Using book-to-market ratio, accounting strength, and momentum to construct a value investing strategy: the case of Spain

ABSTRACT

The weak value-growth premium of the Spanish stock market highlights the importance of enhancing the accounting-based fundamental strength of the value-growth strategy. This accounting strength is needed to detect potential errors in market expectations that result in mispriced stocks. When we select value-growth stocks whose accounting strength is incongruent with the market expectation reflected by their book-to-market ratio, the value-growth strategy becomes highly profitable. Our results are consistent with the evidence in the US market and demonstrate that stock markets with a weak value-growth premium are not necessarily free of errors in market expectations. We also demonstrate that the momentum effect allows better timing of this strategy, indicating the best time to buy and sell mispriced stocks. This effect increases profits and reduces the time needed to hold stocks to achieve these profits.

RESUMEN

El débil premio value-growth en el mercado bursétil español resalta la importancia de mejorar la fortaleza contable de la estrategia value-growth. Esta fortaleza contable es necesaria para detectar potenciales errores en las expectativas del mercado que conduzcan a una incorrecta valoración de las acciones. Cuando los títulos value-growth son seleccionados entre aquellos cuya fortaleza contable es incongruente con las expectativas de mercado reflejadas en su ratio book-to-market, la estrategia value-growth se vuelve altamente rentable. Estos resultados son consistentes con la evidencia observada en el mercado de Estados Unidos y demuestra que los mercados bursétiles con un premio value-growth débil no estén necesariamente libres de errores en sus expectativas. También demostramos que el efecto momentum permite seleccionar mejor el momento oportuno en el que comprar y vender estas acciones incorrectamente valoradas, lo cual supone una mejora en las rentabilidades y una reducción en el tiempo necesario para alcanzar dichos beneficios.

KEYWORDS:

• Value-growth stocks
• mispricing
• rational pricing
• momentum
• expectational errors
• accounting-based fundamental strength

JEL CLASSIFICATION:

• G14
• G11
• M41

Acknowledgements

The authors are grateful for the interesting suggestions received at the presentation of this paper in the seminars of the Accounting and Finance Master at the University of Zaragoza and the suggestion made by Ana González-Urteaga at the XXII Finance Forum. The authors also wish to express their gratitude to some anonymous referees for their valuable comments.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. Based on the Corruption Perception Index (CPI), obtained from Transparency International (www.transparencia.org.es), in 2016 the CPI in Spain (58) is lower than it is in the United States (74).

2. These results are consistent with those of De Peña, Forner, and Lopez-Espinosa (2010) who observe that HML factor returns are only statistically significant at the 9% level from January 1991 to December 2004.

3. According to this interpretation, these stocks are also called ‘glamour stocks’.

4. See figure in page 2847 of Piotroski and So (2012) for an illustrative explanation.

5. See Piotroski (2000) for an explanation of the relation between these variables and fundamental health. See, for example, Dumontier and Raffournier (2002) and Papanastasopoulos (2014) for a review of the relationship between accounting information and capital markets in European countries.

6. Recent studies use the F-Score as a comprehensive measure of a firm’s accounting strength. For example, Chung, Liu, Wang, and Zykaj (2015) find strong evidence that long-term institutions with large shareholdings consistently improve a firm’s F-Score and that such activity occurs primarily through the enhancement of a firm’s operating efficiency.

7. We have also used the binary F_Score categories, but defining low F_Score and mid F_Score categories as figures less than or equal to four, and between five and seven, respectively. These cut-offs allow us to have observations each year in all categories. The results, available upon request, are consistent with those presented in the paper, although they are less significant.

8. According to the Royal Decree 1362/2007, which developed into Law 24/1988, quoted firms must disclose their financial statements within two months of the fiscal year end.

9. Although the buy-and-hold method suggested by Lyon et al. (1999) performs well in random samples of event firms, Lyon et al. (1999) caution about the misspecification of this method in non-random samples where the returns of event firms are positively correlated. Jegadeesh and Karceski (2009) propose autocorrelation-consistent test statistics over the time series of average abnormal holding period returns across all event firms that enter the sample on calendar month t (month t cohort). In our opinion, our equation (3) is equivalent to the ‘events firm month t cohort’ of Jegadeesh and Karceski (2009).

10. I.e. the returns are calculated as in equation (2) but with h = 1-, 2-,…, 60-month holding periods.

11. Forner and Marhuenda (2003) and Muga and Santamaría (2006) find positive evidence for the price momentum phenomenon in the Spanish stock market.

Additional information

Funding

This work was supported by the Universidad de Alicante [VIGROB-056].