ElSl3’lFR Journal of J~tnancial Economics 43 (1997) 3 27

Returns to contrarian investment strategies:

Tests of nqtiveexpectations hypotheses
Patricia M. Dechow, Richard G. Sloan*

(Received I)eccmbe* 1995: final version received March 1996)

Abstract

This paper examines the ability of naive investor expectations models to explain the
higher returns to contrarian investment strategies. Contrary to Lakonishok. Shleifcr, and
Vishny ( 1994). we find no systematic evidence that stock pricer ret&t naive extrapolation
of past trends in earnings and sales growth. Building on Bauman and Dowen (1988) and
La Porta (1995). however. ue find that stock prices appear to naively reflect analysts’
biased forecasts of future e;irnings growth. Further. WC find that naive reliance on
analysts’ forecasts of future earnings growth can explain over half of the higher returns to
contrarian investment strutcgic>

Kq words: Market elliciency; Nai .c expectations Analysts’ fomu.asts

JEL c~lus.s~t;c~ctriittr:
G 12: C 14: M4l

I. Introduction

It is well documented that buying (selling) stocks that are priced low (high)
relative to accounting measures of operating performance such as earnings, cast:
flows, and book values generates higher stock returns. However. the sources 01

*Corresponding author.
We are grateful for the comments of Christine Botasan. John Cochranc. Eugene Fama. Kenneth
French (the referee). S.P. Kothari. Bob Holthausen, Cavid Ikenberry. Crarg MacKinlay, Rick
Ruback, Bill Sehwcrt. Jake Thomas, and workshop participants at Harvard University. the llniver-
sity of Oregon. Rice University. the University of Rochester. the 1~95 Chicago Quantitative Alliance
Conference. the 1995 NBER Asset Pricing Group Meetings. and the Sixth Annual Conference of
Financial EconomiLs and Accounting We thank I/B,!ES/ for providng EPS forecast data availahk
through the Institutional Brokers Estimate System.

0304-405x~97~s15.00 4’ 1997 Elwvier Scicncc S.A. All rights rescrvcd

P/I S0304-405Xt96)00SH7-2
the higher returns to these‘contrarian strategies’are not well understood.
Competingexplanationsincluderisk premiums(Famaand French.1995).naive
investorexpectations of future growth (Lakonishok.Shleifer,andVishny,1994),
researchdesigninducedbiases(Lo and MacKinlay, 1990;Kothari, Shanken,
andSloan,1995).and theexistenceof marketfrictions(Amihudand Mendelson,
1986).
Researchattemptingto discriminatebetweenthesecompetingexplanations
has tended to focus on examiningthe extent to which return behavioris
consistentwith specificrisk-basedexplanations(Lakonishok, Shleifer,and
Vishny, 1994;MacKinley, 1995;La Porta, Lakonishok,Shleifer,and Vishny,
1995;Daniel and Titman, 1996).The resultsof this researchhavegenerally
found that risk-basedexplanationsare unable to explain observedreturn
behavior,leadingsometo concludethat theevidenceis thereforeconsistentwith
naiveInvestorexpectations(Lakonishok,Shleifer,and Vishny,1994).However,
wearguethat theca3efor naiveinvestorexpectations would bemorepersuasive
if return behaviorwere shownto be consistentwith specificmodelsof naive
expectationformation.Whileproponentsof explanationsbasedon naiveexpec-
tations haveproposedspecificbehavioralmodels,thesemodelshavenot been
cubjectedto empiricalscrutiny.We th refore examinethe extentto which the
Acturnsto contrarianstrategtesare consistentwith the behavioralmodelsthat
havebeenproposedto explainthem.
We identify two modelsof naive expectationformation that have been
conjecturedto explainthe returns to contrarianstrategies.First, Lakonishok,
Shleifer,and Vishny(1994)[LSV hereafter]arguethat the returnsto contrarian
strategiesarisebecause pricesreflectthe naiveextrapolationof pastgrowth in
salesand earnings.Second,Baumanand Dowen (1988)and La Porta (1995)
argue that the returns to contrarian strategiesarise becauseprices reflect
analysts’long-termearningsgrowth forecasts,despitethe fact that thesefore-
castsare systematicallybiased.We directly estimatethe expectationsmodels
embeddedin stock pricesand comparethem with the expectationsimplied by
the correspondingrational and naiveexpectationsmodels.This allows us to
directlyassess the economicandstatisticalsignificance of the naiveexpectations
models.We also estimatethe proportion of the returns to the contrarian
strategiesthat is attributableto naiveexpectations.
Contrary to LSV.we find no systematicevidencethat stock pricesreflectthe
naiveextrapolation of past growth in earningsand sales.Consistentwith
Baumanand Dowen and La Porta, however,the evidencesuggeststhat stock
pricesnaivelyincorporateanalysts’forecastsof long-termearningsgrowth. In
particular,our resultsindicatethat earningstend to grow at lessthan half the
rate predictedby analysts,but that stockpricesinitially reflectsubstantiallyall
of the forecastearningsgrowth. Finally,we show that investors’naiverelitrnce
on analysts*growth forecastsexplainsover half of the returns to contrarian
strategies.
 P.M. D~r~~o~. R.G. Sloan ~Journoi o\‘Financiul Economics 43 (IYY7) 3 .?? 5

The papet is organizedas follows. The next sectiondevelopsthe naive

expectationsmodels. Section 3 describessample formation and variable
measurement.Section4 presentsour resultsand is organizedin three parts.
First, we analyzedescriptiveevidenceon the relation betweenthe returns to
contrarian strategiesand variablesassociatedwith the naive expectations
models.Second,we provideformal testsof the naiveexpectationsmodels.Third,
we evaiuatethe proportion of the returnsto contrarianstrategiesthat can be
attributed to the naiveexpectationsmodels.Section5 concludesthe paper.

2. Model development

Thecontrarianstrategiesthat predictfuture stockreturnsaregenerallybased

on ratiosof accountingperformance(e.g.,earnings,cashflows,and book value)
to marketvalue.Thesefinancialratiosshould,in theory,reflectvariationin both
requiredreturnsand expectedfuture growth. This can be seenby considering
simplevaluationmodelssuchas Gordon’s(1962)constantgrowth model:
P = D/(r - y), (1)
where P is the stock price at the beginningof the current period, D is the
dividendto be receivedat the endof the current period,r is the requiredrate of
return per period,and n is the rate per periodat whichdividendswill grow into
the indefinitefuture. Assuminga dividendpayoutratio of oneallowsEq.(I) to
be rewritten as
E/P = r - g . 12)

where E is the current period’saccountingearnings.This simple valuation

modelindicatesthat the earnings-to-price ratio increaseswith the requiredrate
of return and decreases with future earningsgrowth.
More generally,solongasthe numeratorin sucha ratio proxiesfor the ability
of the firm to generatefree cashflow in the current period, basicvaluation
theorysuggests that the ratio will increasewith the requiredreturn anddecrease
with the expectedfuture growth rate.’ This suggeststwo (nonmutuallyexclu-
sive) reasonsthat such ratios are positivelyassociatedwrth future realized
security returns. First, securitiesare priced such that their expectedreturns
equaltheir requiredreturnsandexpectationsare.on average,realized.Second,
the expectationsof future growth embeddedin y?ock pricesare naivein that
‘glamour’firms with highexpectedgrowth realizelowergrow!h than expected,
on average.This resultsin a negativeassociationbetweenexpectedgrowth and

