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Study provides evidence that screening value stocks for earnings quality can improve the performance of value investing strategies.

denphumi/Getty Images/iStockphoto

Value stocks (i.e., stocks with low price-to-earnings ratios) tend to have higher average returns in the long run than growth stocks (i.e., high P/E stocks). This is true not only in Canada and the United States, but also globally. The difference in returns between value and growth stocks is known as the value premium. But are there any particular stocks that drive the value premium? And could knowing such stocks lead to improved investor performance? In a recent study with U.S. data that I carried out with my colleague Vasiliki Athanasakou, we confirm that a value premium exists over the 1982-2013 sample period, but more important, that earnings quality is a differentiating factor of performance for value and growth stocks. We use the standard deviation of net income before extraordinary items as a measure of earnings quality, with higher standard deviation signifying lower earnings quality.

More specifically, we find the following. First, while a value premium is evident in the total sample (4.30 per cent), the value premium is actually driven by poorer earnings quality firms – the average value premium for the best earnings quality firms is 0.6 per cent, whereas the corresponding value premium for the poorest earnings quality firms is 9.60 per cent. Second, average growth stock returns decline from 12.80 per cent for the best earnings quality firms to 10.10 per cent for the poorest earnings quality firms; on the other hand, value stock returns increase from 13.40 per cent for the best earnings quality firms to 19.70 per cent for the poorest earnings quality firms. As a result, the value premium increases as we go from the higher to lower earnings quality firms.

This study also adds clarity to the debate about the drivers of the value premium – namely, whether it is risk or mispricing. How is this so? First, we find that while growth stocks tend to be bid up by investors, poor quality growth stocks, which are found to be less visible, are bid up more, and thus end up having lower returns than the higher quality growth stocks. This evidence favours the mispricing (overvaluation) for growth stocks. Second, we find that deteriorating earnings quality of value stocks is associated not only with a rise in stock returns, but also with a sharp rise in analyst uncertainty (risk) about these stocks' expected earnings. This evidence favours a risk-based explanation for value stocks. The above results help us settle the debate on the drivers of the value premium. It is both mispricing and risk that drive the value premium – deteriorating earnings quality contributes to the mispricing (overvaluation) of growth stocks and to analyst uncertainty (risk) of value stocks.

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In summary, our study provides evidence that screening value stocks for earnings quality can improve the performance of value investing strategies and offers an explanation for the drivers of the value premium – it is not risk or mispricing that drives it, but rather a combination of both.

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario.

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