This document summarizes research on the value premium - the tendency for stocks with value characteristics like low price-to-book ratios to outperform growth stocks over the long run. It discusses several potential explanations for the value premium proposed in academic literature, including that investors extrapolate past growth too far into the future for growth stocks and are surprised by mean reversion for value stocks. The document also reviews evidence that investors predict near-term earnings accurately but overestimate longer-term growth, and that value stocks experience positive earnings surprises while growth stocks see negative surprises.

1. US P/E ratio, Jan 1881 – Feb 2020
0
2
4
6
8
10
12
14
16
18
0
5
10
15
20
25
30
35
40
45
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1860 1880 1900 1920 1940 1960 1980 2000 2020 2040
Long-Term
Interest
Rates
Price-Earnings
Ratio
(CAPE,
P/E10)
CAPE
Long-Term
Interest Rates
2000
1981
1929
1901
1921
31.49
1966

2. Value investing: evidence,
interpretation and likely causes

3. • La Porta, Lakonishok, Shleifer, Vishny (1997) ‘Good news for value
stocks: further evidence on market efficiency’, Journal of Finance, 859-
874.
• Lakonishok, Shleifer, Vishny (1994) ‘Contrarian investment, extrapolation
and risk’, Journal of Finance, 1541-1578.
• Piotroski, J.D. (2000) Value investing: The use of historical financial
statement information to separate winners from losers, Journal of
Accounting Research, 38, 1-41
• Bird and Casavecchia (2007) ‘Sentiment and financial health indicators
for value and growth stocks: The European experience’, European Journal
of Finance, 769-793
• Fama (1998) ‘Market efficiency, long term returns, and behavioural
finance’, Journal of Financial Economics, 283-306.
• Fama & French (1998) ‘Value versus growth: the international evidence’,
Journal of Finance, 1975-1999.
• Fama & French (2020) The Value Premium, Chicago Booth Paper No. 20-
01
• Arnott et al. (2020) Reports of Value’s Death May be Greatly Exaggerated
• Ackert and Deaves (2010), especially pp. 63-65, 219-221 and chapter 19
• Siegel, J.J (2014) Stocks for the long run, McGrawHill, chapter 12
A massive literature! Some suggested readings.

4. Ri – rF = a + b[rM – rF] + eit
a b t(a)
HB/M 0.41 0.94 4.29
HE/P 0.32 0.95 3.96
HC/P 0.31 0.93 3.59
HD/P 0.29 0.87 3.77
LB/M -0.21 1.03 -4.02 Value firm indicators:
HB/M = high book to market ratio
HE/P = high earnings to price ratio  low P/E -- >
value
HC/P = high cash flow to price ratio  value
HD/P = high dividend to price ratio  value
Growth firm indicators:
LB/M = low book to market ratio
LE/P = low earnings to price ratio
LC/P = low cash flow to price ratio
LD/P = low dividend to price ratio
LE/P -0.23 1.04 -4.27
LC/P -0.28 1.01 -3.84
LD/P -0.22 1.07 -3.49
Source: Fama and French (1998)
Note the common link
between the four categories
based on B/M, E/P, C/P, D/P.
They are all ratios of
accounting magnitudes
relative to market values.
They are likely to be related!

5. Ri – rF = a + b[rM – rF] + eit
Ri – rF = a + b[rM – rF] + c[H – L/B] + eit
a b t(a) a b c t(a)
HB/M 0.41 0.94 4.29
HE/P 0.32 0.95 3.96 0.04 0.99 0.45 0.72
HC/P 0.31 0.93 3.59 -0.00 0.98 0.51 -0.02
HD/P 0.29 0.87 3.77 0.10 0.90 0.32 1.46
LB/M -0.21 1.03 -4.02
LE/P -0.23 1.04 -4.27 -0.07 1.02 -0.26 -1.63
LC/P -0.28 1.01 -3.84 -0.16 0.99 -0.19 -2.27
LD/P -0.22 1.07 -3.49 -0.03 1.04 -0.31 -0.64
Source: Fama and French (1998)
H – L/B is the difference between the returns on portfolios of high- and low-B/M stocks (above and below
the 0.7 and 0.3 fractiles of B/M). The returns are monthly.
Data consists of returns on market, value, and growth portfolios for the United States and twelve major
EAFE ~Europe, Australia, and the Far East countries.