’ For extensions of the model to more general settings that a;iow !or mean reversion in future
growth. dividend payout ratios of less than 100°! 0. and the use of book value of equity to proxy for
free cash flow. sx Miller and Modipliani (1961). Malkiel and Crapg (1~70). and Ohlson (19951.
the magnitudeof the forecasterror in expectedgrowth, causingsubsequent
realizedsecurityreturns to be negativelyassociatedwith expectedgrowth.
Thecurrentdebatein the academicliteraturefocuseson the relativecontribu-
tion of thesetwo reasonsfor the returnsto contrarian strategies,with opinions
sharplydivided.Perhapsone reasonthat opinionsareso sharplydividedis that
empirical researchhas focusedalmost exclusivelyon testing traditional risk-
basedexplanations.While the resultsof this researchhavegenerallyfound that
traditional risk-basedexplanationsdo not accountfor observedreturn behav-
ior. the conclusionsresearchershave drawn from these results have been
influencedby the researchers’priors. For example,supporters of risk-based
explanationsconcludethat the resultsare consistentwith nontraditional risk-
basedexplanations(Famaand French.1995).Supportersof behavioralexplana-
tions concludethat the resultsare consistentwith naiveinvestor expectations
(LSV; La Porta, Lakonishok,Shleifer,and Vishny, 1995).Still others note that
the resultsare also consistentwith research-design-induced biasesand capita1
market imperfections(MacKinlay, 1995;Daniel and Titman, 1996).
Further progressin d&riminating betweenthesecompeting explanations
require:,identifvingand testingcpecii‘,*alternativemodels.Thz iact that testsof
tradrtional risk-basedmodelshavefailed to rejectthe null hypothesisdoesnot
providepersuasivesupport for any specificalternativemodel.We help fill this
void by formally developingand testing the predictionsof two behavioral
modelsthat havebeenconjecturedto explainthe returns to contrarian strat-
egies.First, basedon the behavioralevidenceof KahnemanandTversky(1982).
LSV conjecturethat investorsnaivelyextrapolatepast trends in earningsand
salesgrowth, despitethe fact that growth is mean-reverting:

Model I: The expectutions embedded in stock prices are consistent with inces-
tars naively extrapolating pust eurnings and sales growth, et’en though
growth is strongly mean-recerting.

Second,a numberof researchers haveconjecturedthat investorsnaivelyrely

on the long-termearningsgrowth forecastsof analysts.despitethe fact that these
forecastsare systematicallyoveroptimistic.For example,Baumanand Dowen
( 1988)suggestthat takinga contrarianapproachto analysts’consensus expecta-
tions for long-termearningsgrowth enablesinvestorsto earn superiorsecurity
returns.Similarly, La Porta (1995)arguesthat while analysts*expectationsof
long-termearningsgrowth tend to be too extreme,they are representativeof
investors*expectations. ’ Chatfield, Moyer. and Sisneros(1989)confirm that

2 La Porta does no1 directly test this hypothesis. but instead provides evidence that analysts’ growth
forecasts are mean-reverting. However. mean reversion ill analysts’ growth forecasts is consistent
with forecast rationality. because earnings growth itself is mean-reverting.
analysts’forecastsof long-terr;rearningsgrowth Lresystematically
overoptimis-
tic. Our secondmodelassumes that thesebiasedgrowthforecastsarereflectedin
stock prices:

Model 2: The expectations embedded in stoc< prices are consistent with inues-
tors naively relying on analysts’ jxecasts of long-term earnings
growth, even though thesefiwecasts are systematically overoptimistic.

3. Sample formation and variable measurement

The empiricalanalysisusestwo samples.The first samplecorrespondswith

thesampleemployedby LSVand usesdatafrom firmstradingon the New York
Stock Exchange(NYSE)and AmericanStock Exchange(AMEX) from 1963to
1993.Financialstatementdata areobtainedfrom COMPUSTAT and monthly
stock return data are obtainedfrom the Centerfor Researchin SecurityPrices
(CRSP).Sincesomeof the portfolio formation strategiesusefive yearsof past
financial statementdata, our analysisis confined to firms with fiscal years
ending in 1967or latct. Further, sincewe needat least a year’sworth of
subsequentstock returns to analyzestock price performance,our analysisis
restrictedto firms with fiscal yearsendingin 1991or earlier. Firm-yearsare
eliminatedfrom the sampleif they do not appearon both COMPUSTAT and
CRSPor if earningsbeforeextraordinaryitemsanddiscontinuedoperationsare
missingfrom COMPUSTAT. This yieldsa final sampleof 57,412firm-years.
Thesecondsamplecorresponds with the sampleemployedby La Porta(1995)
and coversthe period from 1981to 1993.The sampleperiod beginsin 1981
becausethis is the first year in which data on analysts’long-termearnings
growth forecastsare availableon the Institutional BrokersEstimatesSystem
(l/B/E/S). The sampleincludesfirms on COMPUSTAT, CRSP.and I/B/E/S.
We alsoincludefirms tradedon the National Associationof SecurityDealers
AutomaticQuotationsystem(NASDAQ) because the samplecoversa relativ,iy
short time periodand thelargersamplesizeimprovesthepowerof thetests.The
introductionof thesesmallerfirms raisesconcernsabout durvivcishipbiasesof
thetypediscussed by Kothari, Shanken,andSloan(1995).However,our sample
period postdates the 1978period,when COMPUSTAT undertook a major
expansionof its databaseto includenany smqlierfirms, eliminatingthis poten-
tial sourceof hindsightbias.Firm-yearsare eliminatedfrom the tinal sampleif
earningsbeforeextraordinaryitems and discontinuedoperationsare missing
from COMPUSTAT. or if the long-termearningsgrowth forecastis missing
from I/B/E/S. This yieldsa linal sampleof 23.203firm years.
Portfolioperformanceis evaluatedusingequal-weighted buy-and-holdstock
returns (includingdividends)for periods rangingfrom one to five years.If
a securityis delistedduringa particularreturn interval,then theCRSPdelisting
n P.M k-how, R.G. Sloan (Journal of I=inancir.i Fconomitr 43 (I9971 3 27

return is included in the buy-hold return, and the proceeds are reinvested
equa!!y among the remaining securities in the pcrtfolio. We focus exclusively on
raw stock returns, as opposed to making adjustments for potential risk measures
such as size or systematic risk (beta). Recall that our objective is to assessthe
proportion of the returns to contrarian strategies that can be attributed to naive
expectations models. Using returns adjusted for ‘data-motivated’ risk proxies
such as size would confound the interpretation of the results.
in measuring the returns to the various strategies, we seek to ensure that the
required financial information would have been available to investors. For our
first sample we achieve this using a procedure similar to that in LSV. Specifi-
cal;y, we begin the return measurement interval four months af;er the end of the
fiscal year from which the financial data are obtained. Alford, Jones, and
Zmijewski (1994) report that very few firms delay their Form 10-K filings
beyond this four-month period.’ For our second sample, we use the information
on the l/B/E/S tapes to determine when firms’ earnings are reported to the
market, ,;nd commence our trading strategy in the following month. :/B/E/S
always reports the earnings forecast for the fiscal year of the current I/B/E/S
statistical pried as the two-year-ahead rqrecast until earnings for the previous
‘:s:aI )cclr iubc been rzpor& Consequently, we can infer that earnings for the
previous fiscal year must have been reported in the statistical period that the
current-year earnings forecast changes from the two-year-ahead forecast to the
one-year-aheadforecast. I/B/E/S statistical periods are monthly periods ending
on the day prior to the third Friday of each month. On this day, I/B/E/S
processes all of the available forecasts and computes consensus estimates.
Consequently, the statistical period ends on or before the nineteenth of the
month. For investment strategies that use COMPUSTAT financial data relat-
ing to the prior fiscal year, we begin our return measurement interval on the first
day of the calendar month following the statistical period in which the current
fiscal year becomes the one-year-ahead forecast. For example, if we are inves-
tigating an investment strategy using financial data for a firm with a December
1992fiscal year-end, and its 1992earnings are announced on February IO, 1993,
then we would begin the return measurement interval on March 1, 1993. The
mean time elapsing between the fiscal year-end and the beginning of the return
measurement interval is 2.74 months.
The financial ratios used to implement the contrarian investment strategies
are computed using financial infomlation on COM PUSTAT and market value
information from CRSP. Book-to-market is computed prior to each return
measurement interval as the ratio of the book value of common equity for the

