Reexamination of the E/P Anomaly by the Conditional Trading Strategy

Hsin-Yi Yu
Assistant Professor, Department of Finance, National University of Kaohsiung

700, Kaohsiung University Rd., Nanzih District 81148, Kaohsiung, Taiwan

Tel: +886-7-5919709; Fax: +886-7-5919329; Email: hyyu@nuk.edu.tw

Li-Wen Chen
Assistant Professor, Department of Finance, National Chung Cheng University

168 University Road, Minhsiung Township, Chiayi County 62102, Taiwan,

Tel: +886-5-2720411 ext. 24213; Fax: +886-5-2720818; Email: lwchen@ccu.edu.tw

Electronic copy available at: http://ssrn.com/abstract=1818642

Re-examination of the E/P Anomaly by the Conditional Trading Strategy

Abstract

This paper delivers a conditional trading strategy to re-examine the E/P anomaly, which has been subsumed by the three-factor model for a long time. Under the conditional trading strategy, we purchase undervalued stocks whose current E/P ratios are relatively high compared to their own E/P ratios over the past decade and sell the owned stocks when their E/P ratios are relatively low. The holding period for each stock is not fixed or exogenously predetermined. The returns earned by the conditional trading strategy cannot be rationalized with either Fama-French three-factor model or Carharts four-factor model. Moreover, the significant risk-adjusted returns are not attributed to timing ability. Overall, this paper revises the traditional trading strategy used in academic studies and confirms the E/P anomaly.

Keywords: Conditional trading strategy; Earnings-price ratio; Undervaluation; Anomaly; Holding period

Electronic copy available at: http://ssrn.com/abstract=1818642

Introduction

One of the fundamental conditions for efficient financial markets is the unbiased pricing of assets. However, a large body of literature reveals a host of anomalies based on bias in pricing. Analyzing the cross-section of expected stock returns becomes one of the central lines of financial research. Although various models and rationales have been put forward to explain anomalies, little attention is paid to the trading strategy, i.e. the method of constructing portfolios. Is it possible that the trading strategy plays a determinant role in identifying anomalies? Once we push the trading strategy closer to real investment behavior and disentangle some trading limits, some anomalies subsumed by factor models may be revitalized. This paper develops a conditional trading strategy to construct portfolios and revises the way of sorting the E/P ratios. The finding indicates that the newly designed trading strategy revitalizes the E/P anomaly, which has long been subsumed by the Fama-French three-factor model.

Recently, more and more return patterns cannot be fully explained by asset pricing models. A large number of studies reporting market anomalies in the top journals have mushroomed over the years (Subrahmanyam, 2010). Recent research shows that capital investment, accruals, sales growth rates, idiosyncratic volatility, and capital raising are found to be negatively

correlated with future returns 1 . For example, Fairfield, Whisenant, and Yohn (2003) and Titman, Wei, and Xie (2004) demonstrate that firms which invest more have lower stock returns. Ang, Hodrick, Xing, and Zhang (2006, 2009) illustrate that stocks with high idiosyncratic volatility have extremely low average returns. Sloan (1996) also finds that higher accruals predict lower stock returns. From the corporate finance viewpoint, Daniel and Titman (2006) and Pontiff and Woodgate (2008) show that there is a negative relationship between net stock issues and average returns. Meanwhile, Haugen and Baker (1996) and Cohen, Gompers, and Vuolteenaho (2002) also indicate that more profitable firms have higher average stock returns subsequently. In addition, short-term positive return autocorrelations, i.e. momentum, is also a famous anomaly (Jegadeesh and Titman, 1993). Stocks with high (low) returns in the past tend to have high (low) returns in the future. Such return continuation is left unexplained by the three-factor model of Fama and French (1993). Recently, Cooper, Gulen, and Schill (2008) confirm that asset growth rates are strong predictors of future abnormal returns.

To test whether a variable can be used to predict the cross-section of stock returns, the direct method is to choose stocks based on this variable and then construct a portfolio. If this portfolio can generate risk-adjusted returns, an anomaly emerges. In previous research,

See, for example, Lakonishok, Shleifer, and Vishny (1994), Titman et al. (2004), Sloan (1996), Fairfield et al. (2003), Hirshleifer, Hou, Teoh, and Zhang (2004), Richardson and Sloan (2003), Pontiff and Woodgate (2008), Broussard, Michayluk, and Neely (2005), Zhang (2006), and Anderson and Garcia-Feijoo (2006). See also Cochrane (1996), Lamont (2000), Moeller, Schlingemann, and Stulz (2004), Fama and French (2006), and Polk and Sapienza (2009). 4

equally-weighted or value-weighted portfolios are constructed at the beginning of time t. The stocks in the same portfolio are all held until time t+n; that is, the holding period for each stock in the portfolio is identical. While n is more than 1, the monthly return is computed by averaging the overlapping portfolio returns using the buy and hold method or the rebalance method (e.g., Jegadeesh and Titman, 1993)2.

Our major concern of the traditional trading strategy is that the holding period of a portfolio is exogenously predetermined, i.e. the holding period is decided upon before stocks are purchased, e.g. one month or one year. There is no theoretical explanation offered as to why the portfolio should be held for a fixed time period, not to mention that such a constraint is not consistent with real investment behavior. In practice, the holding period is usually set to be one (e.g. one day in Diether, Lee, and Werner (2009), one month in Fang and Peress (2009), one year in Cooper et al. (2008)). Portfolios are constructed at the beginning of time t based on a predictive variable of the immediately preceding time t-1 and then held until the end of time t. This line of thinking implicitly assumes that the predictive variable of time t-1 will present its

In the buy and hold method, stocks are allowed to have different weights at the beginning of each time. In the rebalanced method, stocks are rebalanced monthly to maintain equal weights. Some studies further long one portfolio and short another portfolio to deliver a zero-investment strategy. The zero investment strategy implicitly assumes that an investor shorts some assets (the short portfolio) to finance the purchase of others (the long portfolio). One of the famous zero investment examples is the phenomenon of momentum in Jegadeesh and Titman (1993). However, most individual investors only sell stocks that they have already owned. They seldom short-sell stocks (Barber and Odean, 2008). Moreover, in practice, the zero-investment strategy is not really zero-cost. If the market begins to move against investors short position, money will be removed from their cash balance and moved to their margin balance. If short shares continue to rise in price and the investor does not have sufficient funds in the cash account to cover the position, the investor will begin to borrow on margin for this purpose, thereby accruing margin interest charges. 5

predictive power exactly at time t, otherwise there is no anomaly caused by this variable. This assumption is questionable. It is possible for us to underestimate the predictive power of the variable if it requires a longer time to present its predictive power.

