Why does such a simple strategy work?
Well, because the low PTB stocks are generally down and out stocks. They could be in an
unglamorous industry, or are going through a rough patch in their business cycle.
Investors are always looking for the next exciting thing or the next novel idea in the
market and are willing to pay a high price for it. And they tend to ignore the "dogs" of the
market, or find it difficult to buy them. As a result, these companies end up trading at a
fraction of the value of their underlying assets.
But in this world, nothing stays constant. Poor performing companies will restructure and
start to perform better. Or, for some, their assets are taken over by competitors. In most
instances, these companies will revert to the mean, or to the category of average
performers. A stock which moved from a down-and-out state, to an acceptable state,
would typically see a big jump in its share price. This explains the persistent
outperformance of low PTB stocks versus the rest.
Fama and French, the US university professors who first discovered this phenomenon of
low PTBs being the best predictor of future outperformance in share price, attributed the
superior performance of the "dogs" portfolios to higher risk. Being "dogs", they have
more uncertain earnings stream and some may even have problems surviving. Investors
who buy such companies are thus assuming a greater risk and therefore have to be
compensated for it, they argued.
However, if one takes a portfolio approach, i.e. buy a big basket of such stocks, even if a
handful of the companies don’t recover from their slump, the impact on the portfolio will be minimal. Often times, the gains from the other stocks in the portfolio will more than
make up for the handful that have disappointed.
It is just our irrational fear of owning a basket of out-of-favour stocks which is deterring
us from reaping the benefits of what study after study have shown to be a very lucrative
stock investment strategy.