6. • For Fama and French, high B/M, E/P CF/P are signals of
risk. The stocks are in distress (e.g. Fama and French
1992, 1998).
• Stocks in distress tend to move together so risk cannot be
diversified – it is systematic risk so it is priced
• On the other hand, stocks with low book-market ratios tend
to be associated with firm with high returns to capital.
These firms provide solid growth performances and
therefore require lower returns.

7. Alternative (behavioural) view
• The same indicators are indicators of cheapness (or
expensiveness). The idea of a cheap, or value, stock is that the
stock is underpriced relative to its fundamental value.
1) Expectational error hypothesis: investors extrapolate too far
into the future and are surprised when value stocks do well and
growth/glamour stocks disappoint
2) Representativeness: mistake good companies as good
investments
3) Institutional investors avoid out-of-favour (value) stocks so as
to appear being prudent and following fiduciary obligations
4) Institutional investors avoid value stocks for career reasons –
investing in value stocks often takes a long time to pay off,
time which some institutional investors don’t feel they have

8. Expectational error hypothesis (see especially Lakonishok, Shleifer
and Vishny (1994) and Haugen (2001) for nice summaries)
• Past earnings are not a good indicator of future earnings
• Investors have a limited ability of predicting earnings
into the ‘near’ future.
• Investors tend to correctly predict direction of future
earnings, but over-estimate the magnitude of change.
• When they are bullish they extrapolate long into the
future, a lot further than is justified.
• Investors are surprised by the recovery of past poor
performers.
• Suggests that investors have over-reacted to past news.
• There must follow a correction (mean reversion)

9. Evidence

11. Investors have an ability to predict into
the near future
• How to test this given that we do not see investors’
predictions? We can use E/P ratios (EPS).
• If a firm has a low E/P ratio it suggests that the
market is predicting that this firm has a good future
– it indicates an expectation of future earnings
growth (It is a “growth” stock).
• The contrary is true for a high E/P stock.

12. • Fuller, Huberts and Levinson (1993) use data from
1973-1990. They rank each stock according to the
previous year’s E/P ratio and group them into 5
quintiles. They then monitor the performance of
earnings of each group relative to the middle
quintile over the subsequent 8 years.

13. Relative Subsequent Growth in Highest, High,
Low and Lowest Quintiles of E/P Ratio
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
-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)

14. Fuller et al.’s findings
• As predicted, high E/P stocks tend to perform worse
(in terms of earnings) than low E/P stocks.
• Greatest difference in performance is in the first year.
• The earnings growth of high E/P stocks have caught
up within 6 years.
• Fuller et. al. conclude that in general investors
correctly identify which stocks are going to have good
future earnings.
• But the question is whether the market expects
extreme performers to “mean revert” within 5-6
years?

15. Investors extrapolate from past performance
• Stocks can be categorised as growth or value
stocks by using P/E or B/M ratios.
Growth stocks High P/E low B/M
Value stocks Low P/E high B/M
Dechow and Sloan (1997) use US data for 1967-1990 to
rank stocks into deciles by their B/M ratios.

16. Expensive
1 2 3 4 5 6 7 8 9 10
Decile
Cheap
Past and Future Growth for Cheap and Expensive Stocks
(Expensive = low B/M, Cheap = high B/M)
-5%
0%
5%
10%
15%
20%
25% Past earnings growth (6 years’ avg)
Future earnings growth (5 years’ avg)
High B/M stocks have had low past earnings
Low B/M stocks have had high past earnings
Not a clear relationship between B/M and future earnings
The market appears to value stocks according to past earnings
performance (extrapolating) on the assumption that this performance
will continue. This is not happening.

17. Are investors surprised at the speed of
the turnaround?
La Porta, Lakonishok, Shleifer and Vishny
(1997) use data from US for 1971-1992. They
look at the performance of stocks for the 3 days
around earning announcements.
• Low B/M (growth) stocks have tended to have
negative earnings surprises
• High B/M (value) stocks tend to have positive
earnings surprises.