Some studies try to revise this weakness by including the information of the predictive variable from t-n to t-1, where n is more than 1. For example, Anderson and Brooks (2006) argue that it is not reasonable to postulate that only earnings from the previous year are relevant in valuing companies. Moreover, the phenomenon of momentum also reveals that the information at an earlier time period also provides predictive power. Jegadeesh and Titman (1993) select stocks based on stock returns over the past 12 months. They regard the past 12-month return as a whole, which implies that the information at month t-12 can still possess predictive power for the returns at month t. Based on Jegadeesh and Titmans work, Yu (2010) further analyzes the trend of past 12-month returns and then creates a hybrid strategy to generate higher risk-adjusted returns which cannot be fully explained by Carharts four-factor model (Carhart, 1997). But, is it possible to revise this weakness along the trading strategy avenue?

This paper develops a conditional trading strategy to construct portfolios. Like the traditional trading strategy, the conditional trading strategy decides which to buy based on a predictive variable. However, unlike the traditional trading strategy, the conditional trading strategy does
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not predetermine a fixed holding period in advance. A stock will be held until it does not deserve to be owned. To be specific, in the conditional trading strategy we need to determine not only when to buy a stock but also when to sell it.

In this vein, the most important question is how to decide when to buy and when to sell. Turning to the unified theoretical models, it is less controversial that investors may overreact or underreact to news about the fundamentals, for example, Daniel, Hirshleifer, and Subrahmanyam (1998), Barberis, Shleifer, and Vishny (1998) and Hong and Stein (1999). Taking all these studies together, most theories emphasize the fact that investors cannot perform rational and homogeneous reactions to information. The conditional trading strategy is developed based on the irrational side of investors. Once investors overreact or underreact to news, stock prices deviate from the fundamentals. This misinterpretation of information creates an opportunity to buy stocks which are more likely to be undervalued and sell them when they are more likely to be overvalued.

The conditional trading strategy creates another question: How to know whether a stock is more likely to be undervalued or overvalued? The prior-detected predictive variable the earnings to price (E/P) ratio is employed to measure the level of under- or overvaluation because the E/P ratio plays a critical role in asset pricing. The earliest described asset pricing
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anomaly, even before the capital asset pricing model (CAPM), was based on the E/P ratio (Sharpe, 1964), so called the E/P effect. It is well subsumed by the three-factor model in Fama and French (1993, 1996). However, the traditional way of employing the E/P ratio leads to a problem. Previous studies cross-sectionally sort the E/P ratios at a given time. In other words, they compare a stocks E/P ratio with the E/P ratios of other stocks in the market. This kind of cross-sectional E/P sorting ignores the fact that there is heterogeneity across the industry average E/P ratios. Furthermore, cross-sectional sorting also assumes that only earnings from the previous year are relevant in valuing companies. Anderson and Brooks (2006) and Campbell and Shiller (1988) argue that the E/P ratio over several years is a more powerful predictor of the return on stock.

Therefore, this paper does not adopt such cross-sectional sorting but employs time-series sorting. To identify whether a stock is undervalued, it is more natural to compare a stocks current E/P ratio with its own historical E/P ratios. Under time-series sorting, the stocks in the highest decile are those whose current E/P ratios are situated in the top 10% over the past ten years. Conversely, the stocks in the lowest decile are those whose current E/P ratios are situated in the bottom 10% over the past ten years. Intuitively, the stocks which are located in the higher (lower) deciles are more likely to be undervalued (overvalued). Taking the conditional trading strategy and time-series E/P sorting together, we purchase stocks in the higher deciles and hold
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these owned stocks until they drop to the lower deciles.

Using all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010, the conditional trading strategy creates significant risk-adjusted returns under both the three-factor and four-factor models. If we purchase stocks whose time-series E/P sortings are in the 9th and 10th deciles in the beginning of each month and hold these owned stocks until they drop to the 1st deciles, the risk-adjusted return is the most significant 16.63 basis points (p-value=0.01), approximately 2.01% annually. The peak is 16.94 basis points per month when we purchase stocks whose time-series E/P sortings are in the 9th and 10th deciles and sell them as they drop to the 3rd, 2nd, and 1st deciles. Furthermore, we also find that holding an undervalued stock without selling cannot generate significant risk-adjusted returns, which suggests that selling behavior is a determinant of abnormal returns.

We next attempt to dissect the risk-adjusted returns earned by the conditional trading strategy. Once a stock is considered as undervalued (overvalued) at time t, we postpone the buying (selling) activity to observe whether the trading time points significantly affect the risk-adjusted returns. Since the ideology behind the conditional trading strategy is to identify and purchase undervalued stocks, which is in the spirit of stock selection ability rather than timing ability, we expect that the risk-adjusted returns remain significant even though the
9

trading activities are postponed. The finding confirms our expectation. In other words, the risk-adjusted returns are not attributed to timing ability.

The remainder of this paper is organized as follows. Section I describes the data and the methodology. Section II presents the empirical results of the conditional trading strategy. This section also tests whether the profit of the strategy is conditional on time, along with a discussion about the robustness checks. Section III dissects the risk-adjusted returns earned by the conditional trading strategy. Section IV concludes.

I. Data and Methodology

A. Data

The sample covers all common stocks listed in the New York, American Stock Exchanges, and NASDAQ from the Compustat monthly file. Throughout, we include stocks that have a stock exchange code of 11, 12, or 14 that is, ADRs, REITs, closed-end funds, and primes and scores are excluded. The sample period is from January 1962 to December 2010.

B. Earnings-Price Ratio
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We employ the earnings-price ratio (E/P ratio) to measure the level of undervaluation and overvaluation. Many previous studies discuss the E/P anomaly, which is applied in many countries, for example the UK (Levis, 1989; Gregory, Harris, and Michou, 2001; Levis and Liodakis, 2001; Anderson and Brook, 2006); the UK and several European countries together (Brouwer, Put, and Veld, 1997; and Bird and Whitaker, 2003); Japan (Aggarwal, Rao, and Hiraki, 1990; Chan, Hamao, and Lakonishok, 1991; Cai, 1997; and Park and Lee, 2003); New Zealand (Chin, Prevost, and Gottesman, 2002).

Institutively, a relatively high E/P ratio indicates that under such profitability, investors intend to buy the stock at a lower price. Given this, the stock is more likely to be undervalued. Conversely, a relatively low E/P ratio indicates that investors are willing to buy the stock at a higher price given such profitability, which means that this stock is more likely to be overvalued. Previous studies, however, usually sort stocks into several groups by comparing the stocks E/P ratio with the E/P ratios of other stocks in the market. It is not natural to identify undervalued stocks through this kind of cross-sectional sorting, because the heterogeneity of the E/P ratio across industries would influence the sorting results. For example, the average E/P ratio of the agriculture industry is higher and more stable than that of the technology industry3.
During the sample period, the mean and standard deviation of E/P ratios in the agriculture industry, i.e. SIC code 0100~0999, are 3.73% (7.31%) respectively. In the wholesale trade (SIC code 5000~5199), the mean and standard deviation of E/P ratios are 2.42% (26.36%). 11
3

Given this, sorting all stocks in the market based on individual E/P ratios may ignore the E/P ratio characteristics of industry and thereby drives plausible results when picking undervalued stocks. Therefore, we replace cross-sectional sorting with time-series sorting. In time-series sorting, the benchmark is the E/P ratios of a stock over the past ten years rather than the contemporary E/P ratios of other stocks in the market.