j Beginning the return measurement interval six months after the fiscal year-end does not affect the
tenor of our results. As a practical matter. the four-month waiting period is overly conservative for
most firms. as the financial information required to implement most contrarian strategies can be
inkrred from earnings announcements, which typically precede IO-K filings.
 P.M. Decfrow. R. G. Shrv :..bumul of Financial Economics 13 (I YY7) 3 27 9

mos’ recently ended fiscal year to the market value of common equity at the
beginning of the return measurement interval. The earnings-to-price ratio is
computed as the ratio of income before extraordinary items and discontinued
operalions to the market value of common equity using the same timing
conventions as for book-to-market. Consistent with LSV, we also compute
a cash-flow-to-price ratio, which is defined similarly t3 earnings-to-price but
with depraiation expense removed from the numerator. For consistency with
LSV, no adjustment is made for accruals other than depreciation. Following
LSV, we do not consider firms with negative earnings or cash flows when
forming portfolios based on earnings-to-price and cash-to-price ratios.
Past and future five-year growth rates in earnings and sales are computed for
use in testing the extrapolation model. Computation of growth rates is complic-
ated by several factors. First, growth rates cannot be computed when the
base-year observation is negative. This results in a substantial number of
missing values for earnings growth. However, this problem does not affect the
computation of sales growth. Second, discrete annualized geometric growth
rates can be extremely vo!atile when the base year is close to zero and when the
base year or final year in the series contains significant nonrecurring items. To
mitigate theseproblems, we lbllow the I/B/E/S procedure ofcomputing five-year
annualize 1growth rates by fitting a ILast squares growth line to the logarithms
of the six annual earnings ob;srvations. For example, to compute annualized
earnings growth for he five years through the end of year t, we fit a least squares
growth line through the six annual earnings observations from year t - 5
through year r. If earnings is missing or negative for either year t - 5 or year t,
then we do not calculate a growth rate for that observation. Otherwise, we
compute the growth rate using all available earnings observations. We use
continuous compounding because discrete compounding produces extreme
outliers vi hen the baseyear is close to zero. Fitting a least squaresregression line
avoids placing excessiveweight on the first and last observations in the growth
per3, resulting in less volatile growth estimates when these years include
substantial nonrecurring items. Following LSV, we also use weighted past
growth rates in tests of the extrapolation model. For example, to compute the
annualized past-five-year weighted earnings growth rate, we first compute the
difference in the logarithm of earnings for each of the last five years. We then
take the weighted mean of the five differences, assigning weights of five to the
most recent difference down to one for the least recent.
A final complication in the computation of growth rates is that variation in
growth can result from both variation in performance on a fixed capital base
and from variation in the capital base for a fixed level of performance. Growth
resulting from performance can be isolated by compating growth rates on
a per-share basis. Ideally, the definition of growth should be determined with
referenceto the behavioral model being tested. However, LSV are not precise in
specifying the definition of growth that is naively extrapolated by investors. In
IO P.M. Dechow. R.ti. Sloon.~Jounuf nf‘Financ+al Economics 43 (lW7) 3 27

their development of the extrapolation model. LSV (t994, p. 1,542)refer to the

extrapolation of past performance. However. the definitions of growth em-
ployed by LSV appear to include growth from both periormance and changesin
the capital base.This implies that imestors not only naively extrapolate growth
in past performance, but also fail to correctly distinguish between growth
attributabic to performance and growth attributable to expansion. To ensure
the robustnessof the results to the definition of growth, we test the extrapolation
model using both firm-level and per-sharegrowth rates. Per-share growth rates
are computed by dividing the firm-level number by the number of common
shares used to compute primary earnings per share (EPS), adjusted for stock
splits and dividends.
Finally. we measure expected long-term growth in EPS using information
obtained from l/B/E/S. We use median forecasts as our consensus forecasts
becausemedians are lesssensitive to outliers. The consensusexpected long-term
growth in EPS is obtained from the summary statistics file of the i/B/E/S
historical database. The growth forecast reported by l/B/E/S is an annualized
five-year growth rate. We select the growth forecast for rlne i/‘&‘E/S monthly
statistical period spanning the announcement of the financial results for the
ti, ~71year fqnrn which we obtain th+,CO * 1PI ISTAT data. This g: owth forecast
reiates to the five-year period beginning in the fiscal year immediately following
the fiscal year-end of the COMPUSTAT data. Recall that the return period
begins in the month following this statistical period, ensuring that the consensus
growth forecast is known to the market prior to the beginning of the return
cumulation period.

4. Emphical analysis

The empirical analysis proceeds in three subsections. The first subsection

documents the returns to contratian strategies for the two samples examined in
this paper and provides descriptive evidence on the relation between the con-
trarian strategies and the naive expectations models. The second subsection
provides formal tests of the naive expectations models. Using the econometric
framework developed in Mishkin (1983).we simultaneously estimate the expec-
tations implicit in stock prices and test for the rationality of these expectations.
The final subsection estimates the proportion of the returns to contrarian
strategies attributable to the naive expectations models.

