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Since actual earnings are compared to investor expectations, one of the key parts of an earnings event study is the measurement of these expectationsMarket Reaction to Information Events Some of the most powerful tests of market efficiency are event studies where market reaction to informational events (such as earnings and takeover announcements) has been scrutinized for evidence of inefficiency. While it is consistent with market efficiency for markets to react to new information, the reaction has to be instantaneous and unbiased. This point is made in Figure 6.5 by contrasting three different market reactions to information announcements Of the three market reactions pictured here, only the first one is consistent with an efficient market. In second market, the information announcement is followed by a gradual increase in prices, allowing investors to make excess returns after the announcement. This is a slow learning market where some investors will make excess returns on the price drift. In the third market, the price reacts instantaneously to the announcement, but corrects itself in the days that follow, suggesting that the initial price change was an over reaction to the information. Here again, an enterprising investor could have sold short after the announcement, and expected to make excess returns as a consequence of the price correction. When firms make earnings announcements, they convey information to financial markets about their current and future prospects. The magnitude of the information, and the size of the market reaction, should depend upon how much the earnings report exceeds or falls short of investor expectations. In an efficient market, there should be an instantaneous reaction to the earnings report, if it contains surprising information, and prices should increase following positive surprises and down following negative surprises. Since actual earnings are compared to investor expectations, one of the key parts of an earnings event study is the measurement of these expectations. Some of the earlier studies used earnings from the same quarter in the prior year as a measure of expected earnings, i.e., firms which report increases in quarter-to-quarter earnings provide positive surprises and those which report decreases in quarter-to-quarter earnings provide negative surprises. In more recent studies, analyst estimates of earnings have been used as a proxy for expected earnings, and compared to the actual earnings. Figure 6.6 provides a graph of price reactions to earnings surprises, classified on the basis of magnitude into different classes from most negative earnings reports (Group 1) to most positive earnings reports (Group 10). The evidence contained in this graph is consistent with the evidence in most earnings announcement studies (a) The earnings announcement clearly conveys valuable information to financial markets; there are positive excess returns (cumulative abnormal returns) after positive announcements and negative excess returns around negative announcements. (b) There is some evidence of a market reaction in the day immediately prior to the earnings announcement which is consistent with the nature of the announcement, i.e., prices tend to go up on the day before positive announcements and down in the day before negative announcements. This can be viewed either as evidence of insider trading or as a consequence of getting the announcement date wrong11. (c) There is some evidence, albeit weak, of a price drift in the days following an earnings announcement. Thus, a positive report evokes a positive market reaction on the announcement date, and there are mildly positive excess returns in the days following the earnings announcement. Similar conclusions emerge for negative earnings reports. The management of a firm has some discretion on the timing of earnings reports and there is some evidence that the timing affects expected returns. A study of earnings reports, classified by the day of the week that the earnings are reported, reveals that earnings and dividend reports on Fridays are much more likely to contain negative information than announcements on any other day of the week. This is shown in figure 6.7. 11 The Wall Street Journal or COMPUSTAT are often used as information sources to extract announcement dates for earnings. For some firms, news of the announcement may actually cross the news wire the day before the Wall Street Journal announcement, leading to a misidentification of the report date and the drift in returns the day before the announcement. There is also some evidence that earnings announcements that are delayed, relative to the expected announcement date, are much more likely to contain bad news than earnings announcements which are early or on time. This is graphed in Figure 6.8. Earnings announcements that are more than six days late, relative to the expected announcement date, are much more likely to contain bad news and evoke negative market reactions than earnings announcements that are on time or early. b. Investment and Project Announcements Firms frequently make announcements of their intentions of investing resources in projects and research and development. There is evidence that financial markets react to these announcements. The question of whether market have a long term or short term perspective can be partially answered by looking at these market reactions. If financial markets are as short term as some of their critics claim, they should react negatively to announcements by the firm that it plans to invest in research and development. The evidence suggests the contrary. Table 6.5 summarizes market reactions to various classes of investment announcements made by the firm. This table excludes the largest investments that most make which is acquisitions of other firms. Here, the evidence is not so favorable. In about 55% of all acquisitions, the stock price of the acquiring firm drops on the announcement of the acquisition, reflecting the markets beliefs that firms tend to overpay on acquisitions. Market Anomalies Websters Dictionary defines an anomaly as a deviation from the common rule . Studies of market efficiency have uncovered numerous examples of market behavior that are inconsistent with existing models of risk and return and often defy rational explanation. The persistence of some of these patterns of behavior suggests that the problem, in at least some of these anomalies, lies in the models being used for risk and return rather than in the behavior of financial markets. The following section summarizes some of the more widely noticed anomalies in financial markets in the United States and elsewhere. Anomalies based upon firm characteristics There are a number of anomalies that have been related to observable firm characteristics, including the market value of equity, price earnings ratios and price book value ratios. a. The Small Firm