An Earnings Yield Anomoly

[Colt McCoy]

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?

[hawk59]

Well a low earnings yield because of very negative earnings is really a different situation than a low earnings yield on a profitable company. I think the reason has to be that the market is overreacting to their current unprofitability.

[Colt McCoy]

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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.

[Perplexity]

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.

[Colt McCoy]

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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.

[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.

[/ QUOTE ]

Ding! Big Bath Theory was my guess as well.

[/ QUOTE ]

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.

[hawk59]

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

[/ QUOTE ]

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.

[/ QUOTE ]

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.

[Colt McCoy]

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

[/ QUOTE ]

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.

[/ QUOTE ]

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.

[/ QUOTE ]

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?

[hawk59]

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

[/ QUOTE ]

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.

[/ QUOTE ]

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.

[/ QUOTE ]

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.

[Scorpion Man]

[ QUOTE ]
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?

[/ QUOTE ]

Biotech, maybe alternative energy, etc.