Download The CAPM and Equity Return RegulaPities

by E>onald B. Keim
The CAPM and Equity Return
RegulaPities
Differential returns on dividend and capital gains income, systematic abnormal returns
surrounding ex-dividend dates, excess returns on small versus large capitalimtion stocks,
excess returns on low versus high price-earnings ratio stocks—these are among the recent
findings that cast doubt on the traditional Capital Asset Pricing Model and tease investors
with the promise of systematic excess returns.
Some of these effects are undoubtedly related. Tests indicate, for example, that the higher a
portfolio's price to book ratio, the higher the corresponding values of market capitalization,
P/E and stock price. Furthermore, P/E, dividend yield, price and P/E effects all experience
significant January seasonals. What has not been conclusively determined is whether the
effects are additive. So far, it appears that the dividend yield and size effects are not mutually
exclusive. Investors may want to use a strategy employing several of these characteristics,
rather than one.
Efforts to explain the size effect have focused on January, because the effect is concentrated
in that month. The most common hypothesis attributes this to year-end tax-loss selling, but
the evidence is less than conclusive. Evidence strongly suggests, however, that, among small
firms, those with the largest abnormal returns tend to be the firms that have recently became
small, that either don't pay dividends or have higher dividend yields, and that have lower
prices and low P/E ratios.
T
HE CAPITAL ASSET Pricing Model
Rz = rate of return on the riskiess asset;^
(CAPM) has occupied a central position E(RM) = the expected rate of return on the
in finandal economics since its introducmarket portfolio of all marketable astion over 20 years ago.' The CAPM states that,
sets; and
under certain simplifying assumptions, the rate
j8j = the asset's sensitivity to market moveof return on any asset may be expected to equal
ments (beta),
the rate of return on a riskiess asset plus a If the model is correct, and security markets are
premium that is proportional to the asset's risk efficient, security return will on average conrelative to the market.^ This is expressed mathe- form to the above relation.* Persistent deparmatically as follows:
hires from the expected relation, however, may
x2rD \ — D _L rc/D \
r> 1 o
indicate that the CAPM and/or the Efficient
E(Ri) - Rz + [E(RM) - Rz]A,
j ^ j ^ g j Hypothesis are incorrect.^
^"^^
The strict set of assumptions underlying the
E(Ri) = the expected rate of return on asset i; C A P M has prompted numerous criticisms. But
1. footnotes appear at end of article.
any nuxiel proposes a Simplified view of the
Dmdd Keim is Assistant Professor (^ Finance at the '^°^^' *«* ^ "o* sufficient grounds for rejecWharton School of tkeUnwersittft^Pennsiflvmia.
*«>«• Rejection or acceptance should rest on
The author tfeinfe Wayne Fmon, AUan Kkidon, Craig sdentific evidence. The Univereity of Chicago's
MacKinla^, Terry Mrn^, Kri^ria Ramasmmy and Jay creation of a computerized datel^se of stock
Ritterfor their helpful comments.
prices and distiibutiicms in the 19^)s made such
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE l^te O 1 9
testing possible. This artide reviews briefly After-Tax Effecte
some of tite results of these tests arui discusses ifecBuse in fte U.S. dividend income is sul^ect
in some detail more recettt evidence that rai%s to a higher marginal tax rate than capital gains,
%rious questikms about the validity of the iayskhke investors should rationally prefer a dolCAFM.
lar of pretax capital gain to a dollar of dividends. ^
&ennan and litzenbei^er and Ramaswamy extended the CAPM to indude an extra factor—
Early Evidence
Numerous studies in the early 1970s generally dividend 3deld. They hypothesized that, the
supported the CAPM, although finding the higher a stock's dividend yield, holding risk
coefficient on beta (representing an estimate of constant, the higher the pretax ietum a taxable
the market risk premium) to be cmly marginally investor vdll require in order to compensate for
imporbmt in explaining cross-sectional differ- ttie tax liability incurred.
ences in avera^ security returns.* In 1977,
There are, of course, coimter arguments.
hovsrever. Roll raised some legitimate questions Miller and Scholes argued that the tax code
about the validity of these tests.^ Briefly, Roll permits investors to transform dividend income
argued that tests performed with any market into capital gains." If the marginal investors are
portfolio otiier than the true niarket portfolio using ttiese or other effective shelters, then the
are not tests of the CAPM, and that tests of the pretax rate on dividend-pa)dng stocks may not
CAPM may be extremely sensitive to the choice differ from the rate on stocks that do not pay
of market proxy. He also pointed out that some dividends. The tax differential has nevertheless
of the early tests' need to specify an alternative prompted some tax-exempt institutions to "tilt"
model to the CAPM may have led to faulty their portfolios toward higher-yielding securiinferences. For instance, Fama and MacBeth ties, with the hope of capturing the benefits of
had tested whether residual variance or beta the supposedly higher pretax returns.
squared help explain returns; thus the CAPM
The effectiveness of such a strategy, of
may be false, but if residual variance or beta course, hinges on how well after-tax models
squared do not capture the violation, the test conform to reality. An after-tax CAPM has the
will not rqect the model.*
following general form:
In response to Roll's first poirit, Stambaugh
E(Ri) = ao + a, j8i H(2)
constructed broader market indexes that included bonds and real estate and found that such where dj equals the dividend yield for security i
tests did not seem to be very sensitive to the and a2 represents an implidt tax coefficient that
choke of market proxy.' Gibbons, Stambaugh is independent of the level of the dividend
and others have addressed Roll's second point yield. The question is whether a2 is reliably
by using multivariate tests that do not require positive and consistent with realistic tax rates.
the specification of an alternative asset pridng
Empirical tests of the hypothesis that a2
model."* T h e ^ multivariate tests have not con- equals zero face several difficulties. Because
clusively proved or disproved the validity of the asset pridng models are cast in terms of exf>ecCAPM.
tations, the researcher needs to arrive at a
Researchers have meanwhile formulated al- suitable ex ante dividend yield measure. Furternative models, ntany of which relax some of ther, he must ask whether the teix effects that
the CAPM assumptions. Mayers, for example, motivate the model ocair at a single point in
allowed for nonmarketable assets such as hu- time (i.e., the ex-dividend date), or whether
man capital; feennan and litzenbeiger and Ra- they are spread over a longer period. Finally,
maswamy rdaxed the no-tax assumption." most researdiers have assumed a linear relation
Otiiere, in the spirit of Fama and MacBettt, have between dividend yields and returns, but the
examined ad hoc alternatives to the CAPM. relation might be more complicated.
