The Inefficient Market What Pays Off and Why Part 2: Why Prentice Hall 1999 Visit our web-site at HaugenSystems.com

Why.

The Topography of the Stock Market the Stock Market

True Abnormal Profit l Best estimate (using all relevant information and state-of-the-art analysis) of the risk adjusted, present value of a firms future abnormal profits.

True Abnormal Profit Priced Abnormal Profit Growth Stocks Value Stocks Efficient Market Line under- priced stock The Position of Portfolios in Abnormal Profit Space

willproduceexcessreturn True Abnormal Profit Priced Abnormal Profit Efficient Market Line over- priced stock The Position of Portfolios in Abnormal Profit Space Growth Stocks Value Stocks

willproduceexcessreturn True Abnormal Profit Priced Abnormal Profit Efficient Market Line willproduce deficient return The Position of Portfolios in Abnormal Profit Space Growth Stocks Value Stocks

Imprecision

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line True Abnormal Profit Priced Abnormal Profit The Position of Portfolios in Abnormal Profit Space

Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line Priced Abnormal Profit True Abnormal Profit

Available assets IMPRECISION: Different prices for stocks with the same TRUE Abnormal Profit The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets IMPRECISION: Stocks with the same price have different TRUE abnormal profit The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Bias

The Market Over- reacts to Success and Failure

Mean-reversion in Relative Profitability How Fast? Fuller, Huberts, and Levinson

Relative Subsequent Growth in Highest, High, Low and Lowest Quintiles of E/P Ratio Low and Lowest Quintiles of E/P Ratio-10%-8%-6%-4%-2%0%2%4%6%8%10% Growth in Earnings per Share Relative to Middle Quintile Lowest E/P(Growth) Low E/P High E/P Highest E/P (Value) 1 Year ahead 2 Years ahead 3 Years ahead 4 Years ahead 5 Years ahead 6 Years ahead 7 Years ahead 8 Years ahead Number of Years After Ranking

Is the Market Surprised by the Speed of Mean- reversion? La Porta, Lakonishok, Shleifer, & Vishny

-1.0%-0.5%0.0%0.5%1.0%1.5%2.0% Three day rate of return -2.0%-1.5% Value Growth First year following ranking Second year following ranking Third year following ranking Fourth year following ranking Fifth year following ranking Returns of Growth and Value Stocks Around Earnings Announcement Dates Around Earnings Announcement Dates

Implications for Market’s Topography

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

Available assets low B / P decile or high E / B decile high B / P decile or low E / B decile The Position of Portfolios in Abnormal Profit Space BIAS: Overreaction to Abnormal Profit True Priced over- priced Efficient Market Line under- priced True Abnormal Profit PricedAbnormal Profit Priced Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Available assets Value investors head West GrowthinvestorsheadNorth PricedAbnormal Profit Priced Abnormal Profit

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Available assets PureGrowth willunderperform GARP willoutperformmarket PricedAbnormal Profit Priced Abnormal Profit

The Relative Positions of The Deciles

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Super Stocks Stupid Stocks Priced Abnormal Profit

What’s Behind the Payoff to Profitability? Imprecision - you can buy more profitable companies without having to pay more expensive prices.

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

What’s Behind the Payoff to Cheapness? Imprecision & bias - you can buy cheaper stocks without sacrificing profitability & market exaggerates the length of the short-run.

The Position of Portfolios in Abnormal Profit Space Efficient Market Line True Abnormal Profit Priced Abnormal Profit

Efficient Market Line True Abnormal Profit Priced Abnormal Profit

What’s Behind the Negative Payoff to Risk?

How long has the payoff to risk been negative? Let’s look at the history of the cumulative relative performance of the low volatility portfolio and the S&P 500 stock index.

Cumulative Difference in Return Between Low Volatility Portfolio and S&P % -25% -15% -5% 5% 15%25%CumulativeDifference

Cumulative Difference in Return Between Low Volatility Portfolio and S&P % -25% -15% -5% 5% 15% 25% CumulativeDifference

Cumulative Difference in Return Between Low Volatility Portfolio and S&P % -25% -15% -5% 5% 15% 25% CumulativeDifference

Two Theories Explaining the Negative Payoff to Risk

I. Over-valued and Risky Growth Stocks l Expensive growth stocks tend – To produce low future returns – To be more risky l Fama/French 1992 Table II

Book to Market Equity of Portfolios Ranked by Beta Beta Book to Market Equity

II. Agency Problems of Financial Analysts* *Sias, Financial Analysts’ Journal, 1996 l Studies NYSE stocks l Forms size deciles in each year l Within each size decile, he forms 3 equal- numbered groupings based on percentage institutionally held l Computes volatility using weekly data

