stocks – stocks that have done well in the past and investors buy them up,
these stocks become overpriced
o Defined by LSV as a stock with high growth in the past and high expected
future growth
o Low B/M
 Describe a company with a lot of intangible assets i.e. R&D capital
  Attractive growth opportunities that do not enter the BV but M price
 Value stocks- overreact to stocks that have done badly, oversell them, and these out-
of-favour value stocks become underpriced
o Defined by LSV as a stock that must have had low growth in the past and be
expected by the market to continue growing slowly.
o High B/M

Findings:
 A wide range of value stocks have produced higher returns, and that the pattern of
past, expected, and actual future growth rates is consistent with the contrarian model.
 Do not find support that value strategies are fundamentally riskier.
 Value strategies based jointly on past performance and expected future performance
produce higher returns than strategies based exclusively on the B/M ratio.
 The value strategy has not been fundamentally riskier than the glamour strategy

Three propositions:
1. Investment strategies that involve buying out-of-favour (value) stocks have
outperformed glamour strategies over their sample period.
2. A likely reason that these value strategies have worked so well relative to the glamour
strategies is the fact that the actual future growth rates of earnings, cash flow, etc. of
glamour stocks relative to value stocks turned out to be much lower than they were in
the past. Market participants appear to have consistently overestimated future
growth rates of glamour stocks relative to value stocks.
3. Value strategies appear to be no riskier than glamour strategies. The reward for
bearing risk does not seem to explain higher average returns on value stocks than
glamour stocks.

Still unclear as to why value stocks perform better.

Small vs. Large firms

 Larger firms are of greater interest for implementable trading strategies. Larger firms
are more closely monitored and therefore may be more efficiently priced.