Contrarian investment.

• Author: Schleifer, Andrei
• Position: Value stock investments - Research Summaries

For over 30 years, the efficient markets hypothesis (EMH) has remained the central proposition of financial economics. The EMH states that, as an empirical matter, prices at which securities trade in liquid financial markets are equal to their fundamental values, given by the expected present values of the cash flows accruing to these securities. In other words, the stock market prices securities at their fair values. Although the EMH flies in the face of the conventional wisdom that astute analysts can beat the market, it has withstood many empirical challenges for decades, becoming a textbook wisdom for most economists. In particular, the implication of EMH that investment strategies based on public information, including those practiced by mutual funds, cannot beat the market, has survived hundreds of tests.

In recent years, a new set of challenges to the EMH has appeared, based on some very old ideas about contrarian investment. These ideas, dating back to Graham and Dodd,(1) state that investing in value stocks - defined as stocks with low prices relative to some measures of their current fundamentals, such as earnings or dividends - is more attractive than investing in growth stocks, those with high prices relative to measures of fundamentals. Although several papers in the 1980s supported the superior returns from contrarian investment strategies based only on publicly available information, the most celebrated study came from the University of Chicago, the cradle of the EMH.

In 1992, Eugene F. Fama and Kenneth R. French reported that, between 1963 and 1990, stocks of companies with high ratios of book values of assets to market price earned higher returns than stocks of companies with low book-to-market (BM) ratios.(2) They found that the spread in returns between portfolios of stocks with high (top 10 percent) and low (bottom 10 percent) BM ratios was on the order of 10 percent per year. Despite finding this enormous benefit to investing in high BM stocks, Fama and French did not interpret the evidence as contradicting the EMH. Rather, they argued that the high BM stocks in some special ways might be riskier than the low BM stocks. According to them, this difference in risks, as measured by the difference in BM ratios, explains the difference in average returns.

These empirical findings have stimulated a great deal of further work, including our research with Josef Lakonishok and Rafael La Porta. With Lakonishok, we have looked at...