Other Anomalies

The Size Effect | Announcement Based Effects | Corporate Transactions
Insider Transactions | The S&P Game

Gary Karz, CFA (email)
Host of InvestorHome
Principal, Proficient Investment Management, LLC

The Size Effect (or Myth?)

Some studies have shown that small firms (capitalization or assets) tend to outperform. The small stock affect was first documented by Rolf W. Banz ¹. He divided the stocks on the NYSE into quintiles based on market capitalization. The returns from 1926 to 1980 for the smallest quintile outperformed the other quintiles and other indexes. Others have argued that its not size that matters, its attention and number of analysts that follow the stock.

This anomaly is subject to intense debate over whether an opportunity to generate excess returns actually exists. Ibbotson data (See Historical Data) and other studies show that small capitalization stocks outperform large stocks in the United States as well as in foreign markets. However, others argue that its not reasonable to assume that investors can realize those returns. Professor Jeremy J. Siegel argues that the period from the end of 1974 through the end of 1983 accounts for the whole outperformance of small caps and according to John C. Bogle, since December 1978, small caps and large caps have earned exactly the same returns (Source: Wall Street Journal 2/10/97).

James O'Shaughnessy argued in What Works on Wall Street that the returns in small stocks are attributable almost entirely to micro-cap stocks with market capitalizations under $25 million. Small stocks typically have large spreads and commissions and cannot be bought by institutional managers without significantly moving the share price. Therefore, he argues that even so called "small company" funds have difficulty taking advantage of small capitalization stocks.

Mark Hulbert argued in "The small-cap myth" (Forbes - 3/10/97) that after accounting for commissions when buying small stocks, there is no advantage. In the same issue of Forbes, David Dreman (in "When statistics lie") pointed out that the Banz study deals only with stocks from the NYSE which are larger than small stocks from other exchanges. Dreman also states that much of the data is based on stocks that traded thinly or not at all, the point being that you couldn't really buy them in large quantities if at all at their quoted price. On the impact of trading costs and liquidity on the analysis of small-cap performance, Marc R. Reinganum ² commented that "Several academic papers have been written on this topic, and depending upon whose you read, some have negated the fact that a small-cap effect exists. Others support the notion that, even taking the transaction costs into account, small caps carry some premium. The answer depends on how the studies are structured." See also Fidelity's Sizing Up Small-Cap Stocks (2009). More recent is Small Caps Loom Large: After a Decade of Dominance, Small-Company Stocks Are Still Rallying—For Now (5/1/10) from WSJ. See also Interrelationships and InvestorHome's discussion about the Wilshire 5000 for historical return information.

Announcement Based Effects and Post-earnings announcement drift (PEAD)

Price changes tend to persist after initial announcements. Stocks with positive surprises tend to drift upward, those with negative surprises tend to drift downward. Some refer to the likelihood of positive earnings surprises to be followed by several more earnings surprises as the "cockroach" theory because when you find one, there are likely to be more in hiding. Robert Haugen in his book The New Finance: The Case Against Efficient Markets argued that the evidence implies investors initially underestimate firms showing strong performance and then overreact. Haugen concluded that "The market overreacts--with a lag" and that " we apparently have a market that is slow to overreact." See also Technical Anomalies and Interrelationships.

There is evidence, and try as they might, the accountants and financial people can't make it go away, that when you get an earnings surprise, somehow or other the market doesn't seem to absorb it all right away.
William F. Sharpe in Investment Gurus by Peter J. Tanous

In "Big News on Your Stock? Hold On to Your Hat" in the 4/27/98 issue of the Wall Street Journal, Greg Ip cited a study by Robert Butman of TQA Investors LLC that analyzed the reactions of thousands of stocks to negative and positive earnings surprises from 1995 to 1998 and compared them with an earlier study from 1983 to 1989. The price reactions that used to take three to four weeks in the 80's accelerated to two days in the more recent period. Many industry experts now believe the reactions are even faster, due to several factors including increased knowledge of the anomaly and the growth of high frequency trading.