Among this group, Banz examirved the imporStudies have employed a variety of definitarux of market value of common equity, and tions of divkiend yieM and metiiods. In the
Basu investigated the imp(»rtanc£ of pritx-eam- interest erf laevity, we forgo discussion of the
ings ratios in explaining risk-adjusted returns. '^ methodolc^cal subdeties and simply summaThe r ^ t of &m artide discuses sudi aitema- rize the major result. Table I leporte estimates
thn^ to the CAFM and ttie implications of die of tihe dividend yield c(»IBctent a^.'^ In each
assodated evidence im ptxtifolk) management. instance, the estimate of a2 is positive; holding
HNANC3AL ANALYSIS K)Vie<iAL / MAY-JUNE 1986 O 20
Table I Summary ^ Impted Tax Rates ftom Studies of
die Relation between Dividend Yields and Stock
Returns
Ex-Dividend Price Behavior
Because the ownership claim to a dividend
expires at the dose of trading before the exdividend day, the price of a dividend-paying
Implied
Percentage stock should drop on ttie ex-dividend day. In
Tax Hue
Test Period and
Author(sj and Date
the absence of effective taxes (or of a tax differof Study
Return Interval
(t-Statistic)
ential between dividends and capital gains),
1936-1966, Monttiiy
22
Black and Scholes
transaction costs and information effects, the
(1974)
(0.9)
price
drop should equal the value of the divi52
Bluine (1980)
1936-1976, Quarteriy
(2.1)
dend. If, as in the U.S., dividend income is
18
Gordon and Bradford 1926-1978, Monthly
taxed at a higher rate than capital gains income,
(1980)
(8.5)
the
price should drop less than the value of the
Litzenberger and
1^6-1977, Monthly
24
Ramaswamy (1979)
(8.6)
dividend. But if short-term traders or tax-exLitzenberger and
1940-1^0, Monthly
14-23
empt institutions dominate the market, then the
Ramaswamy (1982)
(4.4-8.8)
tax-induced differential will be eliminated. '*
Miller and Scholes
1940-1978, Monthly
4
(1982)
(1.1)
Numerous studies have found that the fall in
21
Morgan (1982)
1936-1977, Monthly
prire on the ex-dividend day is, on average, less
(11.0)
40
1931-1966, Mon*ly
Rosenbeig and
than the value of the dividend." For example,
Marathe (1979)
(1.9)
Kalay found that, from April 1966 to Mardi
Stone and Barter
1947-19ra, Monthly
56
1967, the ratio of the dosing price on the last
(1979)^
(2.0)
cum-dividend day minus the ex-day dosing
price to the dividend was 0.734. He conduded,
however, that transaction costs would negate
any
"short-term profit potential for a typical
beta risk constant, the higher the dividend
norunember
investor."^" The evidence sugyield, the higher the pretax rate of return on
gests,
in
effect,
that the magrutude of the ex-day
common stocks. Although not all the coeffieffect
is
related
to the ntiarginal transaction costs
cients are significantly different from zero, and
not all authors attribute the positive coefficients of short-term traders and may have little to do
to taxes, the evidence from many of the studies with taxes.^'
appears to be consistent with the after-tax modFurther studies of ex-day price behavior
els.*'
found abnormal returns over several days surThe truth may not be as simple as the after-tax rounding the "ex" day.^'^ The pattern is one of
models of Brerman and Litzenberger and Ra- significantly positive abnormal retums for the
maswamy suggest, however. Blume and a later six-day period up to and induding the ex date,
study by Litzenberger and Ramaswamy found followed by significantly negative abnormal rethat the yield-return relation is not linear for turns in the subsequent five trading days. Grunsome definitions of dividend yield. '* The aver- dy has a i ^ e d that this pattern of price adjustage return on non-dividend-paying firms is ments conforms to models of optimal stock
higher than the return on many dividend-pay- trading based on tax minimization in the presing firms. Furthermore, Keim foxmd that this ence of current U.S. tax laws and recognizing
non-linear relation stems largely from the exag- costs of delajring or accelerating stock trades.
^rated occurrence of the effect in January.
Fir>ally, other studies have found evidence of
Figure A gives little visual evidence of a yield- abnormal return behavior surrounding the ex
return relation outside January.
dates of non-taxable stock dividends and splits.^
This latter finding is not entirely conastent Grinblatt, Masulis artd Titman report a five-day
with the simple tax-related models and sugg^ts abnormal return of 2 per cent surrounding the
die possible manifestation of otha: anomalous ex date for a sample of 1,740 stock dividends
effecte, such as the size effect (discussed below). and splits over the l%7-76 period. Their results
CM onirse, it does not mean that the docu- are based on post-announcement returns,
mented relation between yields and returns has hence s t ^ e s t trading strategies based on anno value in a fsactical portfolk) amtext. Addi- runmcsmertte of st»dk dividends and splits. But
tiond yieM-related e^cteKS s u ^ e s t s ijtere is because their results <annot ^sily be explained
soQ^ maiginal vahie in ^ e use of dividend i ^ tax-related ai^uments, the autiun^ suggest
yieki, even after iakii^ accotint of firm
"a tsuxx cautious interpretation of ex-date reHNANOAL ANALireXS JOUMMAI. / MAY-JUNE 1986 Q 21
Rebtiofi Betwe«i Average Monthly Returns and EHvkknd Yield for January
and All Other Months, 1931-1978
ID
9
8
7
6
5
4
3
2
1
-
February to December
J
Zero
Highest
Lowest
CHvidend Yield Portfolio*
*Dividencl ykkl in month t is defined as the sum of dividends paid in the previous 12 months divided by the stock price in month t-13.
The six dividend yieW portfolios are constructed from firms on the NYSE.
turns for cash dividends than is currently found
in the literature."^^
Size Effects
Both the finandal and the academic communities have been intrigued by evidence of a significant relation between common stock returns
and the market value of common equity—commonly referred to as the "size effect." Other
things equal, the smaller a firm's size is, the
lai^er its expected return. Banz, the first to
document this phenomenon, estimated a model
over the 1931-75 period of the following I
E{Ri) = ao + a, ft +
plays the average abnormal returns for portfolicMi comprising the 10 dedles of size for NYSE
and AMEX firms. The difference in abnormal
returns between the smallest and largest firms
amounte to about 30 per cent annually.. Blume
and Stambaugh demonstrated, however, that
the portfolio strategy implicit in Reinganum's
paper (requiring daily rebalancing of the portfolio to eqtial weights) produces upward-biased
estimates of small-firm portfolio returns because
of a "bid-ask" bias that is inversely related to
size; they showed that the size-related premium
is halved in portfolio strategies that avoid this
(3)
Portfolio managers normally have two reserwhere Si is a measure of the relative market vations about implementing "small firm" stratecapitalization (size) of firm i. Banz found a gies—(1) the maiket for the smallest capitalizanegative statistical association between retuims tion firms is illiquid and (2) the firms in this
and ^ze of approximately the same magnitude market do not meet minimiun capitalization
as tfiat between returns and Iweta.
r^juiremente for many institutional investors.