18. Glamour Value Mean
difference
10-1
t-stat for
mean
difference
BM 1 2 9 10
Panel A: Event Returns (t-1, t+1)
Q1-Q4 -0.00472 0.00772 0.03200 0.03532 0.04004 5.65
Q5-Q8 -0.00428 0.00688 0.02828 0.03012 0.03440 7.14
Q9-Q12 0.00312 0.00796 0.02492 0.03136 0.02824 5.12
Q13-Q16 0.00804 0.00812 0.02176 0.02644 0.01840 3.67
Q17-Q20 0.00424 0.01024 0.01368 0.02432 0.02008 4.49
Panel C: Annual Returns (buy and hold)
Yr1 0.09254 0.14811 0.22534 0.21547 0.12292 3.84
Yr2 0.09284 0.14590 0.20085 0.21971 0.12686 3.88
Yr3 0.11979 0.14835 0.24195 0.24496 0.12517 4.27
Yr4 0.13063 0.16836 0.23149 0.25141 0.12078 3.82
Yr5 0.12274 0.17032 0.22329 0.23518 0.11244 3.11
Source: La Porta et al (1997), The Journal of Finance
Classified by Book-Market ratio
During first year there is a 12.3% difference between value and growth stock
performance. One-third of this occurs during the event windows
The earnings surprise for value stocks is positive, starting at 3.5% and declines slowly. The earnings
surprise for glamour stocks is negative and declines relatively quickly
Value stocks continue to outperform growth stocks throughout the 5 year post-formation period

19. Large firms (market cap > NYSE median)
Glamour Value
BM 1 2 9 10
Mean
difference
10-1
t-stat for
mean
difference
Panel A: Event Returns (t-1, t+1)
Q1-Q4 0.00315 0.00976 0.01840 0.01348 0.01033 0.80
Q5-Q8 0.00189 0.00662 0.01819 0.01717 0.01528 2.09
Q9-Q12 0.00265 0.00649 0.01341 0.01468 0.01203 1.55
Q13-Q16 0.00474 0.00633 0.00757 0.01172 0.00698 0.93
Q17-Q20 0.00230 0.00569 0.00498 0.00182 -0.00048 -0.08
Panel C: Annual Returns (buy and hold)
Yr1 0.11850 0.13855 0.17810 0.19898 0.08047 1.77
Yr2 0.09456 0.13442 0.18220 0.20341 0.10884 2.83
Yr3 0.11630 0.14040 0.19985 0.22462 0.10831 2.97
Yr4 0.12053 0.15511 0.18150 0.21296 0.09243 3.32
Yr5 0.10921 0.15368 0.20022 0.20082 0.09160 2.76
Source: La Porta et al (1997), The Journal of Finance
Smaller impact for larger firms. Attract greater attention of analysts
– hence smaller effect around earnings

20. • So investors who buy growth (glamour) stocks are
mistaken. They are extrapolating past
performances too far into the future. They are
neglecting the tendency for mean reversion (the
winners’ curse).
• The value strategy is a response to mean reversion
– it is taking a contrary investment strategy to that
suggested by past trends.
• Value investors can sometimes be seen as
contrarian investors. Contrarian investors go
against sentiment, value stocks are sometimes
cheap because of negative sentiment.

21. Is the premium to value stocks a risk
premium?
Risk premiums should change over time with risk and
risk aversion. But we have seen that
• The bulk of the value premium is earned around
earnings announcements
• There is a strong turn of the year effect. Why should
January be riskier than the other 11 months?

22. The expectational errors story
• Past earnings are not a good indicator of future earnings
• Investors do have a limited ability of predicting earnings
into the ‘near’ future.
• Investors tend to correctly predict direction of future
earnings, but over-estimate the magnitude of change.
• When they are bullish they extrapolate long into the
future, a lot further than is justified.
• Investors are surprised by the recovery of past poor
performers.
• Suggests that investors have over-reacted to past news.
• There must follow a correction (mean reversion)

23. A footnote to the debate
An interesting exchange between the author of a popular
book on investment gurus and Fama.
Fama: “The risk, in my terms, can’t be explained by the
market. It means that, because they move together,
there is something about these small stocks that creates
an undiversifiable risk. That undiversifiable risk is why
you get paid for holding them.”
Tanous: “What causes that risk?”
Fama: “You know that’s an embarrassing question because
I don’t know.”