In time-series E/P sorting, a stock whose E/P ratio at the time of portfolio formation is located in the top 10% over the past 10 years would be classified into the highest decile.4 Conversely, when the E/P ratio of a stock at the time of portfolio formation is situated in the bottom 10% of its own E/P ratio distribution over the past ten years, the stock would be grouped into the lowest decile. Thus, undervalued stocks can be defined as being located in the higher deciles, whereas overvalued stocks are those in the lower deciles.

C. Trading Strategy

This paper employs two trading strategies the traditional trading strategy and the conditional trading strategy. This section first presents the traditional trading strategy and discusses the weakness of it. The conditional trading strategy is introduced subsequently to complement the
In Fama and French (1993), portfolios are formed only in June of year t, and the E/P ratio used is computed as the equity income for the fiscal year ending in calendar year t-1 divided by the market equity of calendar year t-1.In other words, Fama and French (1993) update the E/P ratio annually. The calculation of E/P ratio in this study is similar to that of Fama and French (1993). However, we update the E/P ratio quarterly. 12
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insufficiency of the traditional trading strategy.

We first introduce the traditional trading strategy. Similar to Fama and French (1993), at the beginning of each month t, stocks are ranked to several groups based on the sorting of E/P ratios at the end of month t-1.5 The monthly return of each group is the value-weighted average of the selected stock returns in that group. These portfolios are held for one month, and then re-constructed according to the same criteria at the beginning of the next month. If one can obtain significant risk-adjusted returns by purchasing (short-selling) the stocks in the highest (lowest) group, the E/P anomaly is identified. We also compute the long-short profit. The long-short profit is obtained by purchasing the highest group portfolio and short selling the lowest group portfolio. Evidently, the traditional trading strategy only pays attention to the buying time point. There is no need to decide the selling time point because all positions are sold at the end of each month. That is, the holding period for each stock is fixed to one month.

This implicitly assumes that an anomaly can only be observed in a fixed and predetermined time period (e.g. one month). However, there is no underlying theory to decide how long the holding period should be. The holding period is mainly decided under personal subjective preference. This subjective decision may cause two problems. First, some predictive variables

As was discussed in Section I.B, the E/P sorting can be cross-sectional or time-series. One can also rank stocks into terciles, quintiles, or deciles. 13

are unable to reflect predictive power exactly within the predetermined holding period. The traditional trading strategy would neglect the importance of these variables. Secondly, the traditional trading strategy does not consider the speed of information diffusion. If the speed of information diffusion is homogeneous across firms, previous literature should be unable to demonstrate that some anomalies are more significant in firms with specific characteristics. However, they do find such phenomena (e.g. media coverage in Fang and Peress (2009)). Therefore, t is reasonable to conjecture that the speed of information diffusion is heterogeneous across firms. Collectively, an overly-long holding period may dilute the predictive power of information; an overly-short holding period may underestimate the predictive power of information. Therefore, we release this constraint and develop a conditional trading strategy, which is based on the concept that information at time t may not reflect predictive power exactly at time t+1.

In the conditional trading strategy, we invest money in stock which satisfy the buying criterion at the beginning of each month and sell the owned stocks which meet the selling criterion. The portfolio is value-weighted. Here is a brief example when the buying (selling) criterion is whether a stock is undervalued (overvalued). There are three stocks, X, Y, and Z, in the market. At month t, if stock X is undervalued and stocks Y and Z are not, we buy stock X in proportion to its size (usually a millionth of the size). At the beginning of time t+1, if stocks X and Y are
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undervalued, we increase the positions in stocks X and Y with money in proportion to their sizes. At the beginning of time t+2, if stock X is overvalued and stocks Y and Z are undervalued, we sell the whole position of stock X and invest in stocks Y and Z in a value-weighted way.

This study uses the E/P ratios to define the buying and selling criteria. According to the sorting on E/P ratios6, stocks are classified into several groups. If stocks are sorted into deciles, the lowest decile of E/P sorting is 1 and the highest decile is 10. We use the form (Buy, Sell) to describe the buying and selling criteria in the conditional trading strategy. For example, if the buying criterion is to purchase stocks whose E/P sorting is more than or equal to 8 (>=8) and the selling criterion is to sell the owned stocks whose E/P sorting is less than 5 (<5), we refer to this as the form (>=8, <5).

D. Performance Measurement

Fama-French three-factor model is used to calculate the risk-adjusted returns of portfolios.

RMRF SMB HML rp ,t = p + p RMRFt + p SMBt + p HMLt + e p ,t

(1)

As was discussed in Section I.B, the E/P sorting can be cross-sectional or time-series. 15

where r p ,t is the monthly return on a portfolio in excess of the one-month T-bill return; p is the risk-adjusted return of portfolio i; and RMRFt is the return on the market portfolio in excess of the risk-free rate. SMBt and HMLt are value-weighted, zero-investment, factor-mimicking portfolios for size and book-to-market equity in stock returns respectively. These factor data are collected from the website of Kenneth R. French.

We also employ Carharts four-factor model to examine whether the risk-adjusted returns earned by the conditional trading strategy are overlapped with the phenomenon of momentum. The momentum factor (UMD) is computed as the equally weighted average of firms with the highest 30 percent eleven-month returns lagged one month minus the equal-weight average of firms with the lowest 30 percent eleven-month returns lagged one month.

RMRF SMB HML rp ,t = p + p RMRFt + p SMBt + p HMLt + UMDUMDt + e p ,t p

(2)

II. Empirical Results of the Buy-Sell Strategy

In this section, two trading strategies the traditional trading strategy and the conditional trading strategy are used to construct portfolios. Two E/P sorting methods cross-sectional
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sorting and time-series sorting are also adopted to sort stocks into several groups. Therefore, there are in total four combinations with different trading strategies and sorting methods. All combinations are examined and reported.

A. Traditional Trading Strategy and Conditional Trading Strategy

As a base case, we first mirror the methodology in Fama and French (1993), which uses cross-sectional E/P sorting to rank stocks into quintiles and construct portfolios by the traditional trading strategy. The lowest quintile of E/P sorting is 1 and the highest quintile is 5. The portfolio is value-weighted and constructed at the beginning of each month. Table 1 reports the raw returns and risk-adjusted returns.

[INSERT TABLE 1 HERE]

The central results in this table are consistent with those in Fama and French (1993). First, the three-factor model leaves no residual E/P effect. Although there are significant risk-adjusted returns for P4 and P5 under CAPM, the three-factor intercepts for the five E/P portfolios are insignificant between -8.87 and 8.32 basis points per month. Even if we long the highest E/P portfolio and short sell the lowest E/P portfolio (P5-P1), the risk-adjusted return is not
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significant. To sum up, there is no E/P effect under the three-factor model. Second, both raw returns and risk-adjusted returns increase from the lowest to the highest E/P quintile. Moreover, the untabulated results indicate that the increasing pattern in the risk-adjusted returns on the E/P portfolios is due to their loadings on the book-to-market factor HML. The lowest E/P quintile has an HML slope of -0.14, and the highest E/P quintile has an HML slope of 0.41. In brief, the results in Table 1 can be interpreted as suggestive evidence in favor of the argument that the three risk factors in Fama and French (1993) explain the E/P effect.