4.1. Churactefistic.7 of coritrarimr inwwtwnt strategies

Tables 1 and 2 document the returns to portfolios formed on &k-to-market,

earnings-to-price, and cash-to-price. For each formation variable, firms are
ranked annuallyand assignedm equal numbersto deciles,for which equal-
weightedportfolio returnsare computed.Table I presentsresultsfor the first
sample.The sampleperiodis slightlylongerthan LSV’sin that we usefinancial
data through 1991.while they usefinancialdata through 1989.However,the
performanceof the tradingstrategiesis almostidentical.The return differential
betweenthe highestand lowest book-to-marketportfolios is over 10%for the
one-yearholding period and over 90% for the five-yearholding period. The
earnings-to-priceportfolios exhibit a one-yearreturn differentialof over 10%
and a five-year differential of over 80%, while the cash-to-priceportfolios
exhibit a one-yeardifferential of 14% and a five-yeardifferentialof almost
100%.
LSVarguethat the differentialreturnsto theseportfolioscan beattributed to
naiveextrapolatioriof pastgrowth. This reasoningsuggeststhat portfolios with
low realizedfuture r&turnswill haveexperienced highpastgrowth andrelatively
lowerfuture growth. Conversely,portfolioswith highrealizedfuture returnswill
haveexperienced low pastgrowth and relativelyhigherfuture growth. Table 1
reportsthe portfolio meansof salesandearningsgrowth over the pastfiveyears
and fivefuture years.For the book-to-marketportfolios.pastsalesgrowth tends
to be higherin the lower portfolios. However.thereis no evidenceof the msan
reversionin future salesgrowth predictedby the naive extrapolationmodel.
Past-earningsgrowth is alsohigherin the lower portfolios and future earnings
growth does disp’ay the pattern of mean reversionpredicted by the naive
extrapolationmodel.
The earnings-to-priceportfolios displaygrowth characteristicsthat are uni-
formly inconsisten!with the extrapolationmodel. Pastsalesgrc:wth is similar
acrossportfolios.whilefuture salesgrowth is lowerin the higherportfolios.Past
earningsgrowth is lower in the lower portfolios,whilefuture earningsgrowth is
higherin the lower portfolios.The cash-to-priceportfolios alsoexhibit growth
characteristicsthat are inconsistentwith the predictionsof the extrapolation
model.Future growth tendsto exceedpastgrowt.1in the low portfolios,while
the reverseholdstrue in the high portfolios.Overal!.the descriptiveevidencein
Table I doesnot suggestthat the returnsto conr:,arianstrategiesarisefrom the
naiveextrapolationof past growth.
Table2 presentsportfolio returns for the secondsample.The return; to the
contrarianstrategiesare uniformly weakerfor this shorter time period.For the
book-to-marketportfolios,the one-yearreturn differentialbetNet;nthe highest
andlowestportfoliosis lessthan4%, whilethe five-yearreturndifferetltialisjust
over 40%.Theearnings-to-priceandcash-to-priceportfoliosexhibit a one-year
return difTerentialof almost 10% and a five-yeardifferentialof about 40%. If
these return diperentialsare attributable to the secondnaive expectations
model, then the lower portfolios should exhibit relatively positive forecast
errors, while the higher portfolios should exhibit relatively negativeforecast
errors.However,comparisonsof this typeare,tbscuredby thz fact that analysts’
Tat+ 1
Growth and return characteristics of portfoltos formed on the basis of contratian .uisblcs
The sample consists ol firms traded on the NYSE or AMEX and covered by CO? t PL. STAT het*veen 1967 and I99!. Ibr a t;~l of 57,412 firm-years.
Portfolios arc formed annually ;n ascending order on the basis of contrarian varia~~les. -t he contrarian v.riahles arc book-to-market, earnings-to-pncc.
ati ash-to-prim. Rook-to-market is the ratto &the book value of common equity I*w the most recently cndeu fiscal year to the miukct v&c of common
equity at the beginning of’ the return cumulation period. Earnings-to-price is the r: tit) trf annual camings belore extraordinary items and dtseontinucd
rrperattons to the market value of common equity, using the same timing co,#r-cntions as for book-to-market. Cash-u-price is equivalent to
eat+ng+tcFpt-ice but with the exclusion ofdeprcciation expense from the numeralor. t’& tiles growth is obtained hy fitttng an ordinary lcast squares line
through the logarithm of the six most reecntly reported annual observations of sale> ’ Jture sales growth is obtained by fitting an crditiary least squares
line through the logarithm of the most recently reporfd safes and the five future year% of annual sales. Past and future earnings growth arc computed in an
i&n&d manner. Sales are measured using s&s (nctt and earnings are measured usit-g earnings before cxtraordimtry items anJ discontinued opcrattons,
The one- and five-year-ahead stock return cumulation periods begin four months after the firm’s most tcccntly ended fiscal year. Stock return< arc
buy-hold returns, inclusive of dividrnds and any liquidating distributions.

Lowest Portfolio rank Highest

I 2 3 4 5 6 7 3 9 10
-~ _._,_-_ --_._ .,.. --_.-- -.. ..-..-. --- .-.... -. . .. . . . _--_
Ranking on book-to-market
One-year-ahcad return O.OHS 0.123 0.113 t-I.132 0. I25 0.139 0.15x 0.164 0.179 0.192
Five-year-ahead return 0.541 O.K26 O.HU6 O.Y40 0.969 I .067 1.167 1.288 1.370 1.454
Past sales growth 0.153 0.166 0.144 0.131 (1.1 19 0.109 0.103 0.093 0.080 0.060
Future sates growth 0.1s9 0.136 0.117 0.109 0. I03 0.092 0.089 0.083 0.070 0.056
Past earnings growth 0.226 0.194 0.165 0139 0.1’2 0.104 0.096 0.075 0.04x - 0.010
Future earnings growth 0.152 0.11’) 0.106 0.099 0.097 0.091 0.097 0.106 0.1 17 0.164
Table 2
Analysrs’ forecasts of growlh. future growth, and return characteristics of portfohk,a formed on the basis of contrarlan varlahle
iL
The sample covers ~hc period between 1981 and 1992 and consists of firms that ha\c malysts’ forecasts of EI‘S growth available on I.‘B.‘E, S, are traded on
the NYSE. AMEX. or NASDAQ. and are covered by COMPUSTAT. for a total ( I’ ’ _1, H)3 hill-years. ~‘UI ifolios arc formed annually in ascending order
on the basis of contrarian variables in the month following the announcemenr of annual earnings. The ccntrarian variahles are bcmk-to-market.
earnings-to-ptia, and cash-to-pria. Book-to-market is the ratio of the book value :\fcommon equity for the most recently ended fiscal year to thr market
value ofcornmon equity ~~ the beginnmg orlhe return cumulation period. Earning!. L’ e-pria is the ratio of annual earnings before extraordinary items and E
discontinued operations to the market value of common equity, using the same Wl*llg convention< as for book-to-market. Cash-to-price is equivalent 10 9
earnings-to-price but with the exclusion of depreciation expense from the numerator. Future EPS growth is obtained by fitting an ordinary least squares 3
0
line through the logarithm ofthe most reantly reported earnings-per-share and the live future years of annual earnings-per-share. Forecast EPS growth is 7
the median analysts’estimate ofeamings-per-share growth over the next live ycan measured in the I;B;EIS statistical momh spanning the announcement
ofannual earnings. The one- and five-year-ahead stock return cumulation periods b, lrin in the month following the measurement offorasc EPS growth. x
Stock returns are buy-hold returns, inclusive of dividends and any liquidating di ‘;;bulions. *
;
Lowest Portfolio rank Highest $
- _.
I 2 3 4 5 6 7 x 9 IO

Ranking on book-to-market

One-year-ahead return 0.150 0. I30 0.137 0.137 0 I’U 0. I 49 0.163 0.186 O.IXI 0.186
Five-year-ahead r&urn 0.646 0.743 Oh83 0.865 I.OIS 0.976 1.090 I.199 1.035 I .(I.56
Forecast EPS growth 0.245 0.204 0.182 0.163 0. I 5 I 0.131 0.120 0.117 0. I 1x 0. I I4
Future EPS growth 0.095 0.078 0.077 0.058 0.0,!6 0.054 0.047 0.037 0.0.47 0.060
-.--- - .-____ _. .---.--
Ranking on earnings-to-price

One-year-ahead return 0.121 0.123 0. I S6 0.153 0.16’) 0.154 0. I85 0.196 0.210 0.2 I2
Five-year-ahead return 0.757 0.721 0.855 0.882 0.925 I .022 1.069 l.lX6 1.244 I.145
Forecast EPS growth 0.222 0.207 0. I79 0.161 0. I 50 0.141 0. I29 0.120 0.116 0.114
Future EPS growth 0.32Y 0.122 0.080 0.054 0.05, 0.042 0.039 0.019 O.MI -- 0.031
-_~ _ --~.~. - .__._.. -- --.- - -.-. --..
Ranking on cash-to-price
One-year-ahead return 0.123 0.127 0.138 0.151 0. I58 0. I 77 0.168 0.164 (I.206 0.200
Five-year-ahead return 0.701 0.655 0.809 0.840 0.988 I.051 I.1 I2 1.057 1.132 I.092
Forecast EPS growth 0.253 0.199 0.177 0.165 0.153 0.143 0.129 0.116 3.112 0.115
Future EPS growth 0.190 0.102 0.063 0.086 0.052 0.080 0.043 0.012 0.007 0.003
 PAL &chow. R.G. Sloan f.kwrnal of Financia! Economics 43 (1997) 3 27 15

forecasts arz systematically overoptimistic. For example, the mean annualized

realized EPS growth in this sample is 6.0% while the mean annualized forecast
growth is 14.6%, giving a mean forecast error of - 8.6%. Comparisons must
therefore focus on the relative magnitudes of the negative forecast errors.
For : hook-to-market portfolios, the lower portfolios tend to have both
higher realized future earnings growth and higher forecast earnings growth. The
magnitude of the negative forecast errors decreases systematically from
- 15.0% for the lowest portfolio to - 5.4% for the highest portfolio. Realized
earnings growth therefore appears to be particularly ‘bad news’ for the lower
portfolios, which is broadly consistent with model 2 in which investors are
misled by analysts’ overoptimistic earnings forecasts. For the earnings-to-price
uortfolios, the evidence is less consistent with this model. Portfolios with low
earning.-to-price ratios ;Iso have higher realized earnings growth and higher
forecast earnings growth. However, the forecast errors display no systematic
pattern. Similar result3 are observed for the cash-to-price portfolios. Thus, this
preliminary descriptive evidence suggests that the returns to the contrarian
strategies are not simply explained by the naive expectations models.

