Academic literature on investment strategies

Value investment strategies

There is a large amount of research papers that studied the performance of value and growth stocks. Overall, the empirical studies suggest that value stocks outperform growth stocks.

According to Fama and French (1995), size and "book-to- market-equity" explain the difference in earnings. They argue that as the value stocks are more risky than growth stocks, investors require premium for an additional risk.

According to behavioural finance, investors tend to overreact to positive and negative news (Kahneman and Tversky). Consistent with overreaction theory, proponents of the contrarian strategy De Bondt and Thaler (1985) stated that stocks that performed poorly in the past tend to outperform over three-five years, as investors overreacting to negative news push the prices of the stocks down and as a consequence, the stocks become undervalued. In their study, they formed two portfolios of "losers" and "winners", and tracked the stocks from 1930 to 1978. The results of the empirical study have shown that abnormal return of the stocks that were "losers" in previous years was 25% higher than the past "winners" return.

Lakonishok, Schleifer and Vyshny (1993) suggest that value stocks that have characteristics such as low price to earnings outperform the growth stocks. The value strategy is based on receiving profit buying undervalued stocks. Assuming that stock are followed by the trend, investors buy shares that performed good in the past, and that creates overvalued stocks, what makes market inefficient. Investors that follow contrarian strategy behave in opposite way: they buy shares that are out of favour and sell stocks that are overvalued, gaining a profit. Lakonishok , Schleifer and Vyshny studied the performance of US stocks from 1963 to 1990. They identified the stocks that showed no growth in the past and expected to have the same performance in future as a value stocks. They had shown that value stocks outperformed growth stocks by 8% that lasts for several years, and the performance of the stocks was not dependent on the size of the company. The idea of the contrarian strategy is to buy stocks that underperformed in the past, as they are undervalued, and sell that outperformed as they are overvalued.

The portfolio that includes small capitalization companies with market value less than $2 billions and low price to cash flow have shown higher than average performance (Hackel, Livnat, Rai 1994). The small firms that generate stable free cash flow are expected to have a strong growth. The empirical study compared the performance of stocks that have a low price to cash flow with stocks with the same characteristics of market capitalization but with higher price to cash flow multiple. The explanation of this anomaly is consistent with overreaction hypothesis as investors overreact to negative earnings without examining the free cash flow.

In the international market, as the researches have shown, the value strategy proved to be working as well as on the US market. Examining the markets of 21 countries over ten year period, the value stocks had higher average return and higher risk-adjusted return than the growth stocks. (Bauman, Conover, Miller 1998). Moreover, the stocks of small-sized firms have higher returns compared to stocks of larger companies. The explanation of this anomaly is that investors extrapolate past performance into the future, expecting the growth of past "winners" stocks.

Dividend yield strategy is one of the types of value investment strategy. This strategy was performed based on Dow Jones Index and resulted in the returns that were higher than the index itself. The strategy consists of buying stocks with the highest dividend yield. McQueen, Shields and Thorley (1997) studied the ten highest dividend yield stocks and found that these stocks had higher risk-adjusted return (after taxes, transaction costs) than the Dow Jones index over fifty years by 0,95%. Vissher and Filbeck examined the effectiveness of this strategy in the Canadian stock market. They examined stocks form 1987 for subsequent ten years. Choosing ten highest yield stocks from Toronto 35 Index, they rebalanced the equally weighted portfolio once a year. They computed the returns including a price difference and dividend yields. The ten stocks portfolio outperformed the index by 3-6 percent. As the strategy doesn't require a lot of trading, the average abnormal return is sufficient to cover taxes and transaction costs.

Long only or a bit of short?

It is a general thought that investors feel more comfortable in employing long only strategies. However, many academic studies have shown that information efficiency of long only portfolio can be significantly improved by practicing short selling.

