Henriette Wennicke
Master Thesis
Copenhagen Business School
M.Sc. in Finance and Strategic Management
Department of Finance
October 2008
Executive Summary
For decades academics and investment professionals have argued that value strategies outperform growth strategies. Value strategies are identified as strategies where stocks with low prices relative to earnings, cash earnings, book value and other measures of fundamental value are bought, to be able to generate abnormal returns. In general, there is almost universal agreement among researchers on the existence of the value premium in stock returns. The issue of underlying causes for the value premium is far more contentious.
The objective of this thesis is to examine whether the value-phenomenon is present on the Swedish stock market, which is the largest market in the Nordic region. Additionally the thesis explores whether value strategies yield higher returns due to increased risk or irrational behavior of market participants.
The value-phenomenon is indeed present in the Swedish stock market. Accounting and stock market data have been collected for stocks in the OMXS30 index since 1987 and onwards. Value and growth portfolios have been formed based on different sorting variables; Price-to- earnings (P/E), Price-to-cash earnings (P/C), Price-to-book (P/B) and Asset growth (ASSETG). The test and analysis of the four different strategies with either one-, two- or three-year holding periods show that the value strategy in general outperforms the growth strategy on the Swedish stock market. Thus, most of the strategies produce returns that are insignificant, which might however be a consequence of the small sample size. The value premium for the one-year value-weighted strategy is between -1.082% and 7.233%. When the stocks within theportfolios are equally-weighted, the premiums become even stronger and more significant, which might be due to small-cap effects. The same pattern is found when the holding periods were extended to two and three years.
The risk based explanation is analyzed, but it does not seem to explain the value premium. The traditional systematic risk measure beta is on average lower for value portfolios than for growth portfolios, which totally contradicts the traditional finance theory. Additionally the value strategy does not perform worse in bad states of the economy, which otherwise could have indicated that the value stocks had increased downside risk.
The irrational arguments seem to fit the existence of the value premium better. Investors are subject to several kinds of judgment biases, which originate from limited cognitive capacity. Therefore different types of heuristics are used that can limit the investors’ ability to make rational decisions. Incorrect usage of heuristics can encourage investors to extrapolate past performance too far into the future. When performing a simple extrapolation test on the Swedish stock market it is found that the net profit growth ahead of portfolio formation is slightly negative for the value portfolio, whereas net profit after formation is slightly positive. The picture is the opposite for the growth portfolio. The results indicate that markets undervalue value stocks and overvalue growth stocks, which lead to a positive performance of value stocks when the market participants realize that their view of growth stocks have been too optimistic and their view of value stocks too pessimistic.
Introduction
Contrarian investment strategies have been known for decades and have for long been awidespread investment style. Several financial studies have proved significantly superior performance of the contrarian strategies and thus the existence of the value premium. This is achieved when investors buy underpriced stocks and short overpriced stocks. The underpriced stocks are referred to as the loser or value stocks, while the overpriced stocks are often called winners or growth stocks.
Studies by (Lakonishok, Shleifer, & Vishny, 1994), (Fama & French, 1996) and (Chan & Lakonishok, 2004) provide evidence of the existence of the value premium in the US stock markets. Further do (Chan, Hamao, & Lakonishok, 1991) find superior performance of investment strategies based on value styles in Japanese stock market and (Fama & French, 1998) document persistent evidence of value premium in international stock markets including the Swedish one. Thus, there is almost universal agreement on the existence of the value premium in stock returns (Sharma, Hur, & Lee, 2008). The issue of underlying causes for the value premium is far more contentious. In a number of articles Fama and French argue that markets are efficient and that the better performance of the value investing is due to value stocks being more risky. However in the articles by Lakonishok et al. no evidence is found that value stocks are riskier than growth stocks. They use several risk measures in their documentation. Instead they argue that the value premium could be best explained by preference of investors for growth stocks over value stocks. They argue that investors are likely to suffer from cognitive biases, extrapolate past growth rates of glamour stocks and buy them at whatever price. Further growth stocks can often be justified as prudent investments in contrast to many value stocks, which appear financial distressed. Moreover they argue that the contrarian strategy is a long-term strategy, which means that the value premium is only realized in the long run, which might frighten some investors. Therefore in all researchers are in much disagreement when it comes to the reason for the value premium. Some still rely on traditional financial theories while others look for explanations in the behavior finance literature.
