An Analysis of Contrarian Investment Strategies in the UK

Abstract

The performance of contrarian, or value strategies – those that invest in stocks that have low market value relative to a measure of their fundamentals – continues to attract attention from researchers and practitioners alike. While there is much extant evidence on the profitability of value strategies, however, most of this evidence pertains to the US. In this paper, we provide a detailed characterisation of value strategies using data on UK stocks for the period 1975 to 1998. We first undertake simple one‐way and two‐way classifications of stocks in which value is defined using both past performance and expected future performance. Using sales growth as a proxy for past performance and book‐to‐market, earnings yield and cash flow yield as measures of expected future performance, we find that that stocks that have both poor past performance and low expected future performance have significantly higher returns than those that have either good past performance or good expected future performance. Allowing for size effects in returns reduces the value premium but it nevertheless remains significant. We go on to explore whether the profitability of value strategies in the UK can be explained using the three factor model of Fama and French (1996). Broadly consistent with the results for the US, we find that using the one‐way classification the excess returns to almost all value strategies can be explained by their loading on the market, book‐to‐market and size factors. However, in contrast with the US, using the two‐way classification there are excess returns to value strategies based on book‐to‐market and sales growth, even after controlling for their loading on the market, book‐to‐market and size factors.