Next we turn to time-series sorting, whose sorting benchmark is the stocks own E/P ratios over the past decade rather than the E/P ratios of other stocks in the market. Table 2 illustrates that under the traditional trading strategy there is no significant three-factor risk-adjusted return in every portfolio, including the long-short portfolio, P5-P1. To sum up, the three risk factors fully explain the portfolio returns when the traditional trading strategy is employed.

[INSERT TABLE 2 HERE]

However, the traditional trading strategy gives no consideration to the fact that the holding period of each stock should not be fixed. Therefore, we disentangle the constraint on the holding period through the conditional trading strategy. Table 3 presents the three-factor
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risk-adjusted returns under the conditional trading strategy. The stocks are ranked into deciles through cross-sectional E/P sorting7. We can observe that there are 55 combinations of (Buy, Sell) in Table 3. For example, we can purchase undervalued stocks whose E/P sortings are located in the 9th and 10th deciles and hold them until they fall to the lowest decile. The risk-adjusted return earned under such a trading criteria is shown in cell (>=9, <2). In particular, when the selling criterion is <1, it means that once stocks are purchased they would never be sold. In other words, after we purchase a stock we will hold it until the end of the sample period, i.e. December 2010.

[INSERT TABLE 3 HERE]

In Table 3 it is obvious that almost all combinations of (Buy, Sell) cannot create significant risk-adjusted returns at the 5% significance level. The range of risk-adjusted returns is from 4.69 basis points to 11.87 basis points per month. Consistent with our expectation, the combination of the conditional trading strategy and cross-sectional E/P sorting does not generate significant outperformance. As was discussed in Section I.B, cross-sectional E/P sorting neglects the heterogeneity of E/P ratios across different industries. Moreover, it does

Note that if we sort stocks into quintiles rather than deciles, we can still obtain the empirical results from Table 3. When the lowest quintile of E/P sorting is 1 and the highest quintile is 5, buying stocks whose E/P sortings are located in the 4th and 5th quintiles and hold them until they fall to the lowest quintile can be written as (>=7, <3). Similarly, buying stocks whose E/P sortings are located in the 5th quintiles and hold them until they fall to the 2nd and 1st quintiles can be written as (>=9, <5). 19

not consider the E/P ratios from the previous years in valuing companies. Therefore, it may not suit the ideology behind the conditional trading strategy. Time-series E/P sorting is developed to eschew these weaknesses.

In Table 4, we adopt the conditional trading strategy with time-series E/P sorting, whose sorting benchmark is the stocks own E/P ratios over the past decade. The three-factor risk-adjusted returns are reported. Three features stand out.

[INSERT TABLE 4 HERE]

First and foremost, the three-factor risk-adjusted returns become significant. We can observe that when the buying criteria are between >=6 and >=10 and the selling criteria are between <2 and <5, most risk-adjusted returns are significant at the 5% significance level. For example, if we purchase stocks whose E/P sorting is in the 9th and 10th deciles in the beginning of each month and hold these stocks until they drop to the 1st deciles, i.e. (Buy, Sell) = (>=9, <2), we can obtain 16.63 basis points per month, approximately 2.01% annually. The significance level reaches a peak in cell (>=9, <2). Similarly, when (Buy, Sell) is (>=6, <3), the monthly risk-adjusted return is 11.93 basis points per month, approximately 1.44% per year.

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Secondly, once we tighten the buying criteria, the risk-adjusted returns increase. In other words, purchasing stocks in the higher two deciles would obtain higher risk-adjusted returns than purchasing stocks in the higher three deciles. This increasing pattern of returns is not influenced by the selling criteria. Theoretically, undervalued stocks should be found in the higher deciles rather than in the lower deciles. Purchasing stocks in the higher deciles should be more consistent with the spirit of the conditional trading strategy. The results confirm this inference. In a similar vein, once we hold the stocks whose E/P sortings are positioned in the higher deciles, the risk-adjusted returns should be reduced because these stocks are less likely to be overvalued. The results show that the returns decrease when we sell the owned stocks whose E/P sortings are positioned in the higher deciles. This decreasing pattern of returns is not influenced by the buying criteria. Taken together, we can conclude that purchasing stocks in the higher deciles and selling stocks in the lower deciles can achieve higher returns. In other words, it is profitable to purchase stocks which are highly undervalued and hold them until they are very likely to be overvalued.

Thirdly, it is interesting to note that if the selling criterion is <1, i.e. we never sell the stocks once we have purchased them, the risk-adjusted returns become insignificant, regardless of the buying criteria. This finding demonstrates that identifying an undervalued stock and holding it without selling cannot generate significant risk-adjusted returns. To obtain significant
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risk-adjusted returns, the holding period should be neither fixed nor unlimited. It should be varied with the characteristics of every individual stock. Collectively, these results are supportive of the notion that both the buying behavior and the selling behavior independently contribute to the enhancement of risk-adjusted returns.

To summarize, the conditional trading strategy revitalizes the E/P anomaly, which was no longer considered as an anomaly under the three-factor model. This finding suggests that the conditional trading strategy can enhance the possibility of identifying anomalies.

B. The Holding Period

It is reasonable to expect that the average holding period for a stock under the conditional trading strategy is longer than that in the traditional trading strategy. But how much longer? Table 5 describes the statistics of the holding period under the two strategies. For brevity, here the conditional trading strategy is to purchase stocks whose time-series E/P sortings are in the 9th and the 10th deciles and hold them until they drop to the 1st deciles, i.e (>=9, <2). All (Buy, Sell) combinations are examined; the major findings remain unchanged.

The average holding period is computed by summing up the holding periods of all stocks in the
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sample and then dividing by the number of stocks. If there are time gaps in the holding period for the same stock, the stock in different holding zones would be viewed as different objectives. Note that under the traditional trading strategy, if a stock is chosen to be held at the beginning of month t, t+1, and t+2 based on the sorting result, the holding period for the stock is 3. In this way, the average holding period of the traditional trading strategy is not always one month.

[INSERT TABLE 5 HERE]

Panel A of Table 5 shows that the average holding period is a striking 68.9 months under the conditional trading strategy, whereas it is only 1.7 months under the traditional trading strategy. In other words, once we purchase a stock, we will on average hold it for 5.7 years under the conditional trading strategy. However, on average we would not continuously choose to buy a stock into the portfolio over two months under the traditional trading strategy. Panel B reports the average holding period for different industries. We can first observe that the average holding period under the conditional trading strategy is still much longer than that under the traditional trading strategy for all industries. Among various industries, public administration has the shortest holding period under both trading strategies.