Rein^num, using a different method em- Figure B illtratrates that such potential conjrfoying daily data ewer tiie 1963-77 period, straints m&y not be binding, becau^ the abnorfound that p^tfolios of small finns had sutetan- mal letmn opportunities are not confined to tliw
tiaBy h i ^ e r risk-^dfusted returns, on average, vefy smaHest and teast ]«]uid stocks. Portfolios
than portfolic» of ha^ firms. ^' Figure B dis- of security wi& successive smafler firm valHNANCSAt ANALYSTS | m « N A L / MAY-JUNE 19M O 2 2
TTieSi^Efect (NYSE and AMEX ferns, 1963-1979)
0.09
0.07
0.05
0.01
0
-0.01
-0.03
1.1
0.9
0.7
0.3
0.1
SmaO
4
S
6
Laige
Dedfe of Maiicet Value
lies yield sucressively larger risk-adjusted re- Mtnilarly to the S&P 5(X).^ Hus suggests the
turm. the tM»3 largest fwrtfoUos (9 and 10), with existenos ol a wide array of po^>le portfolios
median market opi^lizations raz^iz^ bom vdHt h%her a^^erage returns—^in «7me rases,
$433 million to $1.09 hiBkm, tend to behave st^tani^dlyhi^ierretums—^thanttieS&P500.
FINANOAt ANAtYSTS JCaJSNAL / MAY-JUNE li«6 D 23
Size Effect by Day of the Wedc (NYSE aid AMEX finns, 1963-1979)
0.4 - I
0.3 -
0.2 -
0.1 -
-0.1 -
-0.2
Small
Large
Much subsequent research on the size effect
has attempted to provide a more complete characterization of the phenomenon. We now know
that, among the firms that academic researchers
consider "small" (in 1980, the smallest size
quintile for the NYSE represented firms with
market capitalizations of less than about $50
million), those with the largest abnormal returns tend to be firms that have recently become
small (or that have recently declined in price),
that either do not pay a dividend or have high
dividend yields, that have low prices, and that
have low price-earnings ratios.*
Seasimal Size Effects
Researd:Mrs have also ecamined the timeiekted patterns of pmtfolio letums stratified by
market capitalization. Brown, Kleidon and
Marsh found that, when averaged over all
months, the size effect reverses itself for sustained periods; in many periods there is a consfetent premium for small size, whereas in otiier
(fewer) periods tJtere is a discxnmt.'* In some
periods (1969-73, for example), a small capitalizi^on strategy would have underperformed
the market on a beta-<adfusted
i
The magnitude of the size effect also seems to
differ across days of the week and months of the
year. Keim and Stambaugh found that the size
effect becomes more pronounced as the week
progresses and is most pronounced on Friday.^^
Figure C shows that the negative relation between returns and size fot' the 19^3-79 period
becomes most pronounced at the end of the
week.
The most dramatic seasonal pattern, however, involves the turn of the year. Keim found
that the size effect is concentrated in January:
Approximately 50 per cent of the return difference detected by Reinganum is concentrated in
Jemuary.'^ Figure D shows the extent to which
this January seasonal alfects the month-bymontii behaviof of the size effect. Keim also
found that 50 per cent of this January effect is
amcentrated in Ae first five trading days of the
y«ir. This tum-of-the-year behavior was also
detected by Roll, who noted abnormally large
returns for smdl firms on the last trading day in
December.'*
Researd^rs have sAso looked to international
data to see whettter the January seasonal pattern in the mze eftecttiKatp e r ^ t s at Ute turn of
HNANC3AL ANALYSTS pUF»iAL / MAY-JUNE 1986 D 24
D
The Relation Between A v e r ^ Daily Abnormal Returns and Market Value for Each MtH>th, 1963-1979*
0.5
0.4
0.3
0.2
0.1
Fdmiary
- dirough
December
0
-0.1
-0.2
-0,3
1
-0.4
Smallest
4
I
I
5
6
Decile of Market Value
Largest
•The 10 market value portfolios (dedles) are constructed from firms on the NYSE and AMEX. Abnormal returns are provided by CRSP.
the tax year in the U.S.—and purportedly due
to "tax-loss selling" activity—ocrurs in markets
where the tax year-end is not December.'^ Table
II reports the results of the analysis of stock
returns on four major exchanges—Australia,
Canada, Japan and ihe United Kingdom. It is
difficult to compare the magnitude of the size
effect across the four countries because of differing time periods and research design (e.g.,
some studies use size qtiintiles, others use deciles). Nevertheless, each country exhibits an
inverse relation between stock returns and market capitalization.
Infonnation about the existence of size and
other effects on foreign stock exchanges is valuable for portfolio managers who concentrate in
small capitalization stocks but wish to preserve
adequate diversification via foreign seauities.
The ability to implement such strategies on an
international basis will become increasingly important as institutional presence in the small
capitalization (and low P/E) markete expands.
The Frice-Eaiiii^s Effect
Eamn^-rekted s t r a ^ i e s have a long tradition
itt the investment commumty. The mcmt popu-
lar—buying stocks that sell at low multiples of
earnings—can be traced at least to Graham and
Dodd, who proposed that "a necessary but not
a sufficient condition" for investing in a common stock is "a reasonable ratio of market price
to average earnings."^* They advocated that a
prudent investor never pay as much as 20 times
earnings and a suitable multiplier should be 12
or less.
Nicholson published the first extensive study
of the relation between P/E multiples and subsequent total returns, which showed that low P/E
stocks consistently provided returns greater
than the average stocks.^' Basu introduced the
notion that P/E ratios may explain violations of
ihe CAPM and found that, for his sample of
NYSE firms, there was a distinct negative relation between P/E ratios and average returns in
excess of those predicted by the CAPM.** If an
investor had followed his strategy of buying the
quintile of smallest P/E stocks and selling short
the quintile of largest P/E stocks over the 195771 period, he would have realized an average
annual abnormal return of 6.75 per rent (before
commissiiHts and other transaction costs).''