4.2. TestsoJrhe naice expec:ationsmodels

Table 3 documents the return and growth characteristics of portfolios con-

structed directly on the basis OI the variables entering the naive expectations
models. Past growth is computed using LSV’s weighting procedure to place
more weight on more recent observations. Results are reported for rankings on
growth in sales and earnings rneaslrred at both the firmwide level and on
a per-share bas’IS. Returns tend to be somewhat lower for the high-growth
portfolios. For portfolios constructed an the basis of past sales growth, the
return differential between the highest and lowest portfolio is almost 9% for the
one-y:ar holding period and just over 4@% for the five-year hoiding period.
Ranking on past earnings growth gives a one-year return dilferential of almost
6% and a five-year differential of less than 30%. The return differentials for the
per-share growth rates are somewhat weaker. For sa!es-per-sharegrowth. the
one-year differential between the lowest and highest portfolios is around 5%
and the five-year differential is 15%. The corresponding differentials ior EPS
growth are 3% and 16%. In all of the above cases,the return differentials are
smaller than those reported in Table 1 for rankings on the contrarian variables-
Moreover, the per-share growth portfolios display !jttle evidence of systematic
return differentials for the intermediate portfolios. Extrapolation cf past growth
does not, therefore, appear to provide a complete explanation for the returns to
contrarian strategies.
Table 3 also reports the mean values of future growth for the each portfolio.
There is evidence of weak persistence in sales growth. as the low past sales
growth portfolios tend to have slightly lower future growth than the higher
 F

Tat& 3
Growth and return characteristics of portfolios formed on weighted past growth ;Incl analysts’ forecasts of fulurc growth
Two samples arc reported in the table. The first sample is used when rankii,u on past growth in safes. earnings. sales-per-share (SPS). and
earnings-per-&ate (EPS). and consists of 57,412 firm-years for firms traded on the \ YSF: or AMEX and covered by COMPUSTAT between 1967 and
1991. The second sample is used when ranking on forecast EPS growth and consib’. of 23.203 firm-years between 1981 and 1992 for firms that have
analysts’ forecasts of growth available on J/BiE+& are traded on the NYSE. AME” or NASJ)AQ. and are covered by COMPUSTAT. Portfolios are
formed annually in ascending order on the basis of the ranking variable. Weightec! past growth in X is calculated as

where AX, = log(X,) - tog(X, ,). and X is either sales. e.lrningb. SPS. or EPS

Future growth in X is obtained by fitting an ordinary least squares line through the 10,. rithm of the most rcccntly reported value of X a!ld the five future
yc;lrs value of X. Sales are measured using sales (net) and earnings are measured using earnings before extraordinary items and dlscontmued operations.
Per-share numbers are obtained by dividing sales (and earnings) by the number of \hares outstanding at the fiscal year-end. with shares outstanding
adjusttJ for stock splits and stock dividends using the adjustment factor on COMPUSTAT. Forecast EPS growth is the median analysts’ estimate of
earnings-per-share growth over the next five years measured in the I /B/E S statistical month spanning the announcement of annual carllings. The one- and
five-year-ahead stock return cumulation periods begin four months after the fiscal year-end for the first sample. and the month following the measurcmcnt
of forecast EPS growth for th, second sample. Stclck returns arc huy hold returns. inclusive of dividends and any liquidating distributions.
.___-. -___---- _-.- ..--.. -.-.- ---- ._. ---. .- . .-_ - -._._ -. -~-_--__ -----_--.---_ ..- _ _._.
Lowest Portfolio rank Highest
_-.--.
I 2 3 4 5 6 1 8 9 IO
. _ _ _
Ranking on weighted past sales growth

One-year-ahead return 0. I 69 0.167 0.171 0.160 0.156 0. I53 0.156 0.141 0.133 0.0X0
Five-year-ahead return I.201 I .296 1.203 1.192 I.124 1.086 I .089 0.957 0.936 0.78 I
Wtd. past sales growth - 0.128 0.012 0.047 0.07 I 0.091 0. I I t 0.134 0.162 0.212 0.375
Future sales growth 0.093 0.069 0.074 0.084 0.090 0.093 0.101 0.102 0.112 0. I22
P.M. DechoH: R.G. Shun ~Jwtrnul cf Financrul Economics 43 (IVV7) 3 27 17
18 P.M. Dechvw. R.G. Shn/Jvumal a/Financial E<.onvmics 43 (NW) 3 27

portfolios.In contrast,earningsgrowth is negativelyseriallycorrelated,as the

lower portfolios tend to havehigherfuture growth. The negativeserialcorreia-
tion is particularly pronouncedfor the lowest portfolio, with past growth of
- 35.9% and future growth of 25.0%. Contrary to the naive extrapolation
hypothesis,investorsappearto haveanticipatedthe dramatic improvementin
performance,as the future stock returnsfor thi lowestportfolio are not unusu-
ally large.Thereis evenlessevidenceof persistence in past performancefor the
portfolios formed on per-sharegrowth rates. Portfolios formed on growth in
pastsales-per-share exhibit completemeanreversion,as thereis little difference
in the future growth ratesacrossportfolios.Portfoliosformedon growth in past
EPSexhibit negativeserialcorrelation in a similar fashion to the firm-level
growth rates.In short, the analysisof future growth ratesconfirmsthe strongly
mean-revertingnature of growth, but the analysisof stock returnsprovidesno
clear evidencethat investorsnaivelyextrapolatepast growth.
The final panel of Table 3 reports return and growth characteristicsfor
portfoliosformedon forecastgrowth in EPS.Thereturn differentialbetweenthe
highestandlowestportfolios is almost8% for the one-yearholdingperiodand
almost40% for the five-y;ar holdingperiod.Theone-yearreturn differentialis
cubstan!;~liysmallerthan the return iigerentiaireportedby La Porta of just
over 20%. In addlttonaitests(not reported)we find that major reasonsfor the
differencein resultsacrossthe two studiesare the longertime periodexamined
in this study and the inclusionof NASDAQ firms in this study. If we usethe
sametime periodas La Porta and eliminateNASDAQ firms from our sample,
weobtain a one-yearreturn differentialof 15%.Thefuture EPSgrowth ratesfor
portfoliosrankedon forecastEPSgrowth revealevidenceof systematicbiasesin
analysts’long-term growth forecasts.First, we seethat analystshave overes-
timatedfuture earningsgrowth for ail portfolios. However,we alsoseethat the
magnitudesof the negativeforecasterrors tend to increaseas we move from
portfolio 1 to portfolio 10. For portfolios 1 through 4, the magnitudeof the
negativeforecasterrors does not exceed - 6.0%. However. for portfolios
5 through IO, the magnitudeof the negativeforecasterrors graduallyincreases
from - 6.6% to - 22.8%.The relation betweenthe forecasterrors and future
stock returns is generallyconsistentwith model 2 in which analysts’biased
forecastsare reflectedin stock prices, as the higher portfolios have more
negativeforecasterrors as well as lower future stock returns.
Table3 providesdescriptiveevidenceon the naiveexpectationsmodelsusing
the familiardeciieportfolio approach.We nextconductmoreformal testsof the
economicand statisticalsignificanceof the naiveexpectationsmodelsusingthe
frameworkdevelopedin Mishkin(1983).Securityreturnsaremodeledasa func-
tion of a value-relevantattribute. X, under the maintainedassumptionof
market efficiency:

(r, -r;19r-I)=B(Xl-X~)+~,r (3)

 P.M. Decktw. R.G. Shun rJounul t?f Financial Economics 43 (1997) J- 27 19

where

r1 = return to holdinga securityduring period1.

r1 = market’ssubjectiveexpectationof the requiredreturn for periodI,
A-1 = set of information availableto the market at the end of period I - I,
X, = variablerelevantto the pricing of the securityin period 1.
= rationalforecastof X, at the endof periodt - I[i.e.. X: = E(X,J@,,I].
s”: = X’s valuationmultiplier, and
4 = disturbancewith the property that E(E,~$+-r) = 0.

