One of the most fascinating examples of the phenomenon of mean reversion was identified by Werner F.M. DeBondt and Richard H. Thaler in Further Evidence on Investor Overreaction and Stock Market Seasonality. DeBondt and Thaler examined the relative performance of quintiles of stocks on the NYSE and AMEX ranked according to book value. As an adjunct to the main study, one of the variables they analyzed was the relative earnings performance of stocks in the lowest and highest price-to-book quintiles.
DeBondt and Thaler’s findings are as interesting as they are counter-intuitive. Stocks in the lowest price-to-book quintile (the cheapest stocks) grew their earnings faster than the stocks in the highest price-to-book quintile (the most expensive stocks). Tweedy Browne set out DeBondt and Thaler’s findings in Table 3 below, which describes the average earnings per share for companies in the lowest and highest quintile of price-to-book value in the three years prior to selection and the four years subsequent to selection:
In the four years after the date of selection, the earnings of the companies in the lowest price-to-book value quintile (average price-to-book value of 0.36) increase 24.4%, more than the companies in the highest price-to-book value quintile (average price-to-book value of 3.42), whose earnings increased only 8.2%. DeBondt and Thaler attribute the earnings outperformance of the companies in the lowest quintile to mean reversion, which Tweedy Browne described as the observation that “significant declines in earnings are followed by significant earnings increases, and that significant earnings increases are followed by slower rates of increase or declines.”
The implication here is that not only does the price of stocks that are cheap relative to other stocks regress to the mean, but the underlying performance does too. That’s an amazing finding. There’s really no good reason why low price-to-book should be such a good predictor for short and mid-term earnings growth. I’ve spent some time thinking about why this might be so, and the only possible explanation I can come up with is magic. Nothing else fits.
[…] rather indicates a cyclical top in margins and earnings. This view is broadly supported by other research on mean reversion in earnings that I have discussed in the past, which has suggested, somewhat counter-intuitively, that in […]
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[…] Mean reversion is a favorite investment topic here on Greenbackd (see, for example, my posts on Mean reversion in earnings, Contrarian value investment and Lakonishok, Shleifer, and Vishny’s Contrarian Investment, […]
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[…] paper also discusses in some detail a phenomenon that I find deeply fascinating, mean reversion in earnings predicted by low price-to-book values: Research (in Fama and French 1992, for example) shows that […]
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[…] and Stock Market Seasonality, a paper I like to cite in relation to low P/B quintiles and earnings mean reversion. Thaler is also the “Thaler” in Fuller & Thaler Asset Management, which James […]
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[…] Mean reversion in earnings – Via Greenbackd – One of the most fascinating examples of the phenomenon of mean reversion was identified by Werner F.M. DeBondt and Richard H. Thaler in Further Evidence on Investor Overreaction and Stock Market Seasonality. DeBondt and Thaler examined the relative performance of quintiles of stocks on the NYSE and AMEX ranked according to book value. As an adjunct to the main study, one of the variables they analyzed was the relative earnings performance of stocks in the lowest and highest price-to-book quintiles. […]
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Any chance it’s a function of upgrade cycle/depreciation complex. As an example, a new asset is purchased and undepreciated, usually a new asset has cost saving benefits (ie lower labor costs, higher efficiency, etc). Assuming most depreciation is front loaded, this should depress earnings initially. As benefits of new asset coming online accrue and depreciation expense falls, earnings grow, while after several years, the asset is largely depreciated, the benefits of the new asset have been realized or minimized by competition and earnings fall as does book value as the depreciation shrinks its carrying value. Just a guess.
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Great post.
The underlying performance improves simply because the EPS is reset and becomes so depressed, that any slight improvement later on in earnings will result in a massive increase in earnings growth. As you can see above earnings fell 32% during the first three years, but then rebounded but from a lower base. However, in the high P/B the base is much higher so its harder to consistently have high growth rates. I think it just shows how really perceptions of the fundamentals is what matters at the end of the day. If you can buy these low p/b stocks at the time they have reset the base (in reality we actually don’t know the exact timing and maybe too early) then you can earn decent returns.
Keep up the good work.
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are the returns statistically significant to 3 years after selection?
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Great stuff as always. Glad you are back from your break!
I have a question about price/book. It is definitely the best proxy for the true FMV of net assets on the balance sheet that is available to individual investors. However, the FMV of some items on the balance sheet, especially PP&E, tend to decline when technological developments occur (however, I guess the auditors test for impairment, which may mitigate this somewhat).
Could it be that a low price/book is a good estimate of higher “earnings power” of the assets on the balance sheet? This would seem to somewhat explain mean reversion of stock prices of low p/b value firms (once Mr. Market realizes he can pay less for income-generating assets), but doesn’t explain earnings growth.
Furthermore, is there better information available to individual investors to estimate the fair value (or replacement value) of assets without expertise about the technical specs of assets on the balance sheet? This is kind of what the earnings power value method tries to do, but I’ve found it difficult to implement because of a lack of information. It would also seem that this information would make it easier to select the truly underpriced low p/b value stocks.
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