Effect Studies have consistently found that smaller firms (in terms of market value of equity) earn higher returns than larger firms of equivalent risk, where risk is defined in terms of the market beta. Figure 6.9 summarizes returns for stocks in ten market value classes, for the period from 1927 to 1983. The size of the small firm premium, while it has varied across time, has been generally positive. It was highest during the 1970s and lowest during the 1980s. The persistence of this premium has lead to several possible explanations. (a) The transactions costs of investing in small stocks is significantly higher than the transactions cots of investing in larger stocks, and the premiums are estimated prior to these costs. While this is generally true, the differential transactions costs are unlikely to explain the magnitude of the premium across time, and are likely to become even less critical for longer investment horizons. The difficulties of replicating the small firm premiums that are observed in the studies in real time are illustrated in Figure 6.10, which compares the returns on a hypothetical small firm portfolio (CRSP Small Stocks) with the actual returns on a small firm mutual fund (DFA Small Stock Fund), which passively invests in small stocks. (b) The capital asset pricing model may not be the right model for risk, and betas under estimate the true risk of small stocks. Thus, the small firm premium is really a measure of the failure of beta to capture risk. The additional risk associated with small stocks may come from several sources. First, the estimation risk associated with estimates of beta for small firms is much greater than the estimation risk associated with beta estimates for larger firms. The small firm premium may be a reward for this additional estimation risk. Second, there may be additional risk in investing in small stocks because far less information is available on these stocks. In fact, studies indicate that stocks that are neglected by analysts and institutional investors earn an excess return that parallels the small firm premium. There is evidence of a small firm premium in markets outside the United States as well. Dimson and Marsh examined stocks in the United Kingdom from 1955 to 1984 and found that the annual returns on small stocks exceeded that on large stocks by 7% annually over the period. Bergstrom, Frashure and Chisholm report a large size effect for French stocks (Small stocks made 32.3% per year between 1975 to 1989, while large stocks made 23.5% a year), and a much smaller size effect in Germany. Chan, Hamao and Lakonishok reports a small firm premium of 5.1% for Japanese stocks between 1971 and 1988. b. Price Earnings Ratios Investors have long argued that stocks with low price earnings ratios are more likely to be undervalued and earn excess returns. For instance, Ben Graham, in his investment classic The Intelligent Investor, uses low price earnings ratios as a screen for finding under valued stocks. Studies that have looked at the relationship between PE ratios and excess returns confirm these priors. Figure 6.11 summarizes annual returns by PE ratio classes for stocks from 1967 to 1988. in the lowest PE ratio class earned an average return of 16.26% during the period, while firms in the highest PE ratio class earned an average return of only 6.64%. The excess returns earned by low PE ratio stocks also persist in other international markets. Table 6.6 summarizes the results of studies looking at this phenomenon in markets outside the United States. Annual premium: Premium earned over an index of equally weighted stocks in that market between January 1, 1989 and December 31, 1994. These numbers were obtained from a Merrill Lynch Survey of Proprietary Indices. The excess returns earned by low price earnings ratio stocks are difficult to justify using a variation of the argument used for small stocks, i.e., that the risk of low PE ratios stocks is understated in the CAPM. Low PE ratio stocks generally are characterized by low growth, large size and stable businesses, all of which should work towards reducing their risk rather than increasing it. The only explanation that can be given for this phenomenon, which is consistent with an efficient market, is that low PE ratio stocks generate large dividend yields, which would have created a larger tax burden in those years where dividends were taxed at higher rates. c. Price Book Value Ratios Another statistic that is widely used by investors in investment strategy is price book value ratios. A low price book value ratio has been considered a reliable indicator of undervaluation in firms. In studies that parallel those done on price earnings ratios, the relationship between returns and price book value ratios has been studied. The consistent finding from these studies is that there is a negative relationship between returns and price book value ratios, i.e., low price book value ratio stocks earn higher returns than high price book value ratio stocks. Rosenberg, Reid and Lanstein (1985) find that the average returns on U.S. stocks are positively related to the ratio of a firms book value to market value. Between 1973 and 1984, the strategy of picking stocks with high book/price ratios (low price-book values) yielded an excess return of 36 basis points a month. Fama and French (1992), in examining the cross-section of expected stock returns between 1963 and 1990, establish that the positive relationship between book-to-price ratios and average returns persists in both the univariate and multivariate tests, and is even stronger than the size effect in explaining returns. When they classified firms on the basis of book-to-price ratios into twelve portfolios, firms in the lowest book-to-price (higher P/BV) class earned an average monthly return of 0.30%, while firms in the highest book-to-price (lowest P/BV) class earned an average monthly return of 1.83% for the 1963-90 period. Chan, Hamao and Lakonishok (1991) find that the book-to-market ratio has a strong role in explaining the cross-section of average returns on Japanese stocks. Capaul, Rowley and Sharpe (1993) extend the analysis of price-book value ratios across other international markets, and conclude that value stocks, i.e., stocks with low price-book value ratios , earned excess returns in every market that they analyzed, between 1981 and 1992. Their annualized estimates of the return differential earned by stocks with low price-book value ratios, over the market index, were as follows: A caveat is in order. Fama and French point out that low price-book value ratios may operate as a measure of risk, since firms with prices well below book value are more likely to be in trouble and go out of business. Investors therefore have to evaluate for themselves whether the additional returns made by such firms justifies the additional risk taken on by investing in them. |
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