Some have argued tfiat, because firms in the
HNANOAL ANALYSTS K>URNAL / MAY-JUNE 1986 D 25
Table D The Firm Size Efiect: International Evidence
United Kingdom ^956-1980/'
Gmada (1951-1'.f80/'
Australia (1
Size
Portfolio
% Return
(std. error)
Size
Portfolio
Smallest
6.75
(0.64)
2.23
(0.39)
1.74
(0.31)
1.32
(0.27)
1.48
(0.24)
1.27
(0.24)
1.15
(0.24)
1.22
(0.24)
1.18
(0.2S)
1.02
(0.29)
Smallest
2
3
4
5
6
7
8
9
Largest
2
3
4
Largest
% Return
(std. error)
1951-1972
1973-1980
2.02
(0.27)
1.48
(0.22)
1.14
(0.22)
0.99
(0.23)
0.90
(0.23)
1.67
(0.58)
1.66
(0.56)
1.41
(0.59)
1.39
(0.56)
1.23
(0.58)
Japm n966-1983/'
% Return
(std. error)
1956-1965
1966-19^
Size
Portfolio
% Return
(std. error)
Size
Portfolio
Smallest
2.03
(0.35)
1.50
(0.32)
I.M
(0.29)
1.17
(0.27)
1.14
(0.27)
Smallest
1.27
l.OO
2
1.18
0.89
Largest
0.98
0.84
2
3
4
I-argest
a. P. Brown, D. B. Keim, A. W. IQeidon and T. A. Marsh, "Stock Return Seasonalities and the Tax Loss Selling Hypothesis: Analysis of the
Arguments and Australian Evidence," Jourml of Fimndai Economics, 1983, pp. 105-127.
b. A. Beiges, J. J. McConnell and G. G. Schlarbaum, "The Tum-of-the-Year in Carwda," Journal of Timnce, 1984, pp. 185-192.
c. T. Nakamura and N. Terada, "The Size ESfect and Seasonality in Japanese Stock Returns" (Nomura Research Institute, 1984).
d. M. R. Reinganum and A. Shapiro, "Taxes and Stock Return Seasonality: EviderKe from the London Stock Exchange" (University of
Southern California, ^ 3 )
same industry tend to have similar P/E ratios, a
portfolio strategy that concentrates on low P/E
stocks may indeed benefit from higher than
average returns, but at a cost of reduced diversification. These arguments also suggest that the
P/E effect n « y in fact be an industry effect.
Goodman and Peavy examined the P/E ratio of a
stodc relative to its industry P/E (PER) and
found a distinct negative relation between PERs
and abnormal returns over the 1970-80 period.'**'
A portfolio that bought the quintile of lowest
PER stocks and sold short the highest PER
quintile would have yielded an annualized abnormal return of 20.S) per cent over the period.
These resuits, in conjtmction with the findings
of Basu and Reinganum, suggest that the P/E
ratio—or an underi5dng and perhaps more ftmdamentai variable for which P/E is a proxy—^is
capable of expbining a considerable p c ^ o n of
the variation in cross-sectional security returns.
Survey. Value Line forecasts the prospective
performance of approximately 1,700 common
stocks on a weekly basis, separating the stocks
into five categories of expected return based on
historical and forecast information such as earnings momentum and P/E ratio.
The success of tiie Value line system has
been bome out by ^veral academic studies.*'
All found that, after adjusting for beta risk,
investors can obtain abnormal performance by,
for example, buying group 1 securities and
selling short group 5 securities. Stickel found
that investors can earn abnormal returns by
devising strategies based on rank changes (e.g.,
buying stocks upgraded from group 2 to group
Value Line's successful performance is ptizzling for the same reasons that tine size and P/E
effects are puzzling. It indicates that predetermined variables may be used to construct portfolios tluit have abnormal returns relative to the
The Value Line Eni^na
CAPM. It is, of covirse, possible that Value
favvestawnt advisory services often base their Line's ranking system has a high degree of
rea>mmendations on earrangs-related informa- association with a sin^^e ranking based on P/E
tion. The lai^est and most consistently s u a « ^ - at size. In feet, the eviitence in Stickel
ful advisory service is the Value Line Itwestor tliat mudv of Valtte line's abnormal
HNAJ«3AL ANALYSTS JOURNAL / MAY-JUNE 1986 Q 2 6
ance might be attributable to a small firm effect.
More research is necessary to sort out these
issues.
Interrelations Between Efiecte
Research has documenteci a strong cross-sec-tional relation between abnormal returns and
market capitalization, P/E ratios and dividend
yields. Other effects have also been noted, perhaps most notably the relation between riskadjusted returns and the ratio of price per share
to book value per share (P/B). Few would
argue that these separate findings are entirely
independent phenomena; after all, market capitalization, P/E and P/B are computed using a
common variable—price per share of the common stock. Furthermore, other evidence indicates a cross-sectional association between price
per share and average returns.'*^
Table III gives the average values of P/B,
market capitalization, E/P and price for 10 portfolios of NYSE firms constructed on the basis of
increasing values of P/B. The portfolios were
rebalanced annually over the 1964-82 period. It
is apparent that the higher the average P/B of
the firms in a portfolio, the higher the corresponding average values of market capitalization, P/E and stock price.*^ Further evidence of
some common underljdng factor are the significant January seasonals in the P/E, dividend
yield, and price and P/E effects.'**
In practice, the portfolio manager's objective
is to isolate and use in a portfolio strategy the
characteristics that will result in the highest riskadjtisted returns. That is, the manager is less
interested in the conjecture that all these effects
are somehow related than in finding the ranking characteristics that work best. Recent studies have addressed this issue by trying to answer the following question: If a portfolio
manager screens first on characteristic X (say,
P/E), can he improve risk-adjusted portfolio performance further by adding a screen based on
characteristic Y (say, market capitalization)?