Furthermore, we also compute the average holding period along size partition. However, it is
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very likely for a firm to change its size quintiles during the holding period. Therefore, for a stock we average the values of its size quintile during the holding period as its final size quintile. In Panel C we find that the average holding period is size-neutral. The average holding period under the conditional trading strategy is always longer than that under the traditional trading strategy. Regardless of size partition, a stock would be held for 5-6 years on average under the conditional trading strategy, but less than two months under the traditional trading strategy.

C. Further Evidence of the Buy-Sell Strategy

In this section, several tests are conducted to confirm the robustness of the above findings. Some may argue that the revitalized E/P anomaly could be overlapped with the phenomenon of momentum. Therefore, we employ Carharts four-factor model to observe whether momentum exposure can eliminate the significant E/P anomaly under the conditional trading strategy. Second, the sample period can play an important role in determining returns. Since the returns of portfolios constructed under the E/P partitions are well subsumed by the three-factor model in the works of Fama and French (1992, 1993, 1996, 1998), we use the same time period in Fama and Frenchs work to examine whether the conditional trading strategy can create significant risk-adjusted returns. Finally, similar to Fama and French (2008), we delete stocks
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whose market capitalizations are in the smallest NYSE/AMEX/NASDAQ decile to repeat previous analysis. All major findings remain unchanged under these tests.

C.1 Carharts Four-Factor Model

Some may raise a concern that the E/P anomaly overlaps with the momentum effect. Carharts four-factor model is employed to test this argument. Carharts four-factor model is based on the three-factor model and further includes the momentum factor (UMD). This momentum factor is computed as the equally weighted average of firms with the highest 30 percent eleven-month returns lagged one month minus the equal-weight average of firms with the lowest 30 percent eleven-month returns lagged one month.

As anticipated, there remain significant risk-adjusted returns in Carharts four-factor model. The momentum factor cannot completely explain the significant risk-adjusted returns when the conditional trading strategy is employed. For example, when (Buy, Sell) is (>=9, <2), a significant risk-adjusted return can still be observed, 17.07 basis points per month at the 1% significance level. We also try other combinations of (Buy, Sell). As long as the risk-adjusted return for a combination is significant under the three-factor model, it remains significant under the four-factor model.
25

C.2 Time Partition

We also test whether the above findings are sensitive to time. Fama and French (1992, 1993, 1996, and 1998) claim in their work that the three-factor model can fully explain the anomalies derived from the E/P ratios. The sample periods are generally from 1962 to 1989 in Fama and French (1992, 1993, and 1996) for the US domestic market, and from 1975 to 1995 in Fama and French (1998) for international markets. In Panel A of Table 6, we first follow the sample period in Fama and French (1992), which ranges from January 1962 to December 1989 and sorts stocks into quintiles by using time-series E/P sorting. The second sub-period from January 1990 to December 2010 is used to examine the E/P anomaly in the time period which is not covered by the work of Fama and French. Here (Buy, Sell) is set to be (>=9, <2). Other combinations are also tested though not always reported. The conclusion is not materially altered under different combinations.

[INSERT TABLE 6 HERE]

The findings in Panel A of Table 6 corroborate those in Fama and French (1992, 1993) that there is no E/P anomaly under the traditional trading stretagy regardless of time period.
26

However, when we use the conditional trading strategy to construct portfolios from January 1990 to December 2010, the E/P anomaly cannot be rationalized with the three risk factors. The significant intercept demonstrates the effectiveness of the conditional trading strategy. However, even when the conditional trading strategy is adopted, the E/P anomaly does not prevail in the market from January 1965 to December 1989, which means that the E/P anomaly can only be found in the past two decades. It would be interesting to uncover the reasons which lead to the above finding in the future.

In Panel B of Table 6, we further divide the whole period into five non-overlapping sub-periods. The results show that the traditional trading strategy generates no significant risk-adjusted returns. However, the conditional trading strategy can create significant risk-adjusted returns during some sub-periods. The return reaches a peak during the 1990s, which is 33.56 basis points per month, approximately 4.10% per year. All combinations of (Buy, Sell) are examined, although not always reported, and the major conclusions remain unchanged. In brief, as long as we use the traditional trading strategy to construct portfolios, the E/P anomaly is always subsumed by the three-factor model.

C.3 Robustness Check

27

A test is conducted to ensure that the findings are not driven by small and illiquid stocks. Hence, we filter out all stocks priced under $5 at the beginning of the holding period, and all stocks with market capitalizations that would place them in the smallest NYSE/AMEX/NASDAQ decile and repeat the previous analyses. The test results indicate that the deletion of low-priced and illiquid stocks has little effect on the results. The previous findings are not changed. Moreover, some may ask why use the E/P ratios over the past ten years as the benchmark in time-series E/P sorting. Therefore, we also compare a stocks current E/P ratio with its E/P ratios over the past 5, 12, or 20 years to decide in which decile this stock is grouped and repeat all the above analyses. We find that as long as the conditional trading strategy is adopted, the significant risk-adjusted returns can be identified regardless of which time periods E/P ratio is employed.

III. Dissecting the Risk-Adjusted Returns of the Buy-Sell Strategy

Fama (1972) proposes that the returns of mutual fund managers can be subdivided into two parts: return from stock selection and return from timing activity. Stock selection is the ability to forecast the price movements of individual investment targets relative to other targets in the same market. Timing is the ability to forecast the price movements of one investment set relative to another set, and is an investment strategy based on the outlook for an aggregate
28

market rather than for a particular financial asset.

A methodology is designed to ascertain whether the risk-adjusted returns under the conditional trading strategy are driven by timing ability. Theoretically, when the returns are mainly attributed to timing ability, the time of purchasing and selling stocks would influence the returns significantly. On the other hand, if a portfolio is always able to produce significant risk-adjusted returns when the purchasing and selling time points are postponed, we can infer that the reason is less associated with timing ability and more with stock selection ability. Since the design of the conditional trading strategy is to purchase undervalued stocks and hold them until the undervaluation disappears, the whole process is less related to the spirit of timing activity. Hence, we expect that the portfolio constructed under the conditional trading strategy can still generate significant risk-adjusted returns when the buying and selling time points are postponed.

Following this line, we postpone the buying and selling activities to observe whether the risk-adjusted returns are reduced or become insignificant. When a stock is regarded as undervalued at month t, its purchasing time would be postponed to month t+1, t+2, t+3 or t+6. Similarly, the selling time can also be postponed. When a stock is considered as overvalued at month t, it would be sold at month t+1, t+2, t+3 or t+6 respectively rather
29

than at month t. Because the results look so similar for different combinations of (Buy, Sell), we only present (>=9, <2) for illustrative purposes.

Table 7 presents the empirical results. The risk-adjusted returns remain significant under postponed buying and selling time points. The rows describe the postponed buying time point, where t means that there is no delay between the identification of undervaluation and buying behavior. The columns show the postponed selling time point, where t means that there is no delay between the identification of overvaluation and selling behavior. To illustrate, if we purchase the stock which is regarded as undervalued without delay (at time t) and sell it when it is considered as overvalued without delay, we can obtain 16.63 basis points per month. However, if we postpone both the buying and selling activities to two months later, the risk-adjusted returns are 16 basis points per month. These risk-adjusted returns are still significant. This result reveals that the risk-adjusted returns are not reduced significantly by postponed buying and selling activities. In other words, the risk-adjusted returns under the conditional trading strategy are more likely due to stock selection ability rather than timing ability.

