Do mispriced stocks systematically revert to value under the long-term guidance of information traders? If so, what factors affect the rate of reversion for a particular stock? In their March 2009 paper entitled “How Quickly do Equity Prices Converge to Intrinsic Value?”, Dennis Capozza and Ryan Israelsen investigate the predictability of the reversion of stock price to a changing fundamental valuation baseline. They use annual fundamental (intrinsic) values for stocks from AFG Research, as derived from from estimates of future earnings based on growth rate and the decay of the spread between return on equity and cost of capital. Using monthly return/trading data, annual intrinsic value data and firm characteristics for 8,845 stocks over the period 1997 through 2006, they conclude that:
- The mean deviation of stock price from estimated intrinsic value over the entire sample period is 20%.
- On average, the market removes 15-30% of this stock mispricing in a year.
- Momentum is generally stronger for stocks of firms with greater analyst coverage, more leverage and larger size.
- Reversion is generally faster for stocks of firms with greater analyst coverage and less leverage.
- Results are consistent with the interpretation that momentum drives slow reversion of stock prices toward a changing fundamental value as trend followers pick up the trails of information traders.
In summary, the combined actions of information traders and trend followers typically eliminate 15-30% of the difference between market valuation and fundamental valuation in a year.