Several studies have addressed the interrelation between the P/E and market capitalization
effects, with less than conclusive results. Reinganum aigued that the size effect subsumes the
P/E effect (i.e., there is no marginal value to P/E
after first ranking on size).'*' Basu a i ^ e d just
the opposite.'** Peavy and Gtxximan and Cooke
and R o z ^ , after perfonmng meticulous replications and extensions of the methods of Basu and
Reir^anum, reached surprisangly different con-
Table ni
Prux/Book
Portfolio
Lowest
2
3
4
5
6
7
8
9
Highest
Average Values of Price/Book (P/B), Market
Value, EtP and Price for 10 Portfolios of NYSE
Firms Cortstnicted on ihe Basis of Increasing
Price/Book Values (1964-1982)*
Avenge
P/B
Ratio
0.52
0,83
1.00
1,14
1,29
1,47
1.71
2,07
2.80
7.01
Average
Market Value
($ma)
217.1
402.5
498.6
604,7
680,2
695,6
888,9
872.6
1099.2
1964.3
Average
E/P
0.06
0,11
0,11
0.11
0.10
0.10
0.09
0.09
0.07
0,05
Average
Price
(SJ
20,09
22,97
25.m
27,79
28,97
31,55
36.07
37.84
44.80
60,09
* Portfolios are rebalanced at March 31; December 31 fiscal closers
only.
elusions. Peavy and Goodman's results agreed
with Basu's.^' Cooke and Rozeff concluded,
however, that "it does not appear that either
market value subsumes earnings/price ratio or
the earnings/price ratio subsumes market value
as has been daimed."'"
If an investor constructs a portfolio based on
low P/E stocks, he may still add some value by
considering the additional dimension of firm
size (or vice versa). One interpretation is that
both market capitalization and P/E (as weU as
other variables mentioned above) may be imperfect surrogates for an underlying and more
fundamental "factor" missing from the CAPM.^'
A possible solution for investors is to use a
strategy that employs several characteristics,
rather than one variable. Analysis of the interrelation between dividend yield and size effect,
for example, indicates that the two effects are
not mutually exclusive and, furthermore, that
small capitalization firms that pay no dividends
(or that have higher dividend yields) have experienced the largest abnormal returns over the
1931-78
Explaiituig the Size Effect
The lion's share of efforts to explain the above
anomalies has been directed to the size effect.
Some have argued that alternative asset pricing
models may explain the cross-sectional association between risk-adjusted returns and size.
Chen and Chan, Chen and Hsieh have argued
ttuit most of the abnormal returns associated
with the s i ^ effect are explained by additional
risk factors in ihe context of the Arbitrage Pricing Theory of Ross.^' Others maintan that
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1M6 • 27
market imperfections assumed away by the the effect to year-end tax-toss selling. Brown,
CAPM are responsible. Stoll and Whaley, for Keim, Kleidon and Marsh summarize tids hyinstance, have argued that round-trip transac- pothesis:
"The hypothesis maintains that tax laws intion costs are sufficient to offset the abnormal
fluence investors' portfolio dedsions by enreturns associated witii the size effect.** Schultz,
couraging the sale of securities tttat have
however, points out that transaction costs
experienced recent price declines so that the
would have to be larger in January to explain
(short-term) capital loss can be offset against
the January seasonal in abnormal returns, and
taxable income. Small firm stocks are likely
finds no evidence of seasonally var5mig transaccandidates for tax-loss selling since these
tion costs.^^
stocks tj^ically have higher veiriances of price
Others have addressed the possibility that the
changes and, therefore, larger probabilities of
size effect is merely a statistical artifact. Roll
large price declines. Importantly, the tax-loss
suggested that large abnormal returns on small
argument relies on the assumption that invesfirms could be due to systematic biases (attributtors wait imtil the tax year-end to sell their
able to infrequent or nonsynchronous trading)
conunon stock 'losers.' For example, in the
in these firms' betas, but Reinganum demonU.S., a combination of liquidity requirements
strates that this bias cannot explain the anomaand eagerness to realize capital losses before
ly.^* Christie and Hertzel argue that the size
the new tax year may dictate sale of such
effect could be due to nonstationarity of beta."
securities at year-end. The heavy selling presA firm whose stock price has recentiy desure
during this period supposedly depresses
clined—i.e., a firm that is becoming "small"—
the
prices
of small firm stocks. Aiter the tax
has effectively experienced, other things equal,
year-end,
the
price pressure disappears and
an increase in leverage and a concomitant inprices
rebound
to equilibrium levels. Hence,
crease in the risk of its equity. Thus historical
small
firm
stocks
display large returns in the
estimates of beta that assume risk is constant
beginning
of
the
new
tax year."*"
over time understate (overstate) the risk and
Although
popular
on
Wall
Street, the tax-loss
overstate (understate) the average risk-adjusted
selling
hypothesis
has
not
met
an enthusiastic
returns of stocks whose market capitalizations
have fadlen (risen). However, Christie and Hert- reception in the academic community. Roll
zel have adjusted for this bias and found that called the argument "ridiculous."*' Brown et al.
the size effexrt is not eliminated. Chan makes a maintain that the tax laws in the U.S. do not
similar adjustment and finds that "the size unambiguously induce the year-end small stock
effect is reduced to a magnitude whose econom- price behavior predicted by the h5rpothesis.*^
ic significance is debatable."'* Unfortunately, Constantinides daims that optimal tax trading
neither study differentiated between January of common stocks should produce a January
seasonal pattern in prices only if investors beand non-January returns.
have irrationally.^
Finally, Blume and Stambaugh demonstrated
that portfolio strategies that require rebalancing
The evidence on the tax-loss h5qx)thesis is
of the portfolio to equal weights jrield upward- less than condusive. Tests by Reinganum and
Inased estin^ates of small firm returns because of Roll suggest that part, but not all, of the abnora "bid-ask bias" Aat is inversely related to mal returns in Jantiary is related to tax-related
market capitalization.'' Such strategies some- trading.^ Schultz, however, found no evidence
times buy at the implicit bid price and sell at the of a January effect prior to 1917—i.e., before the
ask price. Portfolio strategies that avoid this bias U.S. income tax as we know it today created
exhibit significant size effects only in January.
incentives for tax-loss selling.^
The hypothesis predicts a price rebound in
the month of January immediately following
Explaining tite January Effect
In light of titiese last findings, attempts to price declines, but makes no predictions about
explain the size phenoaienon have focused on stodc price movements in subsequent tum-ofJanuary. Rather than exploring alternative equi- year periods. Evideiu^ from Chan and DeBondt
Ubiium models that may accommodate seasonal and Thaler indicMes that "loi^r" finns a>ntinue
effects, most studies have instead focused on to expertence abnormal returns in January for as
maiket frictions that violate CAPM assump- long as five years after Hieir identification.^
tions. The most popular hypothesis attributes Chan identified 'losers" and "winners" and
FINANCIAL ANALYSTS JCRBNM. / MAY-JUNE 1986 O
E
January Retting, Tax-Lc^ Portfolios (portfolios formed in Decentbo-, year t)
i
1 —
>
\
0
^^
1
Small
2
1
1
1
1
1
1
1
3
4
5
6
7
8
9
2J
Large
Tax-Loffi Portfolio
constructed an "arbitrage" portfolio (long losers, short wirmers) within each decile of market
value for NYSE firms at December 31 of year t
and tracked January abnormal returns in each of
the following four yeare (t+1 to t+4). His
restdts, presented in Figure E, show a persistent
January effect in each of the subsequent three
years. Based ori such evidence, both Chan and
Debondt and Thaler conduded that the January
seasonal in stock returns may have Uttie to do
with tax-loss selling.