Theimplicationof market efhciencyimplicit in this pricingmodelis that only

unanticipatedchangesin X, can becorrelatedwith (r, - i,h$,- r). In thecontext
of the first naiveexpectationmodel, the value-relevantvariable,X,, is future
growth in earningsor salesand the informationvariableusedto forecastfuture
earningsor salesgrowth is pastearningsor salesgrowth. In the con!extof the
secondnaiveexpecbtionsmodel,X, is future EPSgrowth and the information
variableusedto forecastfuture EPSgrowth is the consensus analystforecastof
future EPSgrowth. Using 2 to denotethe forecastingvariableand employing
the commonassumptionthat the forecastingmodel is lineargives

X,=;‘o+;‘J,-1 +1,, (4)

where

zt - 1 = forecastingvariable,
*I
10,;‘I = forecastingcoefficients,and
1!# = disturbancewith the property that E(l*,/+,_t ) = 0.
CombiningEqs.(3) and (4) givesthe followingsystem:
x, =;‘o +y,Z,. 1 + r,.

(r - i,l#,. ,) = fi(X, - ;‘o - ;‘,z,-,) + c,. (61

Rationalityconstrainsthe forecastingcoefficients,:‘. and ;‘I- to bc :he samein

both equations,providing a test of market efficiency.
Estimationof the systemof equationsin (5) and (6) requiresan assumption
regardingthe ‘expected’return, i,]& _,. For the purposeof estimation, we
assumethat expectedreturnsare uncorrelatedwith the forecastingvariable,Z.
This assumptionhas two implicationsfor our tests. First. if the forecasting
variableis uncorrelatedwith expectedreturns.then the paramctcrestimatesin
the pricing equation will be unbiasedand the test8 remain valid tests of
market efficiency (Abel and Mishkin, 1983). However, if the forecasting
variableis correlatedwith expectedreturns,then the parameterestimatesin the
pricing equation will be biasedand the tests of market efficiencywill be
;nisspecified.”Second,if the foizcasting-variableis uncorrelatedwith expected
returns,the power of our testswill be lower relativeto the benchmarkcasein
which expectedreturns are successfullymodeled,biasing our tests against
rejectionof market efficiency.The uncorrelatedexpectedreturn assumption
providesthe following modelfor usein our empiricalanalysis:
x, = ;‘()+;‘,Z,-, +c,, (7)
~,=Po+Iy*(~,-~o-;‘,~, ,I+&,. (8)
Becausewe must estimatethe mean expectedreturn parameter,PO,the
coefficient,yo,is not uniquelyidentifiablein Eq.(8).Accordingly,we test market
efficiencyby testingthe constraintthat yl is the sameacrossthe two equations.
The two equationsin the systemare simultaneouslyestimatedusingiterative
weightednonlinearleastsquares,asdescribedin Mishkin (1983).Thelikelihood
ratio statisticfor testingmarket efficiency,which is distributed asymptotica!ly
x2(I) under the null hypothesisof market efficiency,is then
2n log(SSR”,!SSR”).

= numberof observations,
ZSR’ = sum of squaredresidualsfrom the constrainedweightedsystem,and
SSR” = sum of squaredresidualsfrom the unconstrainedweightedsystem.
The model is estimatedusinggrowth and return variablesmeasuredover
five-yearintervals.Includingobservationsfrom the samefirm that are lessthan
fiveyearsapart inducesserialcorrelationin the residuals,causingthe standard
errors to be understated(seeHansenand Hodrick, 1980.for a detailedanalysis
of this problem).A simplesolutionto this problemis to useonly nonoverlapping
observations. Adoptingthissolutionreduces our samplesizesto 6,769observations
for testsof the first modeland 2,570observations for testsof the secondmodel.
Table4 providesthe model estimationresults.We test the first model using
four definitionsof growth: salesgrowth, earningsgrowth, salesper share(SPS)
growth, and EPSgrowth. PanelA of Table4 reports the coefficientestimates
from the unconstrainedsystem.The rational forecastingcoefficientis denoted
;‘I, whilethe forecastingcoefficientreflectedin stock pricesisdenote7:. The first
columnof resultsindicatesthat salesgrowth is strongly mean-reverting, as y1is

.-_. --_ --... _.

*We are not aware ofany asset-pricing models that specifically link any of our R>recosting variables
to rationally priced risk factors. If it is assumed that high-growth firms a~ riskier. then high-growth
firms would. on average. have higher realized returns (cunlrary to the cvldcnce presented in Table 31.
Thus, a theory predicting a negative relation between growth and expected returni is required for
any ptential bias in the parameter estimates to be of concern.
Table 4
Results i>f nonhncar weighted least quarts tests of stock market eflicicncy with respect IO the
implications of past growth for future growth
Two samples are reported in the table. The first sample is used when the forecasting variable(Z, ,I is
weighted pas1 growth in sales, earnings. sales per share (SPS). or earnings per share (EPS). and
consists 016.769 nonoverlapping five-year observations traded on the NYSE or AMEX and covered
by COMPLJSTAT between I%7 and 1991. The second sample is used when 7, I is forecast EPS
growth, and consists of 2.570 nonoverlapping five-year observations between 1981 and 1992 that
bavc analysts’ forecasts of growth available on IIB/E;S. are traded on the NYSE. AMEX. or
NASDAQ. and are covered by COMPUSTAT. Weighted past growth in X is calculated as

i ,H.dlX, .,. &( i ,t.). where AX, = log(X,) - log(X, , ). and X is either sales, earnings, SPS,
W=l “1, or EPS.
Fulure growth in X is obtained by fitting an ordinary least squares line through the logarithm of the
most recently reported vdlue of X and Ihe five future years’ value oi ,&‘\‘.Sales are measured using
sales (net) and earnings ar: measured using earnings before extraordinary items and discontinued
operations. Per-share numbrrs are obtained by dividing sa)es(and earnings) by the number of shares
outstanding at the fiscal ytir-end. with shares outstanding adjusted for sleek splits and stock
dividends using the adjustment factor on COMPUSTAT. Forecast EPS growth is the median
analysts’ estimate of earnings-per-share growth over the nexl five years measured in the liB.‘E ;S
statistical month spanning the anrouncement of annual earnings. The five-year-ahead stock return
(r,)cumulation period begins four monthsafter the hscal year-end for the first sample. and the month
following the measurement of forecast EPS growth for the second sample. Stock returns arc
buy- hold returns. inclusive of divider) Is and any liquidating distributions.