Objective
The objective of this thesis is to test the contrarian investment strategies on the Swedish stock market with the methodologies developed by Lakonishok et al. (1994). The superior performance of the strategy has been proved on several markets, and therefore it will be interesting to see, whether similar results can be documented on the Swedish stock market. The Swedish stock market is the largest in the Nordic region, but no former research has been made recently on this market. On the Danish market the strategy has proved its worth and it will be interesting to see if it also can be implemented on the neighboring market in Sweden. It would be surprising if the strategy did not work on the Swedish stock market because of its success on other markets. However, if it works properly it would indicate that on the whole the Swedish stock market is very similar to the global stock market.
Some opponents of the strategy argue that the results for the value premiums are sample specific and cannot be transmitted to other markets or time periods. Therefore the overall objective is to analyze and test whether the value premium found in other markets is also present on the Swedish stock market the last 20 years. Consequently, the evidence presented in this thesis will either confirm or reject the results found in other studies on other markets in other time periods and thereby prove or disprove that the results are due to data mining.
Problem statement
The above introduction to former studies and the objective statement give rise to a number of questions. The overall purpose of the thesis is: To investigate whether a consistent value premium exists on the Swedish stock market and study whether this potential premium is due to increased risk or irrational behavior of market participants.
In order to answer the above problem statement I have identified the sub questions presented in the following. Researchers disagree very much when it comes to explaining the cause of the value premium. The first research question therefore aims at comparing the traditional financial theory with the behavioral theory, so it can be determined what the problems are with the traditional explanation.
- Can the underlying assumption of investor rationality from the standard finance theory be questioned?
When both the traditional finance theory and the behavioral finance theory have been introduced briefly, the contrarian investment strategy will be introduced, outlining how it works and introducing former studies that have proved its worth.
- How do contrarian investment strategies work in practice?
After the introduction to the underlying theories an empirical study will be performed on the Swedish stock market.
- Does the Swedish stock market mean revert?
- Can the contrarian investment strategies be carried out successfully on the Swedish stock market?
Finally the results will be explained with both the traditional and behavioral finance theories.
- Can traditional risk measures explain the results obtained or do we have to search for the explanation in alternative theories like behavioral finance?
These questions will be investigated and answered thought out the paper and in the final conclusion. When differences and similarities to results presented in other studies are found they will be outlined and investigated.
1.2 Methodology
In the following the methodology used in the thesis will be presented. A more detailed discussion of the methodology and theories used in the tests and analysis will be presented in the later chapters wherever relevant.
1.2.1 Limitation
The purpose of this thesis is not to create a new theory, but rather to use the theory already developed and use this empirically on an existing but not yet investigated market. Therefore the empirical analysis is made as realistic as possible. However, taxes and transaction costs are not taken into consideration. Therefore no considerations are made whether the conclusions are the same in a world of taxes and transaction costs. I investigate the contrarian investment strategy on the Swedish market with reference to other former studies of other markets. No investigation is made to check whether these former analyses are made correctly and without errors.
I have chosen to investigate standard and behavioral finance in regard to the contrarian investment strategy based on stocks. Accordingly, I do not investigate other corporate finance issues like for instance irrational investor behavioral in regard to bonds, derivatives or real investments. Since traditional finance is well known and the theoretical foundation have been taught and elaborated upon for decades, the emphasis will not be on this building block. I assign one minor section to standard finance in order to clarify the contrast to behavioral finance, and put my emphasis on the behavioral finance theory. This contrast is pointed out through the thesis wherever relevant.
The thesis should not be seen as a test of the efficient market hypothesis (EMH), even though it is discussed in Chapter 2. Whether the obtained results can lead to a rejection of the hypothesis or not is not possible to answer with the test performed in the thesis. Therefore this hypothesis will not be rejected or accepted or further discussed.
The accounting variables used in the tests could be affected by changes in accounting regulations and errors in the Datastream database, but these kinds of biases will not be investigated in detail due to the limited scope of this thesis. However, a subchapter concerning data problems is included.
Structure
The thesis is structured with the objective of continuation between the chapters. Chapter 2 and 3 involve theories and empirical findings of others, whereas Chapter 4 involves my own study and Chapter 5 an explanation of the obtained results through the introduced theoretical framework. The sub-sections within each chapter are summarized when appropriate due to the length or complexity of the contents. Furthermore, all the chapters finish with a sub conclusion to emphasize the most important findings within each chapter. Figure 1.1 below presents the outline of the thesis.
Theoretical foundation
The theories used throughout the thesis originate mainly from literature such as articles, journals and working papers. The majority of the literature was found via the Internet through different journal databases. The huge numbers of articles on the subject expose the user to the risk of missing relevant and high-quality literature. However, after spending several hours searching and classifying the relevant literature, I am confident that I have uncovered the most important literature on the subject, often written by highly acknowledged authors. Further, most of the applied literature has been published in well-known and reliable media.
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