Others have tested the hypothesis by examining the month to month behavior of abnormal
returns in countries with tax codes similar to the
U.S. code but with different tax year-ends. They
have found seasonals after the tax year-end, but
also in January—a result not predicted by the
hypothesis.*' Berges, McConnell and ScWarbaum found a January seasonal in Canadian
stock returns prior to 1972—a period when
Canada had no taxes on capital gains.^
The intx)nastent evidence argues for investigating otiher possitaUties. One that has received
attention on Wall Street is the notion that lkjuidity constraints on market participants n a y influ&ace security returns in a seasonal feshion. For
escampk, periodic infuakjns of cash into tiie
market as a result of say, institutional transfers
for pension accounts or proceeds from bonuses
or profit-sharing plans may affect the market.
Some evidence may be interpreted as supporting this idea.
Kato and Schallheim, examining small firm
returns in Japan, found January and June seasonals coinciding with the traditional bonuses
paid at the end of December and in June.**
Rozeff found a substantial upward shift in the
ratio of sales to purchases by investors who are
not members of the NYSE coinciding with the
dramatic increase in small firm returns in January; Rozelf, however, interpreted this as evidence of a tax-loss selling effect.™ Ritter documented a similar pattern in the daily sales to
purchase ratios for the retail customers of a
large brokerage firm.'' And Ariel noted a pattern in daily stock returns in every month but
February ttiat parallels precisely the pattern that
occurs at the turn of the year.'^ It would be
easier to interpret sudi monthly patterns as
liquidity or payroll effects than as tax effects.
Pattems
Recent studies have documented additional
empirical regularities related to tiie day of the
FINANCIAL ANALYSTS JOVmiM.
I MAY-JUNE 1986 D 2 9
F«ure F
Monthly Hfect in Stock lietums (vahie^veighted CRSP index, 1963-1^1)
1.6 -
/ n
1.4 -
Rret Half of Mwth
1.2 1
J• n
-
0.8 -
IU
0.6 -
1
^•*1 0 . 2 1
0 "^
-0.2
-
-0.4
-
-0.6
-
-0.8
-
-1.0
-
till
n
ji
•
1
1
1
2
1
3
11
M
n
tJ
i_|
n
J-L
1
I I I I~
11L'
1
4
n
n
1
5
6
l l
H
H
1
1
1
1• 1•
7
8
Last Half of Month
1
9
1
1
10
11
•
12
Month
week or tbe time of the montb. Average stock
returns, for example, tend to be bigher on
Fridays and negative on Mondays—the "weekend" effect. ^^ Because research on this effect
documents negative Monday returns using Friday dose to Monday close quotes, we canrwt
ascertain whether the negative returns stem
from the weekend nontrading period or from
active trading on Monday.
Harris, examining intradaily returns on NYSE
stocks over the 1981-83 period, and Smirlock and
Starks, using Dow Jones 30 stocks over the
1963-73 fjeriod, found negative Monday returns
accrued from Friday close to Monday open, as
well as dviring trading on Monday.^'* Rogalski,
however, looking at intradaily data from 1974 to
1^4, found that negative Monday returns accrued entirely during the weekend nontrading
period.'^
Keim and Stambaugh, noting results in Gibbans and Hess that sugg^t Friday returns vaiy
cross-sectionally with niarket value, found that
tlw return differential between small and large
firms increased as the week progressed, beanning largest on Friday (see Figure C).'^ In addition, Keim demonstrated that, controllmg for
the large average retunts in January, the "Friday"- effect and the "Monday" eSb&± are no
different in January than in other months.'' We
do not yet have an explanation of tbe weekend
effect, but we do know it is not likely a result of
measurement error in recorded prices, delay
between trading and settlement due to check
clearing, or specialist trading activity.^^
The monthly effect was detected by .Ariel,
who showed that for the 1963-81 period the
average returns on common stocks on the NYSE
and AMEX were positive only for the last day of
the month and for days during the first half of
the month.'' During the latter half of the
month, returns were indistinguishable from
zero. Ariel concluded that, during his sample
period, "all of the market's cumulative advance
occurred aroimd tbe first half of the montb, the
second half contributing nothing to the cumulative increase."
Figure F illustrates the phenomenon for the
total returns of the CRSP value-weighted index
of NYSE and AMEX stocks. The figure clearly
indicates that returns in the first half of the
montiti are consistently larger than second-half
returns (except in February); in fact, negative
average returns oarur only in ttie s«:ond half.
The results in Ariel aiso s u r e s t that, with the
ex(%pticai of Januaiy, tf» diSer&xce between
firet-half returns <rf small firms and first-half
FINAhKlAL ANALYSTS VXmiAL I MAY-JUNE 1986 D 30
returns of large firms is not substantial. Ariel is
unaUe to explain the effect, but a fK>tential
explanation involves liquidity constraints.
Implications
Many of these findings are inconsistent with an
investment environment where the CAPM is
descriptive of reaKty and argue for consideration of alternative models of asset pricing.
Other findings, such as the day of the week
effect, do not necessarily represent violations of
any particular asset pricing model, yet are still
intriguing because of their regularity.
The bottom line for portfolio managers is the
extent to which this information can be translated into improved portfolio performance. That
strategies based on this evidence can improve
performance has, in fact, been borne out in
"real world" experiments. There are, however,
severed caveats regarding implementation of
such strategies.
Footnotes
1. See W. F. Sharpe, "Capital Asset Prices: A Theory of Market Equilibrium under Conditions of
Risk," Joumal of Finance 1964, pp. 425-442; J.