Clarke et al. (2004), demonstrate that long only approach is the most important constraint regarding the information loss. They argue that many advantages can be obtained by relaxing the long positions with even modest proportion of short positions. In their research they created so called "fully constrained portfolio" with annualized standard deviation between portfolio's return and return of S&P 500 used as a benchmark of 4%. The portfolio included all significant constraints according to the authors: holding balanced proportion of large and small cap stocks in the portfolio, industry and sector neutrality, and no short selling.

Methodology used by authors is based on Clarke at al. (2002) expanded Fundamental Law i.e. information ratio (IR) depends not only on the information coefficient (IC) but also on the transfer coefficient (TC) i.e. the extent to which IC is transferred into portfolio's active weights. In this direction, the impact of each constraint is measured with documenting the changes in the portfolio's TC by removing constraints one by one.

The results from the study showed that fully constrained portfolio have TC of 0.332 and by allowing short selling TC increased by 108%. Furthermore, their results showed that market capitalization neutrality constraint also have a significant impact on information loss as by removing this constraint TC increased by 46%.

Clarke et al. (2004) argue that portfolios activities could be increased allowing managers to use short selling. Also, modestly 20% of shortening can significantly boost up the TC compared to the long only approach. Likewise, for more conservative investors, shortening provides them an opportunity to employ investment strategy without using the derivatives (put options, swaps, spread beats or stock futures). However, authors note that the trade-offs exist between the range of shortening, tracking error and TC, as all of them cannot be controlled at once.

Some might argue that short selling is hazardous and contributes towards market destabilization. After the credit crunch, regulators applied many restrictions to the short selling such as expanding the list of shared banned for shorting. On the other hand, many academic studies showed that markets are mostly efficient when short selling is employed.

According to Boehmer et al. (2009) short sellers are often those who are unreasonable blamed in sharp fall of share prices. In their study they compared banned and non banned stocks in order to identify the effects of various levels of short selling and changes in price. Banding more than 1000 of stocks for short selling by the US Security and Exchange Commission (SEC) resulted in decreasing the short selling activities by 65%. However, this action did not contribute to the more market quality. In addition, by analyzing the change in prices of stock added to the ban list, they found that stocks were underperforming continuously even in the period when the ban was enforced. Results revealed that applying shorting restriction does not lead to a synthetic increase in stock prices.

Saffi and Sigguardsson (2010) studied the relation between stock price efficiency and short selling using a global data sample of over 12,600 stocks for the period between 2005 and 2008. The results from their empirical study are in support of the short selling investment strategy. More concrete, they found that stocks with short selling restrictions are less price efficient compared to the stocks allowed for short selling. Also, they showed that short selling does not contribute to the negative returns or price instability.

Boehmer et al. (2008) concluded that short selling is present with significant proportion of 12.9% of the total trading volume at the New York Stock Exchange in the period between 2000 and 2004 and that weighed against the average market participants, short sellers are more informed.

Having in mind aforesaid limits of the long only approach and well documented benefits of short selling, our investment strategy aims toward investors who do not feel comfortable in using derivatives but yet are willing in achieving higher returns than those offered by long only portfolios. We believe that short selling is the best alternative for the complex financial products.


  • Ekkehart Boehmer, Charls M. Jones, Xiaoyan Zhang, "Which shorts are informed?", The Journal of Finanace, vol.63, no.2, 2008
  • Ekkehart Boehmer, Charls M. Jones, Xiaoyan Zhang, "Shackling Short Sellers: The 2008 Shorting Ban", 2009, Working paper available at:
  • Pedro A.C. Saffi, Kari Sigurdsson, "Price Efficiency and Short Selling", 2010, Working paper available at
  • Roger G. Clarke, Harinda de Silva, Stiven Sapra "Toward More Information-Efficient Portfolios", Journal of Portfolio Management, Fall 2004, 54-63;
  • Roger G. Clarke, Harinda de Silva, Stiven Thorley "Portfolio Constraints and the Fundamental Law of Active Management", Financial Analyst Journal, vol.58, no.5, September/October, 2002, pp.48-66;
  • Kahneman, D., Tversky, A. 1982. Intuitive prediction: Biases and corrective procedures.

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