Median Institutional Holdings, Capitalization, and Volatility by Capitalization Institutional Holdings Sorted Portfolios, NYSE Firms, Portfolio Smallest Decile 2 Decile 3 Decile 4 Decile 5 Decile 6 Decile 7 Decile 8 Decile 9 Largest Institutional Holdings (%) HighLow Confidence Level (High minus Low) % % % % % % % % % % Capitalization ($millions) HighLow Confidence Level (High minus Low) % % % % % % % % 1, , % 3, , % Annualized Standard Deviation Of Weekly Returns (%) HighLow Confidence Level (High minus Low) % % % % % % % % % %

There May be Two Causes for the Inversion in the Relationship Between Risk and Expected Return l The market’s tendency to over-price the more volatile, growth stocks l The attraction of institutional investors to the more newsworthy, volatile stocks

What’s Behind the Technical Payoffs to Price History? Short-term reversals Intermediate momentum Long-term reversals

Short-term Reversals l Price pressure. l Reversals of over-reactions to new information.

Intermediate Momentum and Long-term Reversals l Repetition of earnings surprises of the same sign (Bernard & Thomas). l Over-estimating the length of the short- run.

Jegadeesh and Titman* l Observe stock returns around earnings announcement dates. l Compute difference in returns to decile winners and losers over previous six months. l Study spans the period *Journal of Finance, 1993

Cumulative Difference Between Winner and Loser Portfolio Rates of Return at Announcement Dates -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%5.00% Cumulative Difference Between Winner and Loser Portfolio Rates of Return Months Following 6-Month Performance Period

Cumulative Difference Between Winner and Loser Portfolio Rates of Return at Announcement Dates -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%5.00% Cumulative Difference Between Winner and Loser Portfolio Rates of Return Months Following 6-Month Performance Period

Cumulative Difference Between Winner and Loser Portfolio Rates of Return at Announcement Dates -5.00% -4.00% -3.00% -2.00% -1.00% 0.00% 1.00% 2.00% 3.00% 4.00%5.00% Cumulative Difference Between Winner and Loser Portfolio Rates of Return Months Following 6-Month Performance Period

Building Weak Expected Return Factor Models Brennan Chordia & Subrahmanyam

Methodology l Study 970 NYSE stocks over the period l Rank stocks first by size and form quintiles. Within each quintile, rank by book-to-price and form quintiles again to obtain a total of 25 groupings. l Construct 5 stock portfolios, the returns to which account, as closely as possible, for the correlations among the returns to the 980 stocks. Use the portfolios as factors to explain the time-series of individual stock returns. Do the same with the size and B/P portfolio returns. l In any given month, regress the cross-section of returns to the 25 portfolios on a profile of 13 portfolio characteristics. Do the same with the unexplained returns to the 25 portfolios. l Compute means for the 13 regression coefficients ( ).

Most Important Factors Most Important Factors Study by Haugen & Baker 1979/01 through 1986/ /07 through 1993/12 FactorMeanConfidenceMeanConfidence One-month excess return-0.97%99%-0.72%99% return Twelve-month excess0.52%99%0.52%99% Trading volume/market cap -0.35%99%-0.20%98% Two-month excess return-0.20%99%-0.11%99% Earnings to price0.27%99%0.26%99% Return on equity0.24%99%0.13% 97% Book to price0.35%99%0.39%99% Trading volume trend-0.10%99%-0.09%99% Six-month excess return0.24%99%0.19%99% Cash flow to price0.13%99%0.26%99%

Average Payoffs to the BCS Factor Model Factor Covering Size Book-to-Market Volume of Trading Number of Analysts Dispersion of Earnings Estimates Percentage Bid-Asked Spread Percentage Institutional Ownership 1.00 if in S&P 0 Otherwise Reciprocal of Share Price Dividend – to – Price Two-Month Past Return Five-Month Past Return Eleven-Month Past Return Portfolio Returns Mean Payoff Confidence %.20593%.73098% % % % % % % % % %.15075%.43099% Residual Portfolio Returns Mean Payoff Con f idence % %.55980% % % %.2596%.44898%.73493%.30165% % % % % Residual Stock Returns Mean Payoff Confidence % % % %.21499% % %.17999%.18495%.06960% % % %.77897%

Response l In the case of the 25 portfolios, it’s, proportionately, like trying to estimate the payoffs to 2 factors with 4 plot points. l In the case of the 25 portfolios, the exposures to all factors except size and B/P are likely to be quite homogeneous. l The unexplained (by their factor model) returns to the individual stocks are likely to be small and for the 40 stock portfolios extremely small.

Diversifiable Risk Decreases with the Number of Stocks in a Portfolio Diversifiable Risk Number of Stocks in Portfolio