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Investors tend to like pricey stocks

Journal tries to find out if overreaction in market is reality

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Do investors overrate the good and underrate the bad? Do they take trends too far by overpricing favorite stocks and underpricing others?

In the first issue of the Journal of Psychology and Financial Markets www.investmentresearch.org, David Dreman and Eric Lufkin, of Dreman Value Management in Jersey City, N.J., tried to find out if overreaction in the stock market is a reality.

Dreman and Lufkin looked at the 1,500 largest stocks traded in the United States from 1973 through 1998 and charted five major fundamentals — earnings, cash flow, sales, profit margins and return on equity — against three important ratios: price-to-book, price-to-earnings and price-to-cash flow. They also created hypothetical portfolios of the most expensive stocks (highest price-to-book ratios) and least expensive (lowest price-to-book). They then examined how well the portfolios performed over the previous five years, and what happened to their fundamentals over the previous 10 years. They also examined how well they did and what happened to their fundamentals afterward.

One of the first discoveries Dreman and Lufkin made was that cash flow increased steadily for the most expensive stocks, from an average of 17 percent annually in the 10th year before portfolio formation to 23 percent in the final year. Meanwhile, the prices of the most expensive stocks, after outperforming the market by 20 percentage points the previous year, underperformed by three points the year following portfolio formation. Then they kept underperforming for the next four years.

Did the fundamentals of the priciest stocks decline enough to justify this change? No, says Dreman.

"Cash-flow growth slowed steadily, from 23 percent to 13 percent in Year 5 but always remained higher than that of both the market and of the inexpensive stock group."

Inexpensive stocks did the exact opposite. From trailing the market by 16 points in the year before being designated as inexpensive, they outperformed in the next year by three points, a 19-point swing. Did their fundamentals justify this turnaround? No again, says Dreman.

"In fact, cash-flow growth declined from 5 percent to 1 percent in year one of the hypothetical portfolio and kept lagging that of the expensive stocks for the next four years."

Dreman and Lufkin found similar results for all five fundamentals using each of the three valuation measures noted above. Their conclusion:

"There is no consistent link between fundamentals and stock price movements. Investors do not correctly value the prospects of stocks with good fundamentals; they overvalue them. Nor do they correctly value the prospects of stocks that are weak; they undervalue them."

If there ever was a time to heed this lesson, concludes Dreman, it is now.

"Even if high-priced stocks sharply surpass the averages in earnings growth, their prices could revert to the mean. So they would underperform. And even if unloved issues don't turn into big earnings growers, their stocks could outperform — as they revert toward the mean going the other way."

Investor's Notebook is a digest of investment opinion from the world's leading financial advisers. It does not recommend any specific investments, and no endorsement is implied or should be inferred. For more information, contact the individual firms cited.