Swedroe: Low Priced Stocks No Bargain

As I wrote about final week, the absolute degree of a firm’s stock price tag is arbitrary, as it could be very easily manipulated by the firm by means of altering the amount of shares outstanding (as an example, by splitting the stock). Regardless of this clear fact, the research into investor behavior has discovered a robust preference among individuals for low-priced stocks.

As an illustration, the investigation shows that person investors are likely to hold lower-priced stocks than institutions. And there’s also evidence demonstrating that the number of little shareholders within a stock increases following a split to a lower price level.

Analysis demonstrates this preference for low-priced stocks by individual investors is motivated by an irrational belief that stocks with reduce nominal prices possess higher upside potential (far more room to develop and much less to drop) plus the lottery-ticket effect. As with lotteries, investors are looking for “cheap bets” with big upside possible. They choose constructive skewness even though it suggests reduced typical expected returns.

The overly optimistic expectations among investors relating to low-priced stocks predict that low-priced stocks will probably be overpriced relative to high-priced stocks, thereby delivering reduced future risk-adjusted stock returns.

More Evidence On Low-Priced Stocks

Justin Birru and Baolian Wang contribute to the literature on low-priced stocks by means of their March 2016 paper, “The Nominal Cost Premium.” The authors begin the paper by noting that “the cross-sectional relationship in between raw nominal prices and future returns is likely to underestimate the genuine economic magnitude of your nominal cost premium.” They explain that is mainly because a sort on raw nominal cost is confounded by the mechanical connection amongst raw nominal cost and expected returns.

Any model of costs (including the Gordon Continuous Development Dividend Discount model) inversely links costs and anticipated returns-stocks with higher risk may have larger expected returns, causing future money flows to become discounted at a greater rate, top to a reduced current valuation.

Therefore, it should not be surprising that past research has failed to document a connection involving nominal cost and future returns. A sort on raw nominal cost combines two countervailing forces: a nominal value premium (predicting that low-priced stocks must exhibit low future returns), and also a mechanical discount-rate impact (predicting that low-priced stocks ought to exhibit high future returns). Because of this, applying nominal price tag as a sorting variable will underestimate the nominal price premium.

To address this difficulty, Birru and Wang employed a set of nominal variables from accounting statements: assets per share, book worth per share, earnings per share and dividends per share. This set of variables, when extremely correlated with nominal prices, is unlikely to endure in the mechanical partnership with expected returns discussed previously. Their accounting information set covered the period 1967 via 2012, even though their returns information set covered the period 1968 by means of 2013.
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