Thesis written by
Rebekka Petersen
&
Philip Arnstedt
Copenhagen Business School
Finance & Strategic Management
Institute of Finance
Counseling by Ole Risager
October 2010
Executive Summary
Contrarian investment strategies have been present for decades, generating superior returns for the investors. Investors who follow the contrarian investment strategy are known as value investors. Value investors follow a strategy where stocks with low prices relative to book value and other measures of fundamental value are bought, to be able to generate abnormal returns.
The magnitude of the value premium is huge and it has been persistent on the American stock market. We have investigated how the value premium performs in general and around recessions in order to draw conclusions on the strategy that a value investor should follow when the economy is faced with a recession. We have found that the value premium, sorted on Book-to-Market values, exists throughout our period of investigation from 1947 until 2009 on the American stock market, generating an average quarterly premium of more than 3 % for the investor. We have also found that the value premium is skewed towards the right, implying that value stocks have a higher upside potential than growth stocks.
On average in the four quarters prior to recessions the quarterly value premium is 0.92 %. During the 11 different recessions in our time period of investigation, we found that the average quarterly value premium is 1.37 %. Therefore, we come to the conclusion that value stocks perform worse prior to recessions and during recessions than on average. We have also found that in the four quarters after recessions the value premium is positive in ten out of 11 different recessions, which indicates that there is a clear tendency towards higher returns on value stocks after recessions. The average quarterly value premium is 5.95 %.
We have established that the standard finance theory does not explain the value premium. The traditional systematic risk measure, beta, is on average lower for our value portfolio than for our growth portfolio. This completely contradicts the traditional finance theory. We believe that the explanation is found within the behavioral finance theory. Investors are subject to several kinds of decision biases, which originate from limited cognitive capacity. We expect that as long as naive investors are challenged by limited cognitive capacity and keep extrapolating past performance into the future the value premium will continue to exist, hence generating possibilities for the value investors.
Introduction
For many years, contrarian investment strategies has been utilized and discussed. Recent, financial researchers have found statistical evidence of a superior return on these strategies. Investors who follow the contrarian investment strategy are often known as value investors because they attempt to buy stocks that are underpriced and sell stocks that are overpriced.
The theory of value investing‘ was formulated by Benjamin Graham and David Dodd as early as 1934 and is based on the assumption that two values are attached to all companies. The first is the market price – the value of the company on the stock exchange. The second is a company‘s intrinsic value. Value investors look for securities with prices that are unjustifiably low based on their intrinsic worth. The intrinsic value is sometimes referred to as the business value. The business value can be interpreted as the value of the company in the event of a merger, a takeover situation, or the amount that could be achieved by breaking up the company and selling all its assets. For long-term investors, business value is the stream of future dividends.
Most often, intrinsic worth is estimated by analyzing a company's fundamentals. Like a bargain hunter, the value investor seeks assets that are beneficial and of high quality but underpriced. In other words, the value investor searches for stocks that he/she believes are undervalued by the market. Like the bargain hunter, the value investor tries to find those items that are valuable but not recognized as such by the majority of other buyers. As the prominent value investor Warren Buffet declares, ”It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
In order for the value investor to be successful it requires that the market is inefficient. The key question for many researchers is therefore to establish, whether the superior returns on contrarian investment strategies compensate for a higher fundamental risk or if the returns in fact are better because naive investors systematically perceive some companies‘ future performance as being too high compared to reality.
Considering the vast amount of empirical support, on the existence of excess return on value stocks, it would be interesting to see if there is any correlation between the excess return, also known as the value premium, and the periodic changes in the economy as a whole. The world economy faces downturns and upturns. This nature of contractions and expansions is known as either recessions or booms.
During recessions, many macroeconomic indicators follow the same path. Production as measured by the Gross Domestic Product (GDP), employment, investment spending, household income, business profits and inflation all fall during recessions, while bankruptcies and the rate of unemployment rises. The opposite is true during a boom.
The majority of recessions have been anticipated by declines in the stock market. Earlier academic studies acknowledge that the value premium also appears to diminish prior to recessions. Siegel (1994) observe that since 1948, ten recessions in America has been preceded by a stock market decline. It is often argued, by private investors, that during recessions value stocks tend to hold up better. However, when the economy starts to recover and the bottom of the market has passed, growth stocks tend to recover faster.
Therefore, it is interesting to investigate if the value premium follows the same trends. Are the returns on a value portfolio superior during recessions but inferior once the economy picks up the pace again or does the value premium defy the conventional direction. If there is any correlation between recessions and the value premium, investors might take advantage of this when deciding on entry and exit strategies in the stock market.
In other words, we will conduct an investigation on whether there is any correlation between the value premium and the cyclical nature of the world economy.
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