Question

What are the key characteristics of value anomalies?

Answer 1

This argues that exposure to downside market risk can explain why value stocks outperform their growth counterparts. The value anomaly higher average returns on value as opposed to growth stocks – is a robust phenomenon on equity markets around the world.

We define anomaly returns as the value'weighted returns of stocks ranked in the highest quintile of a given priced characteristic minus the value'weighted returns of stocks ranked in the lowest quintile. In this case, the relevant cash flow is the log of gross return on equity.

KEY TAKEAWAYS

• Most market anomalies are psychologically driven.
• Market anomalies can be great opportunities for investors.
• Anomalies should influence but not dictate a trading decision.
• Proper research of a company's financials is more important for long-term growth.
• There is no way to prove these anomalies, since their proof would flood the market in their direction, therefore creating an anomaly in themselves.

1. Small Firms Tend to Outperform

Smaller firms (that is, smaller capitalization) tend to outperform larger companies. As anomalies go, the small-firm effect makes sense. A company's economic growth is ultimately the driving force behind its stock performance, and smaller companies have much longer runways for growth than larger companies.

2. Neglected Stocks

A close cousin of the "small-firm anomaly," so-called neglected stocks are also thought to outperform the broad market averages. The neglected-firm effect occurs on stocks that are less liquid (lower trading volume) and tend to have minimal analyst support. The idea here is that as these companies are "discovered" by investors, the stocks will outperform.

Many investors monitor long-term purchasing indicators like P/E ratios and RSI. These tell them if a stock has been oversold, and if it might be time to consider loading up on shares.

Research suggests that this anomaly actually is not true—once the effects of the difference in market capitalization are removed, there is no real outperformance. Consequently, companies that are neglected and small tend to outperform (because they are small), but larger neglected stocks do not appear to perform any better than would otherwise be expected. With that said, there is one slight benefit to this anomaly—through the performance appears to be correlated with size, neglected stocks do appear to have lower volatility.

3. Reversals

Some evidence suggests that stocks at either end of the performance spectrum, over periods of time (generally a year), do tend to reverse course in the following period—yesterday's top performers become tomorrow's underperformers, and vice versa.

Not only does statistical evidence back this up, but the anomaly also makes sense according to investment fundamentals. If a stock is a top performer in the market, odds are that its performance has made it expensive; likewise, the reverse is true for underperformers. It would seem like common sense, then, to expect that the over-priced stocks would underperform (bringing their valuation back in line) while the under-priced stocks outperform.

Reversals also likely work in part because people expect them to work. If enough investors habitually sell last year's winners and buy last year's losers, that will help move the stocks in exactly the expected directions, making it something of a self-fulfilling anomaly.

4. The Days of the Week

Efficient market supporters hate the "Days of the Week" anomaly because it not only appears to be true, but it also makes no sense. Research has shown that stocks tend to move more on Fridays than Mondays and that there is a bias toward positive market performance on Fridays. It is not a huge discrepancy, but it is a persistent one.

On a fundamental level, there is no particular reason that this should be true. Some psychological factors could be at work. Perhaps an end-of-week optimism permeates the market as traders and investors look forward to the weekend. Alternatively, perhaps the weekend gives investors a chance to catch up on their reading, stew and fret about the market, and develop pessimism going into Monday.

5. Dogs of the Dow

The Dogs of the Dow are included as an example of the dangers of trading anomalies. The idea behind this theory was basically that investors could beat the market by selecting stocks in the Dow Jones Industrial Average that had certain value attributes.

It is unclear whether there was ever any basis in fact for this approach, as some have suggested that it was a product of data mining. Even if it had once worked, the effect would have been arbitraged away—for instance, by those picking a day or week ahead of the first of the year.

Investors practiced different versions of the approach, but there were two common approaches. The first is to select the 10 highest-yielding Dow stocks. The second method is to go a step further and take the five stocks from that list with the lowest absolute stock price and hold them for a year.

To some extent, this is simply a modified version of the reversal anomaly; the Dow stocks with the highest yields probably were relative underperformers and would be expected to outperform.