Long-Term Reversals of Industry Performance and Investor Underreaction to Structural Change

While the academic literature demonstrates that individual investors tend to be performance chasers, there’s a strong body of evidence — dating back to a 1985 paper by Werner F.M. De Bondt and Richard Thaler, Does the Stock Market Overreact? — documenting the reversal of long-term stock returns. De Bondt and Thaler found that for U.S. stocks classified based on their returns over the past three to five years, “losers” outperform “winners” over the following three to five years. De Bondt and Thaler, as well as other researchers, attribute this long-term return reversal to investor overreaction. This, of course, is a challenge to the notion of market efficiency.

As out-of-sample tests, several papers on international markets have found the same phenomenon. Contrarian strategies that buy portfolios of stocks that have low long-term past returns (losers) and sell portfolios of stocks that have high long-term past returns (winners) deliver superior performance.

Graham Bornholt, Omar Gharaibeh, and Mirela Malin contribute to the literature on this topic with their study, Industry Long-Term Return Reversal, which appeared in the September 2015 issue of the Journal of International Financial Markets, Institutions and Money.

The authors were motivated by the following logic: “Since an industry’s returns will tend to mirror its underlying health, its past long-term returns may be predictive of such reversals in its fortunes. If investors are slow to recognize that structural changes in an industry will produce a reversal in its fortunes, then low (high) past long-term returns will tend to be followed by high (low) returns in the future. That is, investor underreaction to structural change may also produce return reversal.” However, they also note: “One obstacle that reduces the efficiency of traditional contrarian strategies is that not all long-term losers and winners are equally ready to begin to reverse their past long-term performances.”

To overcome this problem, in addition to investigating a traditional “pure” contrarian strategy, the authors also examined a “late-stage strategy.”

A late-stage strategy “is a double-sort strategy that exploits the recent short-term performances of securities to select those showing indications of being more ready to reverse their long-term past performances. The late-stage strategy is long a portfolio of long-term losers with relatively good recent short-term returns and is short a portfolio of long-term winners with relatively poor recent short-term returns.” They add: “The key insight of the late-stage approach is that late-stage strategies should outperform corresponding pure contrarian strategies because a number of long-term losers and winners that show no signs of reversing have been excluded from the late-stage portfolios.”

Using data from Ken French’s website, Bornholt, Gharaibeh, and Malin’s study covered 48 U.S. industries over the period from July 1963 through December 2013. The long-term loser (LL) portfolios consisted of the 25% of industries that had the lowest returns over the past 36, 48, 60, 72, 84, 96, 108, 120, or 132 months. The long-term winner (LW) portfolios consisted of the 25% of industries that had the highest past returns over the same time frames.

The pure contrarian strategy (LL-LW) buys the long-term loser portfolio and sells the long-term winner portfolio. Portfolios are held for 3, 6, 9, and 12 months. However, consistent with previous studies, the authors maintained a 12-month gap between the end of the formation period and the beginning of the holding period. For example, in their study De Bondt and Thaler found that the first year after the end of the formation period didn’t provide significant contrarian profits. Additionally, the authors observed that other studies had found that adding the 12-month gap “improves the performance of the pure contrarian strategy and generates stronger findings because this procedure helps avoid any long-term reversals being offset by the short-term continuation of returns.”

For the late-stage strategy, the first sort is the same as for the pure contrarian strategy. The second sort is based on the most recent X month returns, where X = 3, 6, 9, 12, 24, 36, 48, or 60 months. This means that returns are from the last X months of the formation period. From the long-term loser portfolio, the 25% of industries with the largest X month returns (the recent winners) are chosen for the long portfolio. Similarly, from the long-term winner portfolio, the 25% of industries with the worst X month performance (the recent losers) are chosen for the short portfolio. As with the pure contrarian strategy, all portfolios in the late-stage contrarian strategy are held for 3, 6, 9, or 12 months.

While a 12-month gap is used between the end of the formation period and the beginning of the holding period in the pure contrarian strategy, the design of the late-stage strategy means that problems arising from short-term continuation offsetting the evidence of long-term reversal are avoided. Thus, their late-stage strategy follows the methodology of prior research and uses only a one-month gap between the formation and the holding periods. The following is a summary of Bornholt, Gharaibeh, and Malin’s findings:

There is strong evidence of reversal in long-term industry returns.

There is strong evidence (both in terms of large returns and statistical significance) that profits produced by contrarian strategies with long formation periods (96, 108, 120, and 132 months), rather than the formation periods typically used in studies of stock return reversals (36, 48, and 60 months), are greater.

• Pure contrarian strategies do not produce statistically significant profits if there is no gap between the formation and the holding periods.

• The reversal in long-term industry returns leads to valuation changes over the following 10 years that seem difficult to reconcile with the notion of investor overreaction.

• The late-stage strategy exhibits significant evidence of reversal in industry returns and has consistently larger profits than the traditional, pure contrarian strategy. This is consistent with a 2013 study on international markets by Mirela Malin and Graham Bornholt, Long-Term Return Reversal: Evidence from International Market Indices.

• The reversal of past long-term performance continues for at least the first five years post-formation.

• As might be expected, the long-term losers have increasing book-to-market ratios in the pre-formation period, while the long-term winners have decreasing book-to-market ratios. In the post-formation period, the long sides of both strategies show shrinking book-to-market ratios over the whole 120 months after formation. This slow recovery in valuations for long-term loser industries seems to take too long to be simply the result of reversal from a past overreaction.

• Results were not due to the influence of a few outliers.

• The long-term return reversal in industry returns cannot be explained by the Fama-French three-factor model.

In their search for a possible explanation of the reversal strategy’s success, and as theory and logic would predict, Bornholt, Gharaibeh, and Malin found that “poor 60-month returns do indeed signal a long period of increasing industry concentration.”

The Bottom Line

Using a broad range of formation and holding periods, Bornholt, Gharaibeh, and Malin found strong evidence of long-term reversal in industry performance that could not be explained by the Fama-French three-factor model. Importantly, they found that “conventional contrarian strategies with the 36-month, 48-month, and 60-month formation periods that are commonly used in stock-level studies and with a gap of twelve months between the end of the formation period and the beginning of the holding period do not provide evidence of long-term reversal in industry returns.”

However, the authors did find that the late-stage contrarian methodology consistently produced stronger evidence than the traditional, pure contrarian approach. They also concluded that “the reversal in long-term industry returns continues for many years, with valuation effects observed up to 10 years after commencement.” For example, the 10-year late-stage contrarian strategy with a six-month holding period produced a significant risk-adjusted return of 5.8% per year, on average, over the sample period.