Big is brilliant: Understanding the Chinese size effect through profitability shocks

Taking a dynamic view, this paper assesses the extent to which profitability shocks affect the size premium in the Chinese market. In the short run, there is a significant U-shaped relationship between size and profitability shocks; i.e., both small and large firms experience large and (in most cases) positive profitability shocks, while firms with medium market capitalizations display small profitability shocks. In the long run, profitability shocks in large firms remain large and stable, while profitability shocks in small firms decrease sharply. Adjusting for profitability shocks increases the returns of small firms but decreases the returns of large firms, indicating that large and positive profitability shocks in small firms cannot bring investors sizable returns even though the correlation between profitability shocks and returns is positive. Mismatches between profitability shocks and the per-unit return impact of such shocks (e.g., when firms experience positive shocks but the market reacts to these shocks irrationally) can help explain this phenomenon. Our work reveals that in terms of fundamentals, large firms are very worthy of investment owing to their superb fundamental performance, i.e., large and persistent profitability shocks.     

Personal Taxation and Investment Incentives in a Small Open Economy

A simple portfolio model is used to investigate the effects of personal taxes on real investment incentives in a small open economy with large and small firms. When shares in large firms can be traded internationally and their rate of return is exogenously determined on international equity markets, a tax on the return on riskless bonds will induce a portfolio shift from bonds to shares in large firms. This shift reduces the impact of the bond tax on the required rate of return on shares in domestically owned small firms, provided that returns on shares in small and large firms are positively correlated. The total impact of the bond tax may even change from a negative to a counter-intuitive positive one if the “beta” between the returns on small and large firms is above unity. A personal tax on equity returns does in general have an ambiguous impact on the pre-tax rate of return requirement of domestically owned firms. An exogenous rate of return on large company shares is shown to enhance the possibility for the equity tax to reduce the required pre-tax rate of return in small domestic firms. A sufficient condition for a negative relationship is again that the “beta” between the returns in small and large firms is above unity. This revised version was published online in July 2006 with corrections to the Cover Date.     

Is There a Size Effect in the Pricing of Stocks in the Chinese Stock Markets?: The Case of Bull Versus Bear Markets

Size effect studies generally suggest that a return premium exists for small firms. While the size effect has mostly disappeared in recent years in mature markets (e.g., US and UK), it remains mostly strong in developing markets. The purpose of this paper is to examine the relationship between firm size and excess stock returns in the Chinese stock markets, and to examine this effect in both a bull and bear market. No studies have previously examined these relationships in the Chinese markets. The results of the study indicate that a size effect exists in the Chinese stock markets over the 6-year period from 1998 to 2003. We find small firms have significantly greater excess returns than large firms. Moreover, small firms are found to have a stronger reaction to the direction of the market than large firms. Small firms have significantly greater positive excess returns than large firms during the bull market. However, small firms have significantly greater negative returns (using total market value), or no significant difference in returns (using float market value) during the bear market period.     

A Possible Explanation of the Small Firm Effect

Recent empirical studies have found that small listed firms yield higher average returns than large firms even when their riskiness is equal. The riskiness of small firms, however, has been improperly measured. Apparently, the error is due to auto-correlation in portfolio returns caused by infrequent trading. Other anomalous predictors of riskadjusted returns, such as price/earnings ratios and dividend yields, may also derive some of their apparent power from this spurious source.     

The anomalous stock market behavior of small firms in January: Empirical tests for tax-loss selling effects

Small firms experience large returns in January and exceptionally large returns during the first few trading days of January. The empirical tests indicate that the abnormally high returns witnessed at the very beginning of January appear to be consistent with tax-loss selling. However, tax-loss selling cannot explain the entire January seasonal effect. The small firms least likely to be sold for tax reasons (prior year ‘winners’) also exhibit large average January returns, although not unusually large returns during the first few days of January.     

THE RELATION BETWEEN RETURNS,OWNERSHIP STRUCTURE,AND MARKET VALUE

Numerous empirical studies have documented the small firm effect of higher risk-adjusted returns for small firms in contrast to large firms. The explanation for such a phenomenon remains incomplete. This research examines the relationship among ownership structure, size, and returns under the hypothesis that firms with diffuse ownership (manager controlled) have higher returns to compensate for the risk inherent in the agency relationship. This research adds a dimension to the explanation of the small firm effect, which is well-founded in economic theory but has not been tested. The results indicate no significant relationship between ownership and return.     

