The inefficient stock market: What pays off and why (2d ed.) Robert A. Haugen

Haugen employed factors, such as dramatic changes in production, interest rates, or inflation to predict stock returns. He divided the eras of finance into three--old, modern, and new finance. He designated the theme of new finance as inefficient markets and its paradigms as "inductive ad hoc factor models" (p. 3). In addition to Haugen's use of factors, other writers applied factors for predictions of risk (Chen, Roll & Ross) and behavior (Kahneman & Tversky). Three disciplines contribute to the understanding of factor models, statistics, econometrics, and psychology.

After discrediting the other methods, Haugen detailed the expected-return factor model and the five classes that it encompasses--risk, liquidity (measures of cheapness), profitability, and technical elements. Because many factors constitute each class, I will not list them all here. One example, however, is the liquidity factors--market capitalization, market price per share, trading volume/market capitalization, and trading volume trend. The author admitted that this list did not exhaust the universe of factors, such as insider trading.

To calculate expected return with factor information, the author instructed the investor to execute the following steps: "you multiply the stock's factor exposure by the projected payoff to the factor. This gives you the component of total expected return coming from the particular factor" (p. 50). This is the formula:
factor exposure X projected factor payoff = factor component of exposure return
"After doing this for each factor, you add up all the components to get the total relative expected return for the stock" (p. 50). This calculation does not incorporate trading costs. Regarding payoffs, the author states "The cheaper the stock, the better the outlook for future returns . . . then other things--including price -- being equal, the outlook for future return improves with more profitable companies in the portfolio" (p. 47).

In the chapter, "Super stocks and stupid stocks", the author graphs the factors to demonstrate the application of his theory. First, the author charts returns on a scale of deciles of 1 to 10, based on risk. He drew six graphs, decile risk characteristics, size and liquidity characteristics, technical history, current profitability, profitability trends, and price level. Decile stocks constitute the stupid stocks and decile 10, the super stock. These stocks exist within a range between true abnormal profit and priced abnormal profit. Furthermore, the author attests that "stocks ranking low in book-to-price ratio are likely to be relatively profitable" (p. 94). Comparing value and growth stocks, the author wrote "while growth stocks have been priced as though they will be able to sustain their relative profitability, this assumption has not been validated by actual corporate performance even during the period over which they enjoyed superior performance in terms of their market price" (p. 95). The author ends by explaining the strengths of the factors, cheapness and the profitability of the company, to increase expected return.

Haugen, R. A. (2002). The inefficient stock market: What pays off and why, 2d ed. Upper Saddle River, NJ: Prentice Hall.

Cheapness Factors:
Earnings to Price Ratio
Earnings to Price Trend (five year monthly time trends throughout)
Book to Price Ratio
Book to Price Trend
Dividend to Price Ratio
Dividend to Price Trend
Cash Flow to Price Ratio
Cash flow to price trend
Sales to Price Ratio
Sales to Price Trend