24. Then when the same author interviews William
Sharpe, he observes:
Sharpe: “The Fama-French position is this kind of
bizarre metaphysics that says ‘value stocks do better;
but we know that in an efficient market things that do
better ought to, in some sense, be riskier, ergo, value
stocks are riskier! Now we don’t happen to have seen
the manifestation of the risk … but it must be so,
therefore the market is efficient.’ End of discussion”.
• Source: Tanous (1997)

25. Some more practical considerations
for value investing
• The literature discussed above uses very crude sorting strategies
• Piotroski (2000) Journal of Accounting Research (see also Bird
and Casavecchia 2007)
• Less than 44% of high B/M stocks earn positive abnormal returns
in first 2 years
• Implies that a crude value strategy based on high BM firms relies
on strong performance of a small number of firms while tolerating
the poor performance of “many deteriorating companies”.
• Raises two issues for the investor
– Separate the genuinely distressed from the under-valued
– Market timing

26. • Value investing: the use of historical financial
statement information to separate winners from
losers.
Characteristics of value stocks
• neglected. Thinly followed by analysts
• limited access to “’informal’ information
dissemination channels” and voluntary disclosures
may not be viewed as credible. So financial
statements are important
• Many are financially distressed. So fundamentals
from financial statements such as leverage, liquidity,
profitability trends and cash flow adequacy are
important to confirm their status.

27. • Firms with weak current signals are more likely to
have low future earnings and delist whereas firms
with strong current signals tend to have strong
future earnings – and performance around
earnings announcement windows indicates the
markets are systematically surprised by these
outcomes (similar to La Porta et al. 1997).
• Need to identify those signals…
• Piotroski claims to achieve this using a variety of
measures of Profitability, financial
leverage/liquidity, and operating efficiency
(yields an F-Score, from 0-9)

28. Future earnings performance based on fundamental signals of
high B/M firms
F_SCORE Mean ROA(t+1) % delisting within
2 years
N
0 -0.08 0.07 57
1 -0.08 0.11 339
2 -0.07 0.08 859
3 -0.05 0.06 1618
4 -0.03 0.05 2462
5 -0.01 0.04 2787
6 0.01 0.03 2579
7 0.0 0.03 1894
8 0.03 0.02 1115
9 0.03 0.02 333
Low -0.08 0.10 396
High 0.03 0.02 1448
H-L 0.11 -0.08
t-stat 15.02 7.88

29. -10%
-5%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Annual returns of long-short based on F-Score of 5
Long position, high B/M with F-Score ≥ 5, short position F-Score <5
Source: Piotroski (2002)
“the mean return earned by a high book-to-market investor can be increased by at
least 7.5% annually through the selection of financially strong high BM firms”

30. Piotroski F score calculation procedure
The score is calculated based on 9 criteria divided into 3 groups.
Profitability
Return on Assets (1 point if it is positive in the current year, 0 otherwise);
Operating Cash Flow (1 point if it is positive in the current year, 0 otherwise);
Change in Return of Assets (ROA) (1 point if ROA is higher in the current year compared to the previous
one, 0 otherwise);
Accruals (1 point if Operating Cash Flow/Total Assets is higher than ROA in the current year, 0
otherwise);
Leverage, Liquidity and Source of Funds
Change in Leverage (long-term) ratio (1 point if the ratio is lower this year compared to the previous one,
0 otherwise);
Change in Current ratio (1 point if it is higher in the current year compared to the previous one, 0
otherwise);
Change in the number of shares (1 point if no new shares were issued during the last year);
Operating Efficiency
Change in Gross Margin (1 point if it is higher in the current year compared to the previous one, 0
otherwise);
Change in Asset Turnover ratio (1 point if it is higher in the current year compared to the previous one, 0
otherwise);
Some adjustments that were done in calculation of the required financial ratios are discussed in the
original paper.