[INSERT TABLE 7 HERE]

30

IV. Conclusion

The traditional trading strategy usually fixes the length of the holding period and thereby underestimates the potential of predictive information. To revise this weakness and be closer to real investment behavior, this paper delivers a conditional trading strategy to revitalize the E/P anomaly previously subsumed by Fama-French (1993) three-factor model. The conditional trading strategy purchases stocks which are more likely to be undervalued and sells them when the stocks are more likely to be overvalued. Apparently, unlike the traditional trading strategy, there is no predetermined holding period for a stock. To measure the levels of undervaluation and overvaluation, the current E/P ratio of a stock is compared with its E/P ratios over the past decade. If the stock has a relatively high (low) E/P ratio it is considered to be undervalued (overvalued).

The risk-adjusted returns of portfolios constructed under the conditional trading strategy remain significant in Fama-French three-factor model. Moreover, the phenomenon of momentum cannot fully explain the observed E/P anomaly. The results are robust to sample division into sub-periods and removing outliers. Even when we postpone the buying and selling activities, the risk-adjusted returns are still significant. In other words, the risk-adjusted returns earned by implementing the conditional trading strategy are less likely to be attributed
31

to timing ability.

Based on these findings, this paper addresses several fundamental concerns. First, the traditional trading strategy merely focuses on the time of purchasing stocks. The selling time point is seldom discussed in the asset-pricing field. Our findings indicate that the criterion and time of selling behavior possesses significant influence on risk-adjusted returns. Secondly, the findings in both this paper and Jegadeesh and Titman (1993) imply that information at time t which can predict stock returns does not have to take effect exactly at time t+1. In other words, information at time t-2, t-3, , t-n may still have predictive power on stock returns at time t. Finally, in the past, most predictive variables are sorted cross-sectionally. Time-series sorting is seldom adopted. The revitalized E/P anomaly suggests that identifying other anomalies through time-series sorting is possible, such as the dividend/price (D/P) ratio in Fama and French (1993). It is interesting to examine whether the other anomalies which have been subsumed by the three-factor model would reappear under the conditional trading strategy and time-series sorting in the future.

32

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Titman, Sheridan, K.C. John Wei, and Feixue Xie, 2004, Capital investments and stock returns, Journal of Financial and Quantitative Analysis 39, 677700. Yu, H.- Y., 2010, Momentum Reversal Strategy, Working paper, National University of Kaohsiung. Zhang, Frank, 2006, Accruals, investment, and the accrual anomaly, Working paper, Yale University.

37

Table 1 Raw and Risk-Adjusted Returns under the Traditional Trading Strategy: Cross-Sectional Sorting
This table reports the raw returns, excess returns and monthly risk-adjusted returns of the portfolios under the traditional trading strategy. The unit is basis points. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010. At the beginning of each month, stocks are ranked into quintiles based on the earnings-price (E/P) ratios. The E/P ratio used in this study is similar to that of Fama and French (1993), but we update the E/P ratio quarterly rather than annually. All portfolios are value-weighted and held for one month. The t-statistics are in parentheses and the p values are in brackets. Quintile Raw Ret 92.36 P1 (lowest) (2.938) [0.003] 86.95 P2 (3.714) [0.000] 93.97 P3 (4.835) [0.000] 106.79 P4 (5.642) [0.000] 117.13 P5 (highest) (5.871) [0.000] 23.76 P5-P1 (0.986) [0.325] Excess Ret 47.64 (1.511) [0.131] 42.32 (1.805) [0.072] 49.69 (2.553) [0.011] 62.83 (3.315) [0.001] 73.18 (3.657) [0.000] 68.48 (2.831) [0.005] CAPM -9.19 (-0.511) [0.610] -3.21 (-0.387) [0.699] 10.15 (1.257) [0.209] 20.77 (2.551) [0.011] 29.69 (3.086) [0.002] 40.79 (1.779) [0.076] Fama-French -8.87 (-0.506) [0.613] 6.83 (0.878) [0.381] 7.78 (0.952) [0.342] 5.46 (0.741) [0.459] 8.32 (0.983) [0.326] 19.78 (0.916) [0.360]

38

Table 2 Raw and Risk-Adjusted Returns under the Traditional Trading Strategy: Time-Series Sorting
Four kinds of monthly returns of the portfolios for the traditional trading strategy are reported in this table. The unit is basis point. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010. At the beginning of each month, stocks are grouped into quintiles by using time-series E/P sorting. The benchmark is their own past 10-year E/P ratios. A stock whose E/P ratio at the time of portfolio formation is located in the top 20% over the past 10 years would be ranked in the highest quintile. All portfolios are value-weighted and held for one month. The t-statistics are in parentheses and the p values are in brackets. Quintile Raw Ret 95.23 P1 (lowest) (3.839) [0.000] 98.04 P2 (4.358) [0.000] 112.27 P3 (4.472) [0.000] 95.98 P4 (4.679) [0.000] 94.46 P5 (highest) (4.755) [0.000] 0.81 P5-P1 (0.051) [0.959] Excess Ret 50.16 (2.018) [0.044] 53.39 (2.368) [0.018] 67.77 (2.697) [0.007] 51.47 (2.505) [0.013] 50.05 (2.515) [0.012] -44.29 (-2.781) [0.006] CAPM 6.88 (0.569) [0.570] 9.60 (1.047) [0.296] 22.12 (1.506) [0.133] 9.32 (1.234) [0.218] 9.46 (1.295) [0.196] -3.83 (-0.243) [0.808] Fama-French 6.55 (0.532) [0.595] 7.38 (0.792) [0.429] 20.63 (1.376) [0.169] 9.54 (1.237) [0.216] 7.65 (1.034) [0.301] -1.77 (-0.111) [0.912]

39

Table 3 The Risk-Adjusted Returns under the Conditional Trading Strategy: Cross-Sectional Sorting
This table presents the monthly risk-adjusted returns of the portfolios under the Fama-French three-factor model for the conditional trading strategy. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010. At the beginning of each month, we compare a stocks own E/P ratio with the E/P ratios of other stocks in the market and group stocks into deciles. One is the lowest E/P group and ten is the highest E/P group. In the conditional trading strategy, if stock X satisfies the buying criterion at time t, we invest in stock X in proportion to its size. At the beginning of time t+1, if stock X satisfies neither the buying criteria nor the selling criteria, it will be held without investing new money. This stock will only be sold when it satisfies the selling criterion. Rows (>=1 ~ >=10) describe the buying criteria and columns (<1 ~ <10) indicate the selling criteria. For example, the number in cell (>=8, <3) is the risk-adjusted return of the portfolio which buys stocks whose E/P ratio sortings are at the 8th, 9th, or 10th deciles and sells the owned stocks when their E/P ratio rankings drop to the 2nd or 1st deciles. If the purchased stocks are in the 7th, 6th, 5th, 4th, or 3rd deciles, they would be held but do not deserve new investment. The unit is basis point. The t-statistics are in parentheses and the p values are in brackets. Selling Criteria <1 (never sell) 6.22 >=1 (1.190) [0.235] Buying Criteria 6.43 >=2 (1.226) [0.221] 6.57 >=3 (1.231) [0.219] 7.14 (1.338) [0.181] 7.18 (1.314) [0.189] 9.90 (1.704) [0.089] <2 <3 <4 <5 <6 <7 <8 <9 <10