X I- - .,O
. + ;‘I z, , + I-,, r, = p,, + jl,(X, - ;‘,, - y:Z,. ,) + c,
Future growth variable (X,): sales Earnings SPS EPS EPS
Forecasting variable (Z,. , ): Weighted Weighted Weighted Weighted FOreCaSt
past sales past earnings past SPS past EPS EPS
growth grow! h growth growth growth
_
-t-n 0.0&M*+ 0. I 17’. 0.062** 0.090** 0.005
(0.002 ) (0.004) (0.002) (0.004) (0.010~
;‘I 0.028 l - 0. I 79” 0.014 - o.m** 0.377’9
(0.012) (0.013) (0.012) (0.014) iO.064)
;t 0.104 - O.IVR*+ - O.lJ9” - 0..303*+ 09.W**
(0.057) (0.057) (0.053) (O.ou)) (0.217)
It, I .O96” l.l86** 1.015** l.l65** 1.40x**
(0.030) (0.03 I ) (0.030) (0.030) 10.066)
PI 3.598+* 2.b I ‘** 3 659,’ 3.0’3.’ I.796**
(0.176) ,O.lOi, p. ‘%I (0.136) (0.119)
-
Panel B: Test c!f marker c$i&w~ .,‘, = ;:
Likelihood ratio statistic’ 2.553 0.465 9.919 6.448 6.934
(Marginal significance IeveP) (0.1 IO) (0.495) (0.002) (0.0 I I ) (0.808)

‘The likelihood ratio statistic is distributed asymptotically as 1’ with one degree of freedom.
babe marginal sigmlicartce level is the probabihty ofgeumg that value oflhe Irkelihood ratio statistic
or higher under the null hypothesis of market efficiency.
Asterisks denote significance at the 5% (*) and I% (**) levels using a two-tailed r-test.
 0.028.The point estimateof the coefficientin the forecastingequation,;!:, is
0.104, indicating that investors overextrapolatepast growth. However, the
likelihoodtest in panelB indicatesthat the differenceis not statisticallysignifi-
cant (significancelevel= 0.110).Moreover, this result doesnot appearparti-
cularly significant from an economicstandpoint. In the secondcolumn of
results,;‘I is - 0.179,indicating that earningsgrowth is negativelyserially
correlate*. However,investorsclearlyanticipatethe negativeserialcorrelation,
as 7: is - 0.198,providingno support for the extrapolationmodel.The third
column indicatesthat growth in SPSis strongly mean-reverting,Ath a ‘Joof
0.014.The expectationsreflectedin stock pricesappearto overanticipatethe
extent of mean reversionin SPS.The 7: estimateof - 0.159indicatesthat
investorsact asif SPSis negativelyseriallycorrelated.Moreover,the likelihood
testin panelB indicatesthat the differenceis statisticallysignificant(significance
level= 0.002).Market efficiencyis rejected,but the directionof the rejectionis
oppositeto the direction predictedby the extrapolationmodel.The resultsin
the fourth column for gi-awth in EPStell a similar story. Growth in EPS is
rlegativc’yserially correlatedwith iI ;dI of - 0.200. but investorsappear to
overanticipatethe negattveserial correlation, with a ;f: estimateof - 0.303.
Market cfftciencyis rejected(significance
level = 0.01l), but again,the rejection
is oppositein directionto the predictionof the extrapolationmodel.Overall,the
resultsin Table4 provide no systematicsupport for the extrapolationmodel,
and the resultsusingper-sharegrowth ratesareconsistentwith a contradictory
story in which investorsunderreactto information in past growth.5
The final column of Table 4 reports resultsfor tests oi the secondnaive
expectationsmodel. The coefficientestimatesfrom the forecastingequation
confirm that analysts’forecastsare systematicallybiased.In particular. ;‘I is
0.377,indicatingthat forecastgrowth is almost threetimesas largeas realized
growth. The pricing equation indicatesthat investorsappear to price these
forecastsat facevalue,despitetheir considerablebias,with a 77 of 0.938.The
estimateof ;,T is significantlyditferent from the estimateof ;‘I (significance
level= 0.008).However,with a standarderror of 0.217.theestimateof ;1: is not
significantlydifferentfrom one,its predictedvaluefrom model2. In short, the
resultsare consistentwith model2: investorsappearto naivelypriceanalysts’
biasedEPSgrowth forecasts.

‘The underreaction results are consistent with the well-documented postearnings-announcnt

drift. whereby investors appear to underreact to information in past earnings surprises (Bernard and
Thomas, 1990). and with recent evidence on momentum strategies (Ghan, Jcgadcesh and
Lakonishok, 1996). The differcncz between the results using firm-level and per-share growth rates is
consistent with the welldocumented post-equity-issuance cfTcct, whmby firms issuing equity
expericna lower subsequent stock returns (Loughran and Ritter. 1995). Equity issuances increase
firm-level growth rates but not per-sham growth rates, resulting in a negative relation between past
growth and fulurc returns for fGm-kvcl growth rates but not per-share growth rates
 P.Af. Dechtrw. R.G. Shun, Journal of Financial Economics 43 (1997) 3-- 27 23

4.3. Explaining returns to contrahan inrestment

The results in !3ection 4.2 indicate that stock prices behave as if investors price
analysts’ forecasts of long-term earnings growth, even though these forecasts are
systematically biased. However, the results in Section 4.1 suggest that the naive
pricing of analysts’ forecasts of earnings growth does not provide a complete
explanation for the returns to contrarlan strategies. This section uses ordinary
least squares regression analysis to investigate the proportion of the returns to
contrarian strategies that can be attributed to naive pricing ofanalysts’ forecasts
of long-term growth. Following Bernard and Thomas (1990) we measure the
independent variables u&g scaled decile rankings. The decile rankings are
assigned in the same way as in our investment strategies. In particular, ranks are
assigned separately for each calendar year in the sample. The decile rankings
(from one to ten) are then reduced by one and divided by nine, so as to range
between zero and one. Measuring the independent variables in this way has
three advantages over using their actual values. First, the regression coefficients
can be interpreted as estimates of the return to a zero investment portfolio with
a long position in the stocks of the highest decile and a short position in the
stocks of the lowest decile. Second, use of ranks avoids assigning a large weight
to the small number of outlying observations that characterize financial ratios
such as earnings-to-price and book-to-market. Finally, we keep the analysis
focused on explaining cross-secttonal variation in realized future returns based
on past information. Using the actual values introduces hindsight bias into the
analysis. because it assumes the ex post empirical distribution of the ranking
variable is known ex ante.
The regression results are presented in Table 5. A separate set of results is
presented for each contrarian strategy. because missing observations and the
elimination of negative values for the earnings-based strategies cause the num-
ber of observations to differ across the strategies. For each contrarian strategy.
we conduct six regressions. We conduct two univariate regressions of onc-year-
ahead buy-hold returns on the contrarian ratio and forecast earnings growth,
respectively, and a third multivariate regression of one-year-ahead re!urns on
both of these explanatory variables. These three regressions are then repeated
using five-year-ahead buy-hold returns as the dependent variab!e. Interpreta-
tion of the univatiate regressions focuses on the point estimates of the coeffi-
cients. which provide estimates of the hedge portfolio returns. Interpretation of
the multivariate regressions focuses on the marginal statistical significance of the
contrarian ratio. In addition, we report the relative contribution of forecast
earnings growth to each contrarian ratio’s ability tc, predict future returns by
taking the ratio of the explanatory power of forecast earnings growth alone to
the combined explanatory power of forecast earnings growth and the contrarian
ratio. This provides an estimate of the relative contribution of forecast earnings
growth to the contrarian ratio’s explanatory power under the assumptions that
Rcpressiocs investigating the abtlity of analysts’ forecast of growth in earnings per sh;rre to explain
the returns to contrarian investment strategies
The sample consists of 23,203 firm-years between 198 I and 1992 for firms that have analysts’
forecasts of growth available on I!B/‘E/S. are tr&d on the NYSE. AMEX. or NASDAQ. and are
covered by COMPUSTAT. The contrarian variables are ho&-to-market. earnings-to-price. and
cash-to-price. Book-to-market is the ratio of the book value of common equity for the most recently
ended fiscal year to the market value of common equiiy at the kginning of the return cumulation
period. Earnings-lo-price is the ratio of annual earning before extraordinary items and discontinu-
ed operations to tat market value of common rquity. using the same timing conventions as for
book-to-market. Cash-to-price is equivalent to earnings-to-price but with the exclusion of deprccia-
tion expense from the numerator. Forecast EPS growth is the median analysts’ estimate of
earnings-per-share growth over the next five years measured in the l/B!E/S statistical month
spanning the announcement ofannual earnings. All independent variables are assigned in ascending
order to deciles. and then scaled so that they range from zero (for the lowest dccile) to one (for the
highest decile). The one- and five-year-ahead stock return cumulation periods begin in the month
following the measurement of forecast EPS growth. Stock returns are buy hold returns. inclusive of
dividends and any liquidating distributions.
---.. --.----_---.------- _ ..- - ---------I--_---
Dependent variables
-.-- -------
One-year-;1 hlx:ld rc’ I II Fivs-year-ahead return

