Title: SHORT TERM MARKET REACTION TO EARNINGS RESTATEMENTS: VALUE STOCKS VIS-À-VIS GLAMOUR STOCKS
Abstract: INTRODUCTION It has long been reported that value (or contrarian) strategies outperform the market since Graham and Dodd (1934), which is counter evidence to the efficient market hypothesis. This strategy calls for buying value stocks and selling glamour stocks. The value stocks are under-priced stocks relative to their intrinsic value indicators such as book value, earnings, cash flows, growth rate, while glamour stocks are over-price stocks relative to their intrinsic value indicators (E.g., Lakonishok et al., 1994). Various hypotheses have been proposed to explain why the return differential between value stocks and glamour stocks persists so long. For examples, Fama and French (1992, 1993, 1995, 1996) argue that value stocks are judged by the market to have poor earnings prospect and higher risks and, thus, are selling at lower prices relative to their book value (i.e., high BM ratio), while the opposite applies to glamour stocks. In one word, value stocks have higher expected returns because they are riskier than glamour stocks. But they fail to provide sufficient explanations for the return differential. Lakonishok et al. (1994) argue that the return differential is caused by investors' naive extrapolation of the past sales or earnings growth of a firm into the future: some investors tend to get overly excited about stocks doing very well in the past, usually glamour stocks, and buy them up, while they oversell stocks doing very bad in the past, usually value stocks. Consequently, glamour stocks are overpriced while value stocks are under priced. Thus, when stock prices finally return to the fundamentals in the long horizon, glamour stocks will have lower return than the value stocks. They also argue that the return differential between glamour stocks and value stocks may be due to the career concerns of portfolio managers: i.e., glamour stocks have lower career risk to portfolio managers than value stocks do. Since glamour stocks appear to be prudent investments and hence easy to justify to sponsors, many portfolio managers tilt toward glamour stocks. Conversely, most value stocks have warts and, if they blow up, the portfolio managers will look foolish since they should have known that the value stocks had problems. Thus, portfolio managers stay away from value stocks. (See Haugen (1999)) To test this naive extrapolation hypothesis, Lakonishok et al. (1997) form portfolios of glamour stocks and value stocks each year during 1971 through 1993 and examine the portfolio returns around the earnings announcement days in the post-formation period. They find that the return differentials around the earnings announcement account for approximately 25 to 30 percent of the annual return differentials between value stocks and glamour stocks in the first two to three years following portfolio formation. This may indicate that positive returns of value stocks are from their positive earnings surprises, while negative returns of glamour stocks are from their negative earnings surprises. They also find that the return differential between value stocks and glamour stocks are smaller in large stocks than in small stocks, consistent with the notion that large stocks about which more information is available are less susceptible to mis-pricing than small stocks. Lo and MacKinly (1990) and Kothari et al. (1995) suggest that the return differential may be due to research design induced biases. Amihud and Mendelson (1986) suggest the return differential may be due to market frictions. Dechow and Sloan (1997) finds no systematic evidence that stock prices reflect investors' naive extrapolation of past growth in earnings and sales. Instead, they find half of the returns to contrarian strategies can be explained by investors' naive reliance on analysts' growth forecasts. In sum, there is not a consensus or the best theory on explanations for the return differentials between value stocks and glamour stocks, yet. …
Publication Year: 2010
Publication Date: 2010-07-01
Language: en
Type: article
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Cited By Count: 1
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