40

6.36 >=4 (1.156) [0.248] 6.54 >=5 (1.136) [0.256] 5.88 >=6 (0.990) [0.323] 5.87 >=7 (0.946) [0.345] 6.55 >=8 (1.002) [0.317] 5.50 >=9 (0.822) [0.411] >=10 3.01 (0.425) [0.671]

6.86 (1.219) [0.223] 7.01 (1.190) [0.234] 6.34 (1.043) [0.297] 6.50 (1.022) [0.307] 7.26 (1.081) [0.280] 6.39 (0.926) [0.355] 4.44 (0.619) [0.536]

9.52 (1.609) [0.108] 9.53 (1.547) [0.123] 9.01 (1.419) [0.156] 9.47 (1.425) [0.155] 10.34 (1.464) [0.144] 9.52 (1.309) [0.191] 7.02 (0.945) [0.345]

11.00 (1.770) [0.077] 10.95 (1.709) [0.088] 10.44 (1.600) [0.110] 10.69 (1.564) [0.118] 11.09 (1.535) [0.125] 10.69 (1.420) [0.156] 9.27 (1.199) [0.231] 8.50 (1.332) [0.184] 8.03 (1.232) [0.218] 7.55 (1.112) [0.267] 7.13 (0.999) [0.318] 5.60 (0.781) [0.435] 5.95 (0.757) [0.449] 5.92 (0.828) [0.408] 6.45 (0.875) [0.382] 6.61 (0.868) [0.386] 4.69 (0.619) [0.536] 6.72 (0.796) [0.426] 4.99 (0.710) [0.478] 5.07 (0.691) [0.490] 4.80 (0.629) [0.530] 8.26 (0.950) [0.342] 6.45 (0.808) [0.419] 8.32 (0.986) [0.325] 11.27 (1.151) [0.250] 11.87 (1.230) [0.219] 22.66 (1.848) [0.065] 19.97 (1.421) [0.156]

41

Table 4 The Risk-Adjusted Returns under the Conditional Trading Strategy: Time-Series Sorting
This table reports the monthly risk-adjusted returns of the portfolios under the Fama-French three-factor model for the conditional trading strategy. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010. At the beginning of each month, stocks are grouped into deciles based on their own past 10-year E/P ratios. When the E/P ratio of a stock at the time of portfolio formation is situated in the bottom 10% over the past ten years, it would be ranked to the lowest decile. One is the lowest E/P group and ten is the highest E/P group. For the conditional trading strategy, if stock X satisfies the buying criterion at time t, we invest in stock X in proportion to its size. At the beginning of time t+1, if stock X satisfies neither the buying criteria nor the selling criteria, it will be held without investing new money. This stock will only be sold when it satisfies the selling criterion. Column (>=1 ~ >=10) describes the buying criteria and row (<1 ~ <10) indicates the selling criteria. For example, the number in cell (>=8, <2) shows the risk-adjusted return of the portfolio which buys stocks whose E/P ratio rankings are in the 8th, 9th, or 10th deciles and sells the owned stocks whose E/P ratio rankings are in the 1st decile. The unit is basis point. The t-statistics are in parentheses and the p values are in brackets. Selling Criteria <1 (never sell) Buying Criteria >=2 >=1 4.53 (0.852) [0.395] 4.77 (0.903) [0.367] >=3 5.07 (0.964) [0.335] 8.42 (1.558) [0.120] 8.82 (1.605) [0.109] 8.23 (1.522) [0.129] <2 <3 <4 <5 <6 <7 <8 <9 <10

42

>=4

5.38 (1.027) [0.305]

9.75 (1.729) [0.084] 11.18 (1.912) [0.056] 12.67 (2.130) [0.034] 14.39 (2.346) [0.019] 15.87 (2.578) [0.010] 16.63 (2.590) [0.010] 16.43 (2.492) [0.013]

9.12 (1.644) [0.101] 10.43 (1.816) [0.070] 11.93 (2.027) [0.043] 13.69 (2.216) [0.027] 15.65 (2.447) [0.015] 16.52 (2.462) [0.014] 15.79 (2.298) [0.022]

9.79 (1.638) [0.102] 10.81 (1.769) [0.077] 12.07 (1.918) [0.056] 13.33 (2.039) [0.042] 15.42 (2.287) [0.023] 16.94 (2.391) [0.017] 16.50 (2.264) [0.024] 10.73 (1.620) [0.106] 11.79 (1.744) [0.082] 12.52 (1.798) [0.073] 14.38 (2.006) [0.045] 16.05 (2.163) [0.031] 16.13 (2.083) [0.038] 9.67 (1.359) [0.175] 9.36 (1.278) [0.202] 10.79 (1.435) [0.152] 13.37 (1.733) [0.084] 14.41 (1.798) [0.073] 9.88 (1.290) [0.198] 10.28 (1.323) [0.186] 11.43 (1.430) [0.153] 12.59 (1.523) [0.128] 10.83 (1.386) [0.166] 13.17 (1.599) [0.110] 13.98 (1.607) [0.109] 10.63 (1.203) [0.229] 11.04 (1.204) [0.229] 8.45 (0.799) [0.425]

>=5

5.94 (1.120) [0.263]

>=6

6.31 (1.199) [0.231]

>=7

6.64 (1.258) [0.209]

>=8

6.94 (1.349) [0.178]

>=9

7.68 (1.461) [0.145]

>=10

7.29 (1.370) [0.171]

43

Table 5 The Average Holding Periods for the Traditional Trading Strategy and the Conditional Trading Strategy: Time-Series Sorting
This table reports the average holding months for stocks in the portfolios constructed by the traditional trading strategy and the conditional trading strategy respectively. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010. The traditional trading strategy here is to purchase stocks in the highest quintile. The conditional trading strategy here is to purchase stocks whose time-series E/P sortings are in the 9th and the highest deciles, and hold them until they drop to the lowest deciles, i.e. (Buy, Sell) is (>=9, <2). In time-series E/P sorting, a stock whose E/P ratio at the time of portfolio formation is located in the top 10% (20%) over the past 10 years would be ranked in the highest decile (quintile). We sum the holding period of each stock in the sample and then divide by the number of stocks to obtain the average holding period. A stock which is held in two different time periods is viewed as two different stocks. Under the traditional trading strategy, if a stock is chosen to be held at the beginning of month t, t+1, and t+2 continuously, the holding period for the stock is 3. Panel A shows the result for the entire sample. Panel B classifies the entire sample to different industries according to the SIC code. Panel C classifies the entire sample into size quintiles. The final size classification of a stock is the mean of the size classification for each month during the holding period. Traditional Trading Strategy (P5-P1) Industry (SIC code) Mean Std Min Max Conditional Trading Strategy (Buy, Sell)= (>=9, <2) Mean Std Min Max