Lintner, "The Valuation of Risk Assets and the
Selection of Risky Investments in Stock Portfolios
and Capital Budgets," Review of Economics and
First, diat some effa:ts have persisted for as
many as 50 years in no way guarantees their
persistence into the future. Second, even if the
effects were to persist, the costs of implementing strate^es designed to capture tiiese phenomena may be prohibitive. Market iliiquidity
and transaction costs may render a small stock
strategy infeasible, for example. Day of the
week and other seasonal effects may have practical value only for those investors who were
planning to trade (and pay transaction costs) in
any event.
Finally, one must be cautious when interpreting the magnitudes of "abnormal" returns
found by the studies. To the extent that alternative models of asset pricing may be more appropriate than the CAPM, studies that use the
CAPM as a benchmcirk may not be adjusting
completely for relevant risks and costs. Superior
performance relative to the CAPM may not be
superior once these costs and risks are considered.!
maintains that research activity in any normal
science will revolve around a central paradigm
and that experiments are conducted to test the
predictions of the underl3dng paradigm and to
extend the range of the phffliomena it explains.
Although research most often supports the underlying paradigm, eventually results are found
that don't conform. Kuhn terms this stage "discovery": "Discovery commences with the awareness of anomaly, i.e., with the recognition that
nature has somehow violated the paradigm-induced expectations that govern normal science"
(pp. 52-53, emphasis added).
6. The most prominent early studies are those of
Black, Jensen and Scholes, "The Capital Asset
Pricing Model: Some Empirical Evidence," in
Statistics 1%5, pp. 13-37; and J. L. Treynor,
"Toward a Theory of Market Value of Risky
Assets."
2. The one-period CAPM assumes that (1) investors
are risk-averse and choose "efficient" portfolios
by maximizing expected return for a given level
of risk; (2) there are no taxes or transaction costs;
(3) there are identical borrowing and lending
rates; (4) investors are in complete agreement
with regard to expectations about individual seJensen, ed.. Studies in the Theory of Capital Markets
curities; and (5) security returns have a multivari(New York: Praeger, 1972); M. Blume and I.
ate normal distribution.
Frifnd, "A New Look at the Capital Asset Pricing
Model," Joumal of Finance, March 1973, pp. 19-33;
3. Rz M the rate erf return on a risk-free asset in the
and E. Fama and J. MacBeth, "Risk, Return and
Sharpe-Lintner-Treynor CAPM; or the rate of
Equilibrium: Empirical Tests," Joumal of Political
return of an asset with zero correlation with the
Economy, May/June 1973, pp. 607-636.
market in the extension by F. Black, "Capital
Market Equilibrium with Restricted Borrowing,"
7. R. Roll, "A Critique of the Asset Pricing Theory's
Journal of Business, July 1972, pp. 444-455.
Tests: Part I: On Past and Potential Testability of
the Tlieory," Joumal of Pimndal Economics, March
4. See E. Fama, "Efficient Capital Marketer A Re1977, pp. 129-176.
view of Theory and Empirical Work," Jounud (^
Fimnce, May 1970, pp. 383-417.
8. SeeFamaandMacBeth, "Risk, Return aned Equilibrium," op. dt.
5. Such persistent de{»trtures are often referred to
as "anomalira." The term anomaly, in this con9. R. Stambaugh, "On the E»lusion of Assets from
text, can be tra<^ to Thomas Kuhn in his dassic
the Two-Parameter Model: A Sensitivity AnalyIxK^ The Siructme ^ Scientific Remlutims (Oikasis," Journal of Financial Economics 1982, p p . 237go: University of Chicago Press, 1970). Kuhn
268.
FINAJ«aAX. ANALYSTS JOURNAL / MAY-JUNE 1986 D 3 1
10. See M. GiHxms, "Multivariate Tests of Hnancial
see Miller and S d u ^ s , "Dividends and Taxes:
M o d ^ : A New Approadt/' Journal of Financud
Some Empirical Evidence," op. cit.
Economks 1982, pp. 3-27, and Stmnbaugh, "CJn 19. See, for example, J. Campbell and W. Berenek,
tiKe Exclusion," op. cit.
"Stock Price Behavior on Ex-Dividend Dates,"
11. See D. Mayers, "Nomnarketable Assets and CapJournal of Finance 1953, pp. 425-429 and E. Elton
ital Market Equilibrium wider Uncertainty," in
and M. Gruber, "Marginal Stockholder Tax Rates
Jensen, ed., Studks in Theory (^Capital Markets, op
and the Clientele Effect," Review of Economics and
cit.; M. Brennan, "Taxes, Market Valuation and
Statistics 1970, pp. 68-74.
Corporate Finandai Poliq^," Natwnal Tax Journal 20. A. Kalay, "The Ex-Dividend Day Behavior of
1970, pp. 417-^7; and R. Utzenberger and K.
Stock Prices: A Re-Examination of the Clientele
Ramaswamy, "The Eltects of Peraonal Taxes and
Effect," Journal (^ Finance 1982, pp. 1059-1070.
Dividends on (Capital Asset PriEes: Theory and 21. For similar arguments, see K.M. Eades, P.J. Hess
Empirical Evidence," Journal (^Financial EcoMomjcs
and E.H. Kim, "On Interpreting Returns During
1979, pp. 163-195.
the Ex-Dividend Period," Jourttal of Financial Economics, March 1984, pp. 3-34. However, M. J.
12. See R. W. Banz, "The Relaticmship between
Barday ("Tax Effects with No Taxes? Further
Return and Market Value of Common Stock,"
Evidence on the Ex-Dividend Day Behavior of
Journal of Financial Economics 1981, pp. 3-18, and
Common Stock Prices" (Department of EconomS. Basu, "Investment Perfonnance of Common
ics, Stanford University, September 1984)) finds
Stocks in Relation to their Price/Earnings Ratios:
that in the period before the institution of the
A Test of the Efficient Market Hypothesis," Jourfederal income tax, stock prices fell on their exnal of Finance 1977, pp. 663-682.
dividend day by the full amount of the dividend.
13. M. Miller and M. Scholes, "Dividends and TaxThis evidence is suggestive of a tax story.
es," Journal of Financial Economics, December 1978,
pp. 333-364.
22. See F. Black and M. Scholes, "The Behavior of
14. The table is an updated version of one in R.
Security Returns Around Ex-Dividend Days"
Utzenberger and K. Ramaswamy, "The Effects of
(University of Chicago, 1973); Eades, Hess and
Dividends on Common Stock Prices: Tax Effects
Kim, "On Interpreting Returns," op, cit.; and B.
or Information Effects," Journal of Finance 1982,
Grundy, 'Trading Volume and Stock Returns
pp. 429-433.
around Ex-Dividend Dates" (University of Chicago, 1985).
