Value-Based Market Anomalies

The value effect shows how stocks with below-average balance sheets tend to outperform the other stocks on the market because of the faith investors have in their growth potential.

Market anomalies are outlier events that have created patterns that have become seemingly predictable. There are a number of market anomalies that exist and investors or traders that are attuned with anomalies have the option of making decisions based on it or even completely leveraging on them.

In our last post, we discussed the January effect market anomaly. In this article, anomalies that arise based on the value of stocks themselves would be assessed.

The value effect shows how stocks with below-average balance sheets tend to outperform the other stocks on the market because of the faith investors have in their growth potential.

The Price to Earnings ratio (popularly called the P/E ratio) shows the proportion of the share price of a company to its earnings per share (EPS). It is used to indicate the amount in Naira that an investor is ideally expected to pay to obtain a share of the company’s earnings.

The market anomaly here is that portfolios that are made up of low P/E stocks outperform those of high P/E stocks.

A simple way to understand the P/E ratio is that it is used to value companies so as to determine whether they are overvalued or undervalued. As such, a low P/E ratio means that a stock undervalued because its stock price is trading at a lower price compared to the share price.

It can also just mean that investors are confident that the stock is worth more. Investors would expect higher returns and would generally make gains when the price rises to be closer to what it is worth.

In the same vein, a high one means that it is overvalued and investors are really paying a higher price for the stock compared to its earnings. Low P/E stocks are good and high P/E stocks are riskier because they can fall in value at any time.

Because of the high risk, they are expected to compensate investors with higher returns. With this analysis, you can tell that the anomaly isn’t baseless – much like all anomalies.

Assuming that you had the option of choosing between a stock with a high P/E ratio and one with a low P/E ratio and both promise the same returns, you would go for the lower one because of the lower risk.

As a measure of caution, while low price-to-earnings stocks tend to outperform as a group, when viewed individually, it doesn’t always apply. As such, it is when you have various stocks in a large portfolio that you can reap the benefits of this – if at all.

Written by Lawretta Egba.