An Earnings Yield Anomoly

[Colt McCoy]

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A hedge fund I work with has been backtesting various investment criteria and found an oddity about earnings yield (E/P).

Basically we divided a group of small cap stocks into deciles based on earnings yield. As you'd expect, the stocks with the highest earnings yield have tended to do better with returns declining as the yields get lower.

The oddity, however, was the stocks in the very last decile with the lowest yield (heavily negative earnings). These stocks have also tended to substantially outperform. Any ideas why? I have a theory but would like to hear some other ideas first. Ideas?

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Biotech, maybe alternative energy, etc.

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I don't get what you're saying? [img]/images/graemlins/confused.gif[/img]

It's not industry specific. It's a pretty big universe of stocks.

[hawk59]

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I think the reason has to be that the market is overreacting to their current unprofitability.

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I think you missed what's going on here. The stocks with very negative earnings are showing high returns following the reporting of those earnings. But it's only the very bottom decile, in other words the companies with most negative earnings are showing high returns.

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Isn't that what I said? When companies are losing a lot of money the market overreacts on average and the shares are too cheap on average. So the bottom decile would outperform going forward.

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So you're assuming the stock has been punished for the low earnings before they're reported and once they're reported people start buying? Kind of a "buy the rumor, sell the news" in reverse?

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I might be misunderstanding what you are saying. What is the important of something 'being reported'? I am saying companies that are losing money tend to get too cheap(undervalued) on average. Therefore they outperform going forward.

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Going forward from when? I'm referring to the date the negative earnings are released. The companies outperform after they report the negative earnings.

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So then what is the problem? Find a company that has historically been profitable, but has been unprofitable for the past year or however long. Chances are the stock is down a lot from where it was trading back when they were profitable. The fact that these stocks outperform going forward means that on average the stock fell too much and the company is now undervalued. As far as I can tell this is the same as saying stocks with low p/e's or low p/b's outperform stocks with high p/e's or high p/b's.

[NajdorfDefense]

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The bottom decile includes lots of companies that are doing a one-time accounting writeoff. Once they get all that stuff off their books, they can/will be profitable. Investors don't understand this and just think the company is losing money, so the price is driven too low.

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Ding! Big Bath Theory was my guess as well.

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The market always reacts. Primacy effect dominates in the short-term. Also Q- and Year-end effects as some firms can't be 'seen' holding companies that just blew up. They sell and buy 'em ack 6 mos later when they are up 20% from the lows, etc.