In Liquidity and the Post-Earnings-Announcement Drift July/August 2009, Financial Analysts Journal (earlier version March 2007) the authors summarize that the post-earnings-announcement drift occurs mainly in the highly illiquid stocks, which have high trading costs and market impact costs, thus supporting for the argument that transactions costs could be the source of the drift. Other recent studies include The Earnings Announcement Premium and Trading Volume (2006) from Owen Lamont and Andrea Frazzini and The Efficiency of Market Reactions to Earnings News from Bin Miao and Gillian H. Yeo.

IPO's, Seasoned Equity Offerings, and Stock Buybacks

Numerous studies have concluded that Initial Public Offerings (IPOs) in aggregate underperform the market and there is also evidence that secondary offerings also underperform (See IPOs). Several studies have also documented arguably related market inefficiencies. Bala Dharan and David Ikenberry ³ found that firms listing their stock on the NYSE and AMEX for the first time subsequently underperform. Tim Loughran and Anand M. Vijh found that acquiring firms that complete stock mergers underperform, while firms that complete cash tender offers outperform. See "Do Long-Term Shareholders Benefit From Corporate Acquisitions?" (December 1997) in the Journal of Finance. The study implies that acquirers who use their stock to effect transactions may believe the stock is overvalued.

Stock repurchases, on the other hand, can be viewed as the opposite of stock issues, and studies have shown that firms announcing stock repurchases outperform in the following years ⁴. See Mark Hulbert's "Putting their money where their mouths are" in Forbes (4/21/97). This evidence seems to confirm the theory that managers tend to have inside information regarding the value of their company's stock and their decisions whether to issue or buy back their stock may signal over or undervaluation. The implication of these studies seems to be that investors may do better buying stocks of firms that are repurchasing their own stock rather than from firms that are selling or issuing more of their own stock.

Insider Transactions

There have been many studies that have documented a relationship between transactions by executives and directors in their firm's stock and the stock's performance. Insider buying by more than one insider is considered by many to be a signal that the insiders believe the stock is significantly undervalued and their belief that the stock will outperform accordingly in the future. However, many researchers question whether the gains are significant and whether they will occur in the future. Mark Hulbert reported in Insider trading (Forbes 11/3/97) that none of the newsletters he follows that focus on insider behavior have done well. The article discussed a study by Josef Lakonishok and Inmoo Lee.

The S&P Game

"The S&P Game" involves buying stocks that will be added to the S&P 500 index (after the announcement but before the stock is added several days later). The fact that stocks rise immediately after being added to S&P 500 was originally documented by Andrei Shleifer as well as Larry Harris and Eitan Gurel in 1986. ⁵ See also A Scorecard from the S&P Game The Journal of Portfolio Management (Winter 1997) and An Anatomy of the S&P Game: The Effects of Changing the Rules by Messod D. Beneish and Robert E. Whaley in the December 1996 issue of the Journal of Finance. More recently the discussion has included other indexes. See for instance Index Changes and Losses to Investors in S&P 500 and Russell index funds from Vijay Singal, Honghui Chen and Greg Noronha in the July/August 2006 edition of the Financial Analysts Journal. See also The Cost of Trading Transparency from Gary L. Gastineau in The Journal of Portfolio Management (Fall 2008) (or here).

1. Rolf W. Banz, The Relationship Between Market Value and Return of Common Stocks, Journal of Financial Economics, November 1981.

2. Marc R. Reinganum, "The Size Effect: Evidence and Potential Explanations," Investing in Small-Cap and Microcap Securities, Association for Investment Management and Research, 1997.

3. Bala Dharan and David Ikenberry, The Long-Run Negative Drift of Post-Listing Stock Returns Journal of Finance, December 1995.

4. David Ikenberry, Josef Lakonishok, and Theo Vermaelen, Market Underreaction to Open Market Share Repurchases, Journal of Financial Economics, October 1995.

5. Larry Harris and Eitan Gurel, Price and Volume Effects Associated with Changes in the S&P 500 List: New Evidence for the Existence of Price Pressures. Journal of Finance, September 1986.

This page is not a stand-alone page and should not be read or used without first viewing the main Anomalies page which includes important information and warnings about interpreting historical stock market anomalies.

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