Adjustment of Stock Prices to new information

 Arun

Tripathi  Bhadresh Thakkar  Chintan Jani  Rahul Pandya

Adjustment of Stock Prices to new information
 A paper

by Eugene Fama, Lawrence Fisher, Michael Jensen & Richard Roll published in International Economic review (Feb-1969)  Examines the process by which stock prices adjust to the information that is implicit in a stock split & more specifically addressing the following two questions
1)

2)

Is there some unusual behaviour in rates of return on a security in months surrounding the split? If splits are associated with unusual behaviour of security returns, to what extent can this be accounted for by relationships between splits and changes in other more fundamental variables?
Slide no.1

usually occur. highest avg monthly return on split shares occur in few months immediately preceding the split which may lead us to believe that proposed split may itself be providing the impetus for increased returns which actually is not the case.2 .Adjustment of Stock Prices  In answer to the 1st question. Slide no. as per the empirical study made by them . However . stock splits are preceded by a period of high returns far in advance of the split because these companies have experienced dramatic increase in expected earnings and dividends.   This actually reflect the market’s anticipation of substantial increases in dividends which . in fact .

Adjustment of Stock Prices Empirical Study-Sample & Methodology  A split security listed on NYSE for atleast 12 months before and 12 months after the split  Split type: 5 for 4  24 successive months of price-dividend data around the split date 940 splits meeting these criteria were captured from Jan-1927 to Dec-1959 Slide no.3 .

Adjustment of Stock Prices    During the sample period of 33 years.e ln(Rjt)=αj + βjln(Lt) + ujt Where . Rjt is the price relative of jth security for month t Lt is the Fisher’s index which represents a complicated average of Rjt for all securities on NYSE Ujt is the stochastic variable Slide no.4 . we need to adjust the security returns for general market conditions This was done by expressing the monthly rates of return provided by individual security as a linear function of corresponding general market condition i. the economic and hence the general stock market conditions were far from static Since our interest is to study the effects of split and associated dividend history on returns in isolation.

Symmetry is desirable since models involving symmetrically distributed variables present fewer estimation problems  Finally.Adjustment of Stock Prices  Ujt accordingly should satisfy the following pertaining to a linear regression model  E(Ujt) = 0 .e expected value is zero  Variance is independent of t  Ujt values are serially independent  Distribution of Uj is independent of ln(L)  Why the logarathmic form ?  Ln of the price relative is rate of return for given month on that security  Ln of the market index relative is the market return on entire portfolio  The distribution of above Ln values for a month are farily symmetric whereas the distributions of relatives is skewed. the residuals conform to the above assumptions for a simple linear regression model Slide no.5 . i. when least square is used to estimate for αj & βj .

Using the available time series on Rjt & Ljt. ln(Rjt)=αj + βjln(Lt) + ujt   Now. least squares was used to estimate αj & βj in below equation for each of the 622 securities in sample of 940 splits. Slide no.Adjustment of Stock Prices  Hence the above formulation was found to be a satisfactory method for regressing the security returns on market returns over time for abstracting the effects of general market conditions on monthly rates of return on individual securities. if stock split is associated with abnormal behaviour in returns during the months surrounding the split date. this behaviour should get reflected in the estimated regression residuals of the security for these months.6 .

cross-sectional averages of estimated regression residuals in months surrounding the split dates should be used.  We term this average residual as um which can also be interpreted as the avg deviation of returns of split stocks from their normal relationships with market.7 . Slide no.Adjustment of Stock Prices Effects of Splits on Returns : Empirical Results  Since we are interested with whether the process of splitting is in general associated with specific types of return behaviour & not with effects of splits for individual companies.

um-.8 . since we are also interested in dividend behaviour of split stocks. . Um+.Adjustment of Stock Prices Effects of Splits on Returns : Empirical Results  We also define a term called cumulative average residual Um as sum total of abnormal return behaviour in months surrounding the split months which can also be interpreted as the cumulative deviation of returns of split stocks. we bring in um+. Umwhere. Slide no.  Further.refers to dividend “decreases” which include cases of relative dividend decline. + refers to dividend “increases” which are cases where dividend change ratio of split stock > ratio for Exchange as whole.

9 .Adjustment of Stock Prices Empirical results AVERAGE RESIDUALS-ALL SPLITS Slide no.

Adjustment of Stock Prices Empirical results AVERAGE RESIDUALS-FOR DIVIDEND INCREASES Slide no.10 .

11 .Adjustment of Stock Prices Empirical results AVERAGE RESIDUALS-FOR DIVIDEND DECREASES Slide no.

e when prices of their shares have increased significantly. The sharp improvement relative to market in preceding years hence relates to the earnings prospects of the company during those years. the average residuals (um) in 29 months prior to the split are uniformly positive for all splits and both class of dividend behaviour.5 years in advance of split date. Slide no. Based on this. it can be concluded that companies tend to split their shares during “abnormally” good times i. the gap between split announcement and effective date was generally 1 to 1.12 . Split cannot account for the behaviour of regression residuals as far as 2.Adjustment of Stock Prices Empirical results       As apparent in all of these plots. Moreover as per the finding from various random samples.5 months & only in 10% of cases exceeded 4 months. Hence. This cannot be completely considered as an impetus provided by stock split announcement.

e no.Adjustment of Stock Prices Empirical results The above conclusion gets validated in the above table i. of splits increases dramatically with increase in general rise in stock prices Slide no.13 .

the cumulative average residuals rise dramatically up to split month.Adjustment of Stock Prices Empirical results  Another important thing to note is that for all splits examined together. but there is almost no further systematic movement thereafter. Slide no. the largest positive average residuals occur in 3 to 4 months preceding the split but that after the split are randomly distributed about 0. Equivalently.14  .

15 .Adjustment of Stock Prices Empirical results Slide no.

This can be explained from market interpretation of higher probability that dividends will soon be substantially increased.  Slide no.16 .Adjustment of Stock Prices Empirical results  This is especially striking since 71. is a signal to the market that a company’s directors are confident of future earnings of the company. Hence large price increases in months immediately preceding a split are due to altering expectations concerning the future earning potential of firm rather than any intrinsic effects of the split itself.   Since firms are reluctant to reduce dividends.5% of all splits experienced greater % dividend increases in year after the split than the average of all securities on the NYSE. then a split. which implies an increased expected dividend.

Adjustment of Stock Prices Empirical results Cumulative Average Residuals (DIVIDEND INCREASES) Cumulative Average Residuals (DIVIDEND DECREASES)  For both dividend cases. cumulative average residuals rise sharply which is in line with our hypothesis that market recognizes that splits are usually associated with higher divided payments. Slide no.17 . in the months preceding the split.

a split per se has no net effect on common stock returns. Hence to sum up. the returns on stocks which had experienced dividend “increases”. Slide no. market makes unbiased dividend forecasts for split securities and these forecasts are fully reflected in the price adjustments that take place to the extent of anticipated level of future dividends.     The study suggests that once the information effects of associated dividend changes are considered.18 . After the 1st year.  This implies that on an average. in case of dividend “decreases” case. it can be attributed to the fact that in many cases dividend increases in the year after the split. have resumed their normal relationships to market returns. the effect of split are completely wiped away which is supported by the plummeting values of these residuals.Adjustment of Stock Prices Empirical results-Conclusion  For the behaviour post split in case of dividend “increases” case. for the 1 st year where there is a slight upward drift. by the time it has become clear that anticipated dividend increase is not forthcoming.’ Contrary.

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