Saturday, February 23, 2013

Paper: "Contrarian Investment, Extrapolation, and Risk"

This paper, Contrarian Investment, Extrapolation, and Risk by Josef Lakonishok, Andrei Shleifer, and Robert Vishny, was also written up on the Greenbackd blog. Shleifer puts out some good papers, and he and his wife are actually in the hedge fund industry.

The authors provide evidence that value strategies have higher returns because they exploit other investors' mistakes, not because they are fundamentally riskier (which is the EMH view). They define value strategies as "buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value."

There is a bias among many investors in favor of glamour stocks that have performed well in the past and are expected to perform well in the future. The behavioral, non-EMH hypothesis is that value stocks are mispriced because they have performed poorly in the past and therefore are expected to continue to perform poorly. Contrarian value investors are in the business of betting on the value stocks and, either explicitly or implicitly, against the glamor stocks.

Pretty much everyone agrees that this works, but EMH advocates believe that the value investors are taking greater risk. The problem for EMH advocates is that they are essentially arguing that risk is increasing as prices go down, and vice versa, when any businessman could tell you that the opposite is the case.

The EMH advocates have to argue that, of course, or the value anomaly would sink their ship. Meanwhile, remember the great paper from last year (a 5/5) which hypothesized that "agency issues create demand by professional investors and their clients for highly volatile stocks. This demand overvalues the prices of volatile stocks and suppresses their future expected returns." It found that low risk stocks outperform within all observable markets of the world. This paper has only 2,000 downloads in the last year! Something like 40k people sit for the Level I CFA exam!

Anyway, the Contrarian Investment paper tests the idea that value stocks are fundamentally "riskier" by measuring the frequency of inferior performance by value strategies as well as their performance in market crashes and recessions. They find nothing to suggest that value strategies are fundamentally riskier.

A variety of strategies that involve buying value/out-of favor stocks have outperformed glamour strategies over recent market history. Also, there are optimism/estimation errors being made by the market and other investors generally, where they consistently overestimate the prospects of the glamor stocks relative to value stocks.

One major behavioral problem that the authors point out is that people "just equate well-run firms with good investments, regardless of price." This is obviously common with retail investors (when they aren't buying worthless stocks), but institutional investors like the glamour stocks because they appear to be prudent and are easy to explain.

Many institutional investors also seem to prefer momentum strategies that can make money now, rather than value strategies that take "too long" to work - which causes career risk. Just another example of the ever present agency problem.

The problem with the glamour stocks that causes subsequent underperformance is that investors get "too excited about a performance of a company that is doing well for a prolonged time period, as did Cisco, Microsoft, etc., [and] extrapolate past performance too far into the future and push prices up too high".

That describes Apple perfectly. How do we know that they will continue to make $40 billion a year? What makes them immune from competition? I like the Einhorn preferred stock idea, but I think Apple was the wrong company to try it with. And when he says on slide 43 that it's "difficult to imagine Apple burning cash or losing money" I see a troublesome failure of imagination and recency bias.

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