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An investigation of leverage, contrarian overextrapolation and the p/e effect Hochachka, Eugene A.

Abstract

The most common explanation for the superior returns of undervalued stocks is that market extrapolation of recent results too far into the future results in profitable opportunities for those "contrarian" investors who take advantage of the market's mistake before it corrects itself. An opposing view is that because a security's price impounds expected returns, those stocks which are riskier and will therefore be accorded high discount rates should ceteris paribus appear to be undervalued, and should thus exhibit positive excess returns over most periods. We review the evidence for both arguments and then test whether various types of leverage are priced, in the belief that leverage risk may be a factor behind the excess-returns of undervalued stocks. We find only weak evidence that leverage risk is priced, and it is clearly not priced sufficiently to be a causal factor in value-investing. We then focus our attention on a dataset in which the contrarian explanation does not hold because share price and cashflow have moved opposite to one another from previous periods, whereas for the contrarian explanation to hold price must move in the same direction as cashflows but by too much. We find the value-investing effect to be just as strong in the non-contrarian subsets as in the universe of all firms and thus conclude that the effect is not contrarian in nature but is instead consistent with market rationality, where myriad forms of risk are initially reflected in firm price and are eventually reflected in realized returns.

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