Contrarian variable is book-lo-market

Intercept 0.14+* 0.21** 0.18’. 0.74.. 1.24” 1.12**

Book-to-market 0.06- 0.03*+ 0.44*= 0.15
Forecast EPS growth - 0.08*+ - 0.06- - 0.60** - 0.52’.
Adjusted Rz (%I 0.19 0.30 0.34 0.72 1.4t 1.45
Proportion explained’ 88.2% 97.2%

Contrarian variable is earnings-to-price

Intercept 0.12’. 0.21** 0.15.’ 0.65.. I .25** 0.96**

Earnings-to-price 0.09- 0.08’. 0.59*+ 0.39.5
Forecast EPS Growth - 0.08** - 0.04*” - 0.6Pf - o&i+*
Adjusted Rz (%) 0.45 0.29 0.53 1.35 I.44 1.92
Proportion explained 54.7% 76 1%

Contrarian variable is cash-to-price

Intercept 0.12*+ 0.20+* 0.15++ 0.64** 1.25** 0.99**

Cash-to-price 0.08** 0.06” 0.59” 0.34”
Forecast EPS growth - 0.07” - 0.G-P - 0.63** - 0.45”
Adjusted RL f%) 0.33 0.23 0.38 1.31 1.57 1.86
Proportion explained’ 60.5% 84.4%
-. _ -______
’ Proportion explained represents the proportion of the explanatory power of the contrarian ratio
with respect to Future returns that can k attributed to forecast earnings growth. and is computed as
R’ (forecast earnings growth)/R’(contratian ratio. fotLmst earnings growth).

l * Denotes significance at the I% kvel using a two-tailed r-test. Standard errors are computed
assuming that residuals in the annual regressions are cross-sectionally and temporally uncorrelated.
The standard errors in the regressions using overlapping five-year returns incptporate the theoret-
ical correlation structure resulting from cumulating overlapping uncorrelated annual residuals.
 P.M. De-how. R. G. Slcan;Joumul o/‘F’inanc.ial Economics 43 (19Y7) 3 2 7 25

(i) forecast earnings growth is uncorrelated with other factors contributing to

cross-sectional variation in the contrarian ratio. and (ii) the linear additive
structure imposed by the regression model is appropriate.
The first panel of Table 5 reports the regressionresults for the book-to-market
strategy. The first regression indicates that the estimated return to the strategy
over the subsequent year is 6%. The explanatory power of the regressionis only
0.19%. highlighting the small proportion of the total variation in realized
returns explained by contrarian strategies.The next regressionindicates that the
corresponding return to a strategy based on forecast earnings growth is 8%.
Notice that in the table the estimated returns to the forecast earnings growth
strategy are negative becauseour estimation procedure assumesa long position
in the highest decilc and a short position in the lowest decile. The explanatory
power of the regression is 0.30%. When we combine book-to-market and
forecast earnings growth, the explanatory power of the regression increasesto
0.34%. The incremental explanatory power of the book-to-market ratio is
statistically significant, but forecast earnings growth contributes 88.2% of the
explanatory power. The im,portance of forecast earnings growth is greater in the
regressions using the buy-hold return over the subsequent five years. The
estimated hedge portfolio ret*ims are 44% for book-to-market and 60% for
forecast earnings growth. However. the incremental explanatory power of
book-to-market is not statisticalIy significant and forecast earnings growth
accounts for 97.2% of the explanatory power.
The second panel of Table 5 reports regression results for the eamings-to-
price strategy. Employing one-year-ahead returns as the dependent variable
yields estimated returns of 9% to the earnings-to-price strategy and 8% to the
forecast earnings growth strategy. The incremental explanatory power of earn-
ings-to-price is statistically significant and forecast earnings growth accounts for
54.7% of the explanatory power. Moving to the longer five-year holding period
again increases the relative importance of forecast earnings growth: the esti-
mated hedge portfolio returns are 59% for earnings-to-price and 62% for
forecast earnings growth. The incremental explanatory power of er,mings-to-
price is statistically significant. but forecast earnings growth accounts for 76.1%
of the explanatory power. The results for cash-to-price in the final panel closely
resemble those for earnings-to-price. In summary, the results in Table 5 indicate
that forecast earnings growth accounts for over half of the returns to contrarian
strategies, and that its relative importance is greater over the longer five-year
holding period.

We examine the ability of naive investor expectations models to explain the

returns to contrarian strategies. Contrary to LSV, we find no systematic
26 P.M. &chow. R.G. Slwn rJourd of’fi’nuncial Economics 4.4 (1997) 3 .27

evidencethat the returnsto contrarianstrategiesarisebecauseinvestorsnaively

extrapolatepastsalesor earningsgrowth. Consistentwith Baumanand Dowen
(1988)and La Porta (1995).we find that over 50% of the returns to the
contrarianstrategiescan be attributed to investors’naiverelianceon analysts’
long-termearningsgrowth forecasts.
Thisconclusionis subjectto severallimitations.First, the behavioralmode1in
whichinvestorsnaivelypriceanalysts’forecastshasbeenspecifiedin an ad hoc
manner.It is simpleto developbehavioralhypotheseson an ex post basisto
explainobservedempiricalregularities.Behavioralmodelswill gain morecredi-
bility if they are developedex ante from a soundtheoreticalbasis.Second,we
cannotrule out the possibilitythat analysts*forecastsof future earningsgrowth
are correlatedwith a risk factor that is rationally pricedaccordingto an asset
pricing theory that hasnot yet beenidentifiedin the academicliterature. For
example,investorsmay rationally demanda premium to hold firms with low
expectedgrowth. Alternatively,Baumanand Dowen(1988)raisethe possibility
that analystsma) naivelyinfer their long-termearningsgrowth forecastsby
;,4riparirlr cgrrcn! ~~i.n’q_9<
ani stoLk price. Under this scenario,analysts
mistakenlyattribute higherexpectedrisk to higherexpectedgrowth.
Theselimitationsaside,our evidenceleavesunansweredthe questionof why
analystssystematicallyoverestimatethe growth prospectsof high-growthcom-
panies.One possibilityis that they intentionallymisrepresentthe future growth
prospectsof companiesthat are expandingin order to reducethe cost to these
companiesof raisingadditionalcapital.in this vein,Lin and McNichols(1991)
find that analysts’forecastsof client companies’earningsare systematically
overoptimistic,providinga potentialexplanationfor the overoptimismin con-
sensusforecasts.Alternatively,analystsmay themselvesusea naiveforecasting
model that causesthem to unintentionally provide biasedforecastsof the
long-termearningsgrowth of high-growthfirms.

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