Panel A: Entire Sample All industries (0100~9999) 1.7 11.9 1 480 68.9 88.7 1 521

Panel B: Industry Partition Agriculture, Forestry, and Fishing Mining Construction Manufacturing Transportation, Communications, Electric, Gas, and Sanitary Services Wholesale Trade Retail Trade Finance, Insurance, and Real Estate Services Public Administration (5000~5199) (5200~5999) (6000~6799) (7000~8999) (9100~9999) 1.7 1.6 1.5 1.8 1.1 11.5 10.9 8.8 11.5 1.4 44 1 1 1 1 1 406 401 478 400 36 75.8 72.3 58.8 64.7 38.9 94.4 90.8 71.5 76.4 49.7 1 1 1 1 1 501 495 495 519 289 (4000~4999) 1.5 8.9 1 426 63.9 76.7 1 521 (0100~0999) (1000~1499) (1500~1799) (2000~3999) 1.7 1.7 1.7 1.7 11.4 12.9 12.1 13.5 1 1 1 1 273 436 420 480 58.9 72.0 81.2 74.7 78.7 94.3 97.1 99.7 1 1 1 1 381 495 486 518

Panel C: Size Partition 1 (smallest) 2 3 4 5 (largest) 1.6 1.7 1.8 1.7 1.5 11.4 12.6 13.1 12.6 9.5 1 1 1 1 1 478 480 459 448 452 65.2 72.1 72.3 70.7 62.4 92.6 96.4 93.8 85.4 69.2 1 1 1 1 1 516 519 521 507 495

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Table 6 The Risk-Adjusted Returns of the Portfolios in Sub-periods: Time-Series Sorting

This table reports the monthly risk-adjusted returns of the portfolios in basis point constructed by the traditional trading strategy and the conditional trading strategy in several sub-periods. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ. Fama-French three-factor model is used to measure the risk-adjusted returns. Stocks are grouped into quintiles in the traditional trading strategy and into deciles in the conditional trading strategy based on their own past 10-year E/P ratios. A stock whose E/P ratio at the time of portfolio formation is located in the top 10% (20%) over the past 10 years would be ranked to the highest decile (quintile). The traditional trading strategy here is to long stocks in the highest quintile and short-sell stocks in the lowest quintile (P5-P1). The (Buy, Sell) is (>=9, <2) in the conditional trading strategy. All portfolios are value-weighted. Panel A separates the entire sample period into two sub-periods; the first one copies the period in Fama and Frenchs work in the 1990s. Panel B separates the entire period into five non-overlapping sub-periods. The t-statistics are in parentheses and the p values are in brackets.

Traditional Trading Strategy (P5-P1) Panel A: Two Sub-periods 8.17 Jan. 1962 Dec. 1989 (0.797) [0.426] 3.85 Jan. 1990 Dec. 2010 (0.413) [0.680] Panel B: Five Sub-periods 46.06 Jan. 1962 Dec. 1969 (1.217) [0.228] -7.24 Jan. 1970 Dec. 1979 (-0.685) [0.495] 4.84 Jan. 1980 Dec. 1989 (0.382) [0.703] -3.52 Jan. 1990 Dec. 1999 (-0.273) [0.785] 5.81 Jan. 2000 Dec. 2010 (0.490) [0.625] 46

Conditional Trading Strategy (Buy, Sell)= (>=9, <2) 1.08 (0.123) [0.902] 32.74 (4.319) [0.000] -2.48 (-0.081) [0.936] 9.37 (1.363) [0.176] 1.21 (0.112) [0.911] 33.56 (3.087) [0.003] 20.16 (2.330) [0.021]

Table 7 The Risk-Adjusted Returns under the Conditional Trading Strategy with Postponed Buying and Selling Time
This table shows the three-factor risk-adjusted returns of portfolios in basis point under the conditional trading strategy with postponed buying and selling time. The sample includes all common stocks listed in NYSE, AMEX, and NASDAQ from January 1962 to December 2010. The (Buy, Sell) is (>=9, <2) in the conditional trading strategy. All portfolios are value-weighted. In time-series E/P sorting, a stock whose E/P ratio at the time of portfolio formation is located in the top 10% over the past 10 years would be ranked to the highest decile. When a stock is regarded as undervalued at month t, we can purchase it at month t or postpone the buying time to month t+1, t+2, t+3 or t+6. Similarly, when a stock is considered overvalued at month t, it can be sold at month t+1, t+2, t+3 or t+6 rather than immediately at month t. The t-statistics are in parentheses and the p values are in brackets. Postponed Selling Time t 16.63 t (2.590) [0.010] 16.79 t+1 (2.591) [0.010] 17.25 t+2 (2.641) [0.009] Postponed Buying Time t+3 18.41 (2.810) [0.005] 18.38 t+4 (2.781) [0.006] 18.24 t+5 (2.744) [0.006] 18.17 t+6 (2.694) [0.007] t+1 16.52 (2.589) [0.010] 16.62 (2.592) [0.010] 17.08 (2.641) [0.009] 18.18 (2.802) [0.005] 18.13 (2.769) [0.006] 18.01 (2.734) [0.006] 17.89 (2.675) [0.008] t+2 15.43 (2.438) [0.015] 15.55 (2.448) [0.015] 16.00 (2.508) [0.012] 17.13 (2.678) [0.008] 17.09 (2.645) [0.008] 16.99 (2.612) [0.009] 16.92 (2.562) [0.011] t+3 16.42 (2.582) [0.010] 16.54 (2.592) [0.010] 17.01 (2.655) [0.008] 18.10 (2.830) [0.005] 18.12 (2.804) [0.005] 18.03 (2.772) [0.006] 18.00 (2.724) [0.007] t+4 16.37 (2.566) [0.011] 16.47 (2.577) [0.010] 16.96 (2.646) [0.008] 18.05 (2.822) [0.005] 18.01 (2.799) [0.005] 17.90 (2.765) [0.006] 17.87 (2.715) [0.007] t+5 15.98 (2.520) [0.012] 16.17 (2.541) [0.011] 16.65 (2.612) [0.009] 17.76 (2.793) [0.005] 17.73 (2.775) [0.006] 17.59 (2.746) [0.006] 17.56 (2.698) [0.007] t+6 16.12 (2.540) [0.011] 16.20 (2.547) [0.011] 16.78 (2.629) [0.009] 17.83 (2.805) [0.005] 17.82 (2.790) [0.005] 17.71 (2.769) [0.006] 17.61 (2.721) [0.007]

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