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Equity return anomalies and their causes

The vast range of academically researched equity return anomalies can be condensed into five categories: [1] return momentum, [2] outperformance of high valuation, [3] underperformance of high investment growth, [4] outperformance of high profitability, and [5] outperformance of stocks subject to trading frictions. A new empirical analysis suggests that these return anomalies are related to market inefficiencies, such as investor protection, limits-to-arbitrage, and investor irrationality. In particular, the analysis provides evidence that the valuation return anomaly is largely driven by mispricing.

Mike Dong (2019), “Risk or Mispricing? Cross-Country Evidence on the Cross-Section of Stock Returns”.

The below are excerpts from the paper. Headings and text in italics and brackets have been added. Some acronyms have been replaced by full wording and some grammatical corrections have been made for ease of reading.

The post ties in with this site’s summary on price distortions.

What are equity return anomalies?

“This paper collectively tests 94 anomalies that are published in top finance and accounting journals…these anomalies are aggregated into five anomaly indices: momentum, value-growth, investment, profitability, and trading frictions.”

Momentum anomalies

“[Academic research] documents a robust return predictability from mid-term past returns (2 to 12 months)…[and that] future stock returns are positively related with earnings surprises. Many studies explain this momentum phenomenon from a behavioral perspective…investor herding, underreaction to information, excess trading, or over-extrapolation of recent performance.”

Value-growth anomalies

Value firms are fundamentally riskier due to higher financial distress thus generate higher future returns. Another rational explanation argues that higher returns come from countercyclical compensation for investment risk…The behavioral side argues that value premium is caused by overreaction of past performance. A contrarian strategy that takes advantage of such cognitive bias will produce a high return.”

Investment anomalies

“The rational explanation, also more widely referred to as the optimal investment theory, suggests that firms invest more when the expected cost of capital is lower. This effect should be particularly strong in markets with high investment frictions. There are several stories on the mispricing side. First, managers have incentives to entrench themselves by overinvesting and empire building. Second, firms are likely to engage in earnings management before making large investments such as mergers and acquisitions…In addition, managers often time the market when raising external capital…Finally, investors tend to excessively extrapolate glamour news such as high investments which leads to lower returns.”

Profitability anomalies

“Valuation theory indicates that investors require higher return on risky firms thus price them at a lower value. Mechanically same earnings will provide risky firms a higher profitability (e.g. return on equity) than their peers. On the behavioral side, profitable firms may be undervalued due to agency issues, asymmetric information, or investor underreaction to good earnings news.”

Trading frictions

“The trading frictions index aggregates size, volatility and liquidity anomalies. A rational risk hypothesis suggests that returns are compensation for bearing liquidity risk. The effect, therefore, should be stronger where limits-to-arbitrage is higher and market liquidity is weaker.”

How common are these anomalies?

“This paper [examines] the performance of each anomaly index across 40 countries. The results show that the value-growth anomaly [is] most widely spread among all five effects, generating significant high-minus-low equal-weighted returns in 28 countries. The momentum anomaly and the investment anomaly exist in 24 and 18 countries [respectively]. The profitability and trading frictions anomalies are relatively weak, covering only 11 and 4 countries. Performance is generally stronger in developed markets than emerging markets.”

An empirical analysis

“This paper takes a cross-country approach and examines if anomaly returns vary across global markets with different characteristics…To ensure a meaningful cross-section and time-series I require a minimum of 30 stocks in each country each month. To ensure each country plays an important role in the analysis, I further require 15 years of trading history by December 2016.”

“To investigate what drives each anomaly, I test the anomaly returns against a novel collection of market characteristics. The panel data are collected from various sources including World Bank, World Economic Forum, and journal publications.”

“Anomalies driven by rational risk pricing should be stronger where price efficiency is higher, markets are more developed, and investors are better protected; their performance should not correlate with measures of investor irrationality.”

The key findings

“Results show that anomaly returns highly correlate with proxies for market efficiency, investor protection, limits-to-arbitrage, and investor irrationality… It provides the first piece of international evidence that the value-growth anomaly is largely driven by mispricing. [Also] for the investment anomaly I find strong support for mispricing.”

“First, I examine each anomaly index under different market conditions. The value-growth anomaly is stronger where idiosyncratic volatility is higher, investors are more overconfident, and earnings management is more severe. These results consistently support a mispricing explanation. In addition, the value-growth anomaly is significantly stronger where markets are less developed and investor over-extrapolation is more severe. [By contrast] the profitability anomaly is stronger where markets are more developed and idiosyncratic volatility is smaller. Results for the momentum anomaly and the trading frictions anomaly are mixed.”

“To further test which explanation dominates, I create an average ranking for each country based on their market conditions in six dimensions: individualism, price efficiency, market development, investment frictions, investor protection, and limits-to-arbitrage. I then run a pooling regression using all dimensions’ ranking. Results…[point] towards a mispricing story for the profitability anomaly and a limits-to-arbitrage story for the momentum anomaly. The profitability anomaly becomes significantly stronger where investor protection is weaker, indicating investors underreact to good earnings news facing high earnings management or other agency issues. The trading frictions anomaly is not robustly correlated with any market conditions likely due to its weak global performance.”


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