Sentiment and Financial Health Indicators for Value and Growth Stocks: The European Experience

Abstract

The well-documented market underperformance of the majority of value and growth stocks over a 12-month holding period reflects that traditional valuation metrics might tell us whether a stock is potentially cheap or expensive but little about when, or even if, it will experience a market correction. Two indicators have come to the fore in recent years that provide useful insights: sentiment/momentum and accounting fundamentals/financial health. We examine their single and combined impact on value and growth stocks and find that (i) they are effective in introducing a timing element into the selection of both value and growth stocks, (ii) the sentiment indicator completely dominates the financial health indicator and, (iii) both indictors contribute to the performance of the good and bad growth stocks. The size and significance of the investment profits that potentially can be generated using the two indicators in combination questions of the efficiency of the European equity markets. We conclude that our findings are consistent with the pricing cycle for a stock proposed by Lee and Swaminathan (Lee, C., Swaminathan, B. (2000) Price momentum and trading volume, Journal of Finance, 55, pp. 2017-2069.) and the under- and over-reaction in pricing inherent in models proposed by Barberis et al. (Barberis, N., Shleifer A., and Vishny, R. (1998) A model of investor sentiment, Journal of Financial Economics, 49, pp. 307-343.) and Hong and Stein (Hong, H., Stein, J.C. (1999) A unified theory of underreaction, momentum trading and overreaction in asset markets, Journal of Finance, 54, pp. 2143-2184.).Sentiment, financial health, market efficiency, asset pricing anomalies,

How value–glamour investors use financial information: UK evidence of investors’ confirmation bias

“…Those observations suggest that, among value (glamour) stocks, those that are financially stronger (weaker) are more severely mispriced. A similar observation also derives from Bird and Casavecchia (2007). Overall, the cumulative intuition is that the pattern may follow a "rule", which is consistent with investor's behaviour suffering from a confirmation bias.…”

“…Piotroski, 2000;Bird and Casavecchia, 2007). Thus, it is important to identify investment strategies that can recognise the better performing stocks in value and glamour portfolios as implied by simple value measures, such as the fundamental-to-price ratios.…”

“…Most of the research in this area (Piotroski, 2000;Mohanram, 2005;Bird and Casavecchia, 2007) defines excess returns against a benchmark, such as the market portfolio or the corresponding size deciles. Bird and Casavecchia (2007) also find evidence that the Fama and French three-factor model cannot explain the observed returns. Although the debate is far from being settled, the cumulative evidence seems to reject risk-based explanations and suggests instead that behavioural biases may be responsible for the observed return pattern.…”

“…In a similar vein, Mohanram (2005 ) designs a G Score from eight fundamental signals and finds that this measure of financial strength can differentiate winners from losers among low BM glamour stocks in the US stock market during the 1979-1999 period. Subsequently, Bird and Casavecchia (2007) use a dynamic model based on 24 accounting variables to predict the probability of a stock having an improved earnings-per-share performance, and they employ that probability as a measure of financial strength. Bird and Casavecchia's evidence is consistent with Piotroski's and Mohanram's conclusions that fundamental analysis can help differentiate "good" from "bad" value and glamour stocks.…”

Enhancement of value portfolio performance using momentum and the long-short strategy: The Finnish evidence

“…Parallel results are also reported by Bird and Whitaker (2003), who find that the optimal holding period for value portfolios formed on the basis of price-to-book (P/B) ratios or price-to-sales ratios is somewhere between 24 and 36 months for a large sample of European stocks. Using the same portfolio-formation criteria, Bird and Casavecchia (2007a) report a steady expansion of the value premium when the holding period is extended to 36 months, which is the maximum length for portfolio reformation included in their study. The recent results of Leivo and Pätäri (2009) from the Finnish stock market indicate that the outperformance of value portfolios against both the general stock market and comparable glamour portfolios persists even when portfolios are reformed at a 5-year frequency.…”