Understanding partial mergers in Japan

Since the late 1990s, Japan has witnessed a substantial increase of partial mergers where two or more firms spin off whole operations in the same business and combine them into a joint venture (JV). This paper provides the first academic evidence on this phenomenon. I find that partial mergers normally occur as a response to negative economic shocks by firms that are larger and more diversified than firms in total mergers. An event study identifies positive and significant returns to partial merger announcements. Unlike total mergers whose value accrues mostly to the shareholders of small (acquired) firms, large and small firms in partial mergers receive comparable returns, which are particularly large to firms forming an equally owned JV. This study also finds that partial mergers are often ex post transformed, with equity sale between partners being the main source of change.     

Dissecting the Long-Term Performance of the Chinese Stock Market

Domestically listed Chinese (A-share) firms have lower stock returns than externally listed Chinese, developed, and emerging country firms during 2000 to 2018. They also have lower net cash flows than matched unlisted Chinese firms. The underperformance of both stock and accounting returns is more pronounced for large A-share firms, while small firms show no underperformance along either dimension. Investor sentiment explains low stock returns in the cross-country and within-A-share samples. Institutional deficiencies in listing and delisting processes and weak corporate governance in terms of shareholder value creation are consistent with the underperformance in stock returns and net cash flows.     

The relation between stock returns and short-term interest rates

This study examines the relation between the expected returns on common stocks and short-term interest rates. Using a two-factor model of stock returns, we show that the expected returns on common stocks are systematically related to the market risk and the interest-rate risk, which are estimated as the sensitivity of common-stock excess returns to the excess return on the equally weighted market index and to the federal fund premium, respectively. We find that the interest-rate risk for small firms is a significant source of investors' portfolio risk, but is not properly reflected in the single-factor market risk. We also find that the interest-rate risk for large firms is “negative” in the sense that the market risk estimated from the single-factor model overstates the true risk of large firms. An application of the Fama-MacBeth methodology indicates that the interest-rate risk premium as well as the market's risk premium are significant, implying that both the market risk and the interest-rate risk are priced. We show that the interest-rate risk premium explains a significant portion of the difference in expected returns between the top quintile and the bottom quintile of the NYSE and AMEX firms. We also show that the turn-of-the-year seasonal is observed for the interest-rate risk premium; however, the risk premium for the rest of the year is still significant, although small in mangitude.     

Book–to–Market Equity, Distress Risk, and Stock Returns

This paper examines the relationship between book–to–market equity, distress risk, and stock returns. Among firms with the highest distress risk as proxied by Ohlson's (1980) O–score, the difference in returns between high and low book–to–market securities is more than twice as large as that in other firms. This large return differential cannot be explained by the three–factor model or by differences in economic fundamentals. Consistent with mispricing arguments, firms with high distress risk exhibit the largest return reversals around earnings announcements, and the book–to–market effect is largest in small firms with low analyst coverage.     

Transaction costs and the small firm effect: A comment

Stoll and Whaley (1983) suggest large transaction costs may be responsible for the large risk-adjusted returns earned by small firm stocks. This study, using data from the AMEX as well as the NYSE, shows that investors can earn risk-adjusted excess returns after transaction costs by holding small firms for relatively short holding periods. Other literature that provides evidence that is inconsistent with the transaction costs hypothesis is cited.     

On information release and the January effect: Accounting-information hypothesis

Since most firms select December fiscal year-ends, theJanuary effect is a fiscal year-end accounting effect, according to the accounting-information hypothesis. This hypothesis attributes the unusually large stock returns in January to higher risk, caused by uncertainty about the impending announcement of firm performance. The empirical evidence does not support the hypothesis. Small firms with non-December fiscal year-ends fail to display a fiscal year-end effect. Yet all small firms, regardless of their fiscal year-end month, exhibit large January returns.     

TAX-LOSS SELLING,INSTITUTIONAL INVESTORS,AND THE JANUARY EFFECT: A NOTE

In this note we test the hypothesis that trading by tax-motivated individual investors is responsible for the January effect. We examine the ownership structure of a large sample of firms over a four-year period and find that the small firms that usually exhibit high January returns have low institutional ownership. After controlling for firm size, we still find that institutional ownership is significantly related to January abnormal returns. These results suggest that one reason the January effect may concentrate in small firms is because these firms are held by tax-motivated individual investors.     

Structural and Return Characteristics of Small and Large Firms

We examine differences in structural characteristics that lead firms of different sizes to react differently to the same economic news. We find that a small firm portfolio contains a large proportion of marginal firms-firms with low production efficiency and high financial leverage. We construct two size-matched return indices designed to mimic the return behavior of marginal firms and find that these return indices are important in explaining the time-series return difference between small and large firms. Furthermore, risk exposures to these indices are as powerful as log(size) in explaining average returns of size-ranked portfolios.     

