Knowledge that Transforms

This study investigates the impact of Pennsylvania Senate Bill 1310 on the share prices of Pennsylvania corporations. Considered the most severe of the second-generation antitakeover laws, the statute limits the ability of shareholders to challenge management through the proxy process and eliminates the traditional fiduciary obligation of directors to promote shareholders' interests. We find that PA SB1310 significantly decreased share values, and estimate the loss to shareholders of Pennsylvania firms at $4 billion. However, firms with antitakeover charter amendments already in place were less affected, and firms that exempted themselves from PA SB1310 recovered a portion of shareholders' wealth.

This paper examines the extent to which aggregate stock return variation is explained by variables chosen to reflect revisions in expectations of future dividends. In effect, we decompose realized dividend growth into expected and unexpected components using information in aggregate investment, dividend yield, and future returns. A parsimonious specification accounts for over 70% of annual return variation. We also conduct a cross-sectional experiment using portfolios formed on the basis of annual return performance. This analysis shows that nearly 90% of the portfolio return variation is explained by dividend and expected return variables.

We examine share-price reactions of commercial bank common stock issues and find negative effects on rival commercial and investment banking firms. In comparison, we find no such intra-industry effects for equity issues by industrial firms. Our results support theoretical models in which bank loan portfolios impound asymmetric information about client firms, so that adverse individual bank announcements generate external information effects on other banks. A policy implication of these results is that regulatory pressures applied to individual banks induce spillover costs for the commercial and investment banking industries. Our evidence also indicates that the legal separation of commercial and investment banking activities is artificial.

A highly controversial issue in financial economies is whether stocks overreact. In this paper we find an economically-important overreaction effect even after adjusting for size and beta. In portfolios formed on the basis of prior five-year returns, extreme prior losers outperform extreme prior winners by 5–10% per year during the subsequent five years. Although we find a pronounced January seasonal, our evidence suggests that the overreaction effect is distinct from tax-loss selling effects. Interestingly, the overreaction effect is substantially stronger for smaller firms than for larger firms. Returns consistent with the overeaction hypothesis are also observed for short windows around quarterly earnings announcements.

We develop an analytical framework to explain firm's choice of equity flotation method and the near disappearance of rights offers by U.S. exchange-listed firms. The choice between uninsured rights, rights with standby underwriting, and firm-commitment underwriting depends on information asymmetries, shareholder characteristics, and direct flotation costs. Underwriter certification and current-shareholder takeup are viewed as substitute mechanisms for minimizing wealth transfers between shareholders and outside investors. Uninsured rights create adverse-selection effects when shareholder takeup is low. Implications for stock-price behavior around issue announcements, shareholder subscription precommitments, and relative issue frequencies are supported by large-sample evidence.

There is a significant foreign influence on the risk premium for U.S. assets. Using a bivariate GARCH-in-mean process, we find that the conditional expected excess return on U.S. stocks is positively related to the conditional covariance of the return of these stocks with the return on a foreign index but is not related to its own conditional variance. Further, we are unable to reject the international version of the CAPM. We present evidence for different model specifications, multiple-day returns, and alternative proxies for foreign stock returns.

We document that instrumental variables known to possess forecast power in equity and bond markets (Treasury bill yields, equity dividend yields, and the ‘junk’ bond premium) also possess forecast power for prices in agricultural, metals, and currency futures markets. The pattern of forecastability in futures is consistent with economic equilibrium as embodied by a two-‘latent-variable’ model. We test whether the latent variables that explain these futures returns coincide with latent variables that explain returns on size-ranked equity portfolios. This hypothesis is rejected, suggesting that futures are subject to different sources of priced risk than are equities.

In contrast with numerous studies that find significant underpricing for initial public offerings of industrial firms, we document a statistically significant average return of −2.82% on the first trading day for a sample of 87 initial public offerings of real estate investment trusts during the 1971–1988 period. Our overpricing result is invariant to offer price, issue size, distribution method, offer period, and underwriter reputation. Newly issued REITs, on average, substantially underperform a matching sample of seasoned REITs during the first 190 trading days. Interestingly, buyers of overpriced REITs are predominantly individual or non-13(f) institutional investors.

We investigate the relation between the Value Line enigma and post-earnings-announcement drift. The ability of Value Line's ‘timeliness’ ranks to predict future abnormal returns is well-documented. However, we show that most rank changes occur within eight trading days of an earnings announcement. Once we control for post-earnings-announcement drift, differences in abnormal returns across Value Line timeliness ranks are no longer significant. Moreover, we find that timeliness ranks have no predictive power for firms with small earnings ‘surprises’. We conclude that the Value Line enigma is a manifestation of post-earnings-announcement drift.

It seems plausible that an increase in stock market volatility raises required stock returns, and thus lowers stock prices. We develop a formal model of this volatility feedback effect using a simple model of changing variance (a quadratic generalized autoregressive conditionally heteroskedastic, or QGARCH, model). Our model is asymmetric and helps to explain the negative skewness and excess kurtosis of U.S. monthly and daily stock returns over the period 1926–1988. We find that volatility feedback normally has little effect on returns, but it can be important during periods of high volatility.