What is fundamental analysis?
On Wall Street, it’s usually assumed that there are no free lunches or free rides. There are no simple techniques to beat the market, as hundreds of investors are always searching for even a tiny percentage of extra performance. However, there are trading oddities that continue to exist in the stock market, which naturally intrigues a lot of investors.
Although it is worthwhile to investigate these oddities, investors should exercise caution: Anomalies can arise, vanish, and then resurface nearly without any prior notice. Therefore, trading strategies of any kind can be dangerous to follow automatically, but astute investors may benefit by paying attention to these seven occasions.
1. Small Businesses Typically Outperform
Smaller businesses—that is, those with lower capitalization—generally do better than bigger ones. The small-firm effect makes sense in terms of anomalies. The primary factor influencing a company’s stock performance is its economic development, and smaller businesses tend to have longer growth runways than bigger ones.
For a 10% growth rate, a larger firm like Microsoft (MSFT) could require an additional $10 billion in sales, whilst a smaller company might just require an additional $70 million in sales. Smaller businesses may thus usually expand far more quickly than larger ones.
2. The January Impact
An oddity that is very well-known is the January effect. In this case, the theory is that equities that did poorly in the previous year’s fourth quarter often beat the markets in January. It is nearly difficult to characterize the January impact as an oddity since its cause makes so much sense. Late in the year, investors frequently try to sell failing equities in order to deduct capital gains taxes from their losses (or to claim the minimal deduction allowed by the IRS in the event of a net capital loss for the year).
This “tax selling” may drive these companies to a point where January purchasers find them appealing since selling pressure can occasionally be independent of the company’s true fundamentals or value. Similarly, in order to avoid getting sucked into the tax-loss selling frenzy, investors frequently steer clear of underperforming equities in the fourth quarter and instead wait until January. This is the outcome of excessive selling pressure prior to January and excessive purchasing demand following January 1.
3. Insufficient Book Value
Numerous scholarly studies have demonstrated that firms with price-to-book ratios below average typically outperform the market. Purchasing a basket of companies with low price/book ratios can produce market-beating performance, as demonstrated by several test portfolios.
This anomaly makes sense in theory—unusually inexpensive equities should draw interest from investors before returning to the mean—but sadly, it is a very modest abnormality. While it’s true that low price-to-book equities perform better than the market as a whole, individual performance varies greatly, and the advantages are only apparent in extremely large portfolios of low-price-to-book companies.
4. Ignored Stocks
Neglected stocks, a close relative of the “small-firm anomaly,” are likewise believed to do better than normal for the market. The neglected firm effect affects equities with lower trading volume and lower levels of analyst support when they are less liquid. The theory behind this is that the stocks will do better when investors “discover” these firms.
A lot of investors keep an eye on long-term buying signs such as RSI and P/E ratios. These let them know whether a stock has been overpriced and whether buying more shares could be a good idea.
According to research, there is no meaningful outperformance if the consequences of the market capitalization difference are taken into account, proving that this oddity is not real. Smaller, ignored firms therefore tend to do better because they are smaller, while larger, neglected stocks don’t seem to fare much better than would be predicted. Having said that, there is one small advantage to this anomaly: disregarded stocks seem to have reduced volatility, even if their performance seems to be connected with size. What is fundamental analysis? One technique for figuring out a stock’s fair market value is fundamental analysis.
5. Inversions
According to certain data, equities at either extreme of the performance spectrum do have a tendency to go the other way over extended periods of time (usually a year): yesterday’s top performers become tomorrow’s underperformers, and vice versa.
This is supported not just by statistical data but also by the anomaly’s logical connection to investing fundamentals. It is likely that a stock that outperforms the market has become pricey due to its success; the opposite is true for underperformers. Therefore, it would seem reasonable to anticipate that the undervalued stocks would outperform and the expensive ones would underperform, putting their valuation back in line.
It’s also possible that reversals function in part because people anticipate them to. A self-fulfilling anomaly might occur if a sufficient number of investors consistently sell last year’s winners and purchase last year’s losers. This would assist move the stocks in precisely the predicted directions. Some have stated that this method was a result of data mining, thus it’s unclear if there was ever a foundation for it. If it had ever been effective, it would have been arbitraged away, maybe by those who chose a day or a week before the new year. This is really just an altered version of the reverse anomaly, in that the Dow stocks with the highest yields were most likely relative underperformers and were anticipated to do better.
The Final Word
Trading anomalies is a hazardous investment strategy. Not only are many anomalies erratic, but many of them are not genuine at all. Furthermore, they are frequently the outcome of extensive data research that examines portfolios with hundreds of stocks that only provide a marginal performance benefit. Similarly, it would seem to logical to attempt to sell off losing assets before the major spike in tax-loss selling occurs and to wait until well into December to acquire underperformers.