Is there a symmetric nonlinear causal relationship between large and small firms?

This paper uses both linear and nonlinear causality tests to reexamine the causal relationship between the returns on large and small firms. Consistent with previous results, we find that large firms linearly lead small firms. We also find a significant linear causality in the direction from small firms to large firms, particularly in the more recent time period where the impact from small firms to large firms is greater than from large to small. More important, in contrast to the received literature, we find significant nonlinear causality that is bi-directional and of the same duration in either direction. Using the BEKK asymmetric GARCH model we are able to capture most of the detected nonlinear relationship. This indicates that volatility spillovers are largely responsible for the observed nonlinear Granger causality.     

The impact on stock prices of deferral and elimination of internal control audit requirement for small firms

This paper examines the cumulative market reaction to the events related to deferral of internal control audit requirement under the Sarbanes-Oxley Act of 2002 and its elimination under the Dodd-Frank Act of 2010 for nonaccelerated filers (small firms). We document that small firms experienced negative cumulative abnormal returns around these events; and the differences between the cumulative abnormal returns for small firms and the two control groups (accelerated and large accelerated filers) were negative and significant at the 1% level. These results support the notion that market participants value the reliability of financial information irrespective of the firm size. Within the small firms, we find no firm characteristic significantly explains the market reaction to the events considered. That is, all small firms lost market value in reaction to the events that delayed and eliminated their internal control audit requirement.     

Institutional trading and information processing: Evidence from complicated firms and easy-to-analyze firms

In this article, I examine institutional trading within two groups of firms with different demands on investor information processing: conglomerate firms and stand-alone firms. On average, institutional trading in conglomerate firm stocks yields significantly lower returns than institutional trading in stand-alone firm stocks. Inferior returns following institutional trading in conglomerate firm stocks persist across small and large firms. Moreover, financial institutions with a low concentration of conglomerate firms in their portfolios are more profitable in their trading. This study provides evidence that skilled institutional investors intentionally focus their information-processing efforts on easy-to-analyze firms.     

TIME-VARYING FACTORS AND CROSS-AUTOCORRELATIONS IN SHORT-HORIZON STOCK RETURNS

In this paper I show that the lead-lag pattern between large and small market value portfolio returns is consistent with differential variations in their expected return components. I find that the larger predictability of returns on the portfolio of small stocks may be due to a higher exposure of these firms to persistent (time-varying) latent factors. Additional evidence suggests that the asymmetric predictability cannot be fully explained by lagged price adjustments to common factor shocks: (i) lagged returns on large stocks do not have a strong causal effect on returns on small stocks; (ii) trading volume is positively related to own- and cross-autocorrelations in weekly portfolio returns; and (iii) significant cross-autocorrelation exists between current returns on large stocks and lagged returns on small stocks when trading volume is high.     

Weekend Effect, 'Reverse' Weekend Effect, and Investor Trading Activities

Abstract:   In this study, we document evidence of a 'reverse' weekend effect – whereby Monday returns are significantly positive and they are higher than the returns on other days of the week – over an extended period of eleven years (from 1988 to 1998). We also find that the 'traditional' weekend effect and the 'reverse' effect are related to firm size in that the 'traditional' weekend effect tends to be associated with small firms while the 'reverse' weekend effect tends to be associated with large firms. In addition, we find that during the period in which the 'reverse' weekend effect is observed, Monday returns for large firms tend to follow previous Friday returns when previous Friday returns are positive , but they do not follow the previous Friday returns when Friday returns are negative . Furthermore, we find that during the period in which the 'reverse' weekend effect is observed, Monday returns are positively related to the volume of medium‐size and block transactions, but negatively related to the volume of odd‐lot transactions.     

Size-related anomalies and stock return seasonality: Further empirical evidence

This study examines, month-by-month, the empirical relation between abnormal returns and market value of NYSE and AMEX common stocks. Evidence is provided that daily abnormal return distributions in January have large means relative to the remaining eleven months, and that the relation between abnormal returns and size is always negative and more pronounced in January than in any other month — even in years when, on average, large firms earn larger risk-adjusted returns than small firms. In particular, nearly fifty percent of the average magnitude of the ‘size effect’ over the period 1963–1979 is due to January abnormal returns. Further, more than fifty percent of the January premium is attributable to large abnormal returns during the first week of trading in the year, particularly on the first trading day.