15. Coefficients are not significantly different from
zero in findings by F. Black and M. Scholes, "The 23. B. Grandy, "Trading Volume," op, cit,
Effects of Dividend Yield and Dividend Policy on 24. See, for example, Eades, Hess and Kim, "On
Common Stock Prices and Returns," Journal of
Interpreting Returns," op. dt, and M. S. GrinFinancial Economics 1974, pp. 1-22 and Miller and
blatt, R.W. Masulis and S. Titman, "The Valuation
Scholes, "Dividends and Taxes: Some Empirical
Elfects of Stock Splits and Stock Dividends,"
Evidence," Journal of Political Economy 1%2, pp.
Journal of FinaiKial Economics, December 1984, pp.
1118-1141. M. E. Blume ("Stock Returns and
461-490.
Dividend Yields: Some More Evidence," Review of 25. Grinblatt, Masulis and Titman, "The Valuation
Economks and Statistics 19M), pp. 567-577) and
Effects," op, dt.
R.H. Gordon and D. F. Bradford ("Taxation and 26. Banz, "TTte Relationship Between Return and
the Stock Market Valuation of Capital Gains and
Market Value," op, dt,
EKvidends: Theory and Empirical Results," Jour- 27. M. R. Reinganum, "Misspedfication of Capital
nal of PuMic Economics l%0, pp. 109-136) do not
Asset Pricing: Empirical Anomalies Based on
attribute the effects to taxes.
Earnings' Yields and Nfarket Values," Journal of
Finandal Economics 1981, pp. 19-46.
16. See Blume, "Stock Returns and Dividend
Yields," op. dt, and R. litzenberger and K. 28. M. E. Blume and R. F. Stambaugh, "Biases in
Ramaswamy, "IMvidends, Short Selling RestricComputed Returns: An Application to the Size
tions, Tax-Induced Investor Clienteles and MarEffect," JourruA of Finandal Eamomics, November
ket Equilibrium," Journal of Finance 1^0, pp.
1983, pp. 371-386.
4^-482.
29. The S&P 500, bdng a value-weighted index of
17. See D.B. Keim, "Kvidend Yields and Stock Reprimarily hig^-capitalization firms, behaves very
turns: Implications (rf Almormal January Remuch Hke a portftdio <rf very large firms.
turns," Journal of Financial Economics 1 9 ^ , pp. 30. Tlie dividend influence is examined in Keim,
473-^9, and itom "dividends Yields and the
"Dividend Yields and the January Effect, op, dt.;
January Effect/' Journal of Portfciio ManagenKnt,
see H. R. SfoH and R.E. Whaley, 'Transactions
1%6, pp. 61-65.
Costs and fte Snail Rrm Effect," Journal of Finandal Economks, June 1983, pp. 57-80 and Bhune
18. Except that translation costs may keep the price
and Stambai^ji, "Biases in Computed Returns,"
from fallhtg by tite full mnount of the cfivitiend;
FTNANOAL ANALYSTS JOURNAL J MAY-JUNE W86 O 3 2
31.
32.
33.
,
34.
35.
36.
37.
38.
39.
40.
41.
42.
43.
44.
and the Snuill Firm Effect," op. cit.; and Blume
op. cit., for flK effect (rf price; and Reinganum,
and Stambaugji, "Biases in Computed Returns,"
"Nfisspedficatkm erf Caistal Asset Pridng," op.
op. dt.
cit., for the effect of low P/E.
P. Brown, A. W. Kleidon and T. A. Marsh, "New 45. One excefriion is the lowest P/^ portfolio, whose
stocks on average have a low (high) average E/P
Evidence on tl»e Nature of Size-Related Anoma(P/E). This is attributaWe to the negative earnings
lies in Stock Prices," Jourrud ofFimncM Eanwmics,
firms that tend to be concentrated there. Note
June 1^3, pp. 33-56.
that firms with negative book values are exchided
D. B. Keim and R. F. Stambaugh, "A Furflwr
from the sample.
investigation of the Weekend Effect in Stock
Returns," foumal cf Finance, July 1984, pp. 819- 46. For P/E, see T. J. Cooke and M. S. Rozeff, "Size
and Earnings/Price Ratio Anomalies: One Effect
S35.
or Two?" Journal of Financial and Quantitative AnalSee D. B. Keim, "Size-Relat«i Anomalies and
ysis 1^4, pp. 449-466; for dividend )deld, see
Stock Return Seasonality: Further Empirical EviKeim, "Kvidend Yields and Stock Returns," op.
dence," Jourml of Financial Economics, June 1983,
dt.;
and for price, see J. Jaffe, D. Keim and R.
pp. 13-32.
Westerfield, "EMsentangling Earnings/Price, Size
R. Roll, "Vas ist das? The Turn of the Year Effect
and Other (related) Anomalies" (University of
and the Return Premium of Small Finns," Journal
Pennsylvania, 1985).
of Portfolio Managmmt, 1983, pp. 18-28.
47.
See
Reinganum, "Misspedfication of Capital AsOne exception is T. Nakamura and N. Terada
set Pridng," op. cit.
("Hie Size Effect and Seasonality in Japanese
Stock Returns" (Nomura Research Institute, 48. S. Basu, "The Relationship Between Earnings'
Yields, Market Value and the Returns for NYSE
4984)), who document a P/E effect on the Tokyo
Stocks: Further Evidence," Journal of Finandal
stock exchange.
Economics, June 1983, pp. 129-156.
B. Graham and D. L. Dodd, Security Analysis
49. J. W. Peavy and D. A. Goodman, "A Further
(New York: McGraw-Hill, 1940), p. 533.
Inquiry into the Market Value and Earnings Yield
S. F. Nidvolson, "Price-Earnings Ratios," FinanAnomalies" (Southern Methodist University,
dal Analysts Jourml, July/August 1960.
1982).
Basu, "Investment Performance of Common
50. Cooke and Rozeff, "Size and Earnings/Price Ratio
Stocks," op. dt.
Anomalies," op. dt., p. 464.
Reinganum ("Misspedfication of Capital Asset
Pridng," op. dt.), analyzing both NYSE and 51. See for example R. Ball, "Ancwnalies in Relationships between Securities' Yields and Yield-SurroAMEX firms, confirmed and extended Basu's
gates," Journal of Finandal Economics 1978, pp.
findings using return data to 1975.
108-126.
J. W. Peavy and D. A. Goodman, "Industry52.
See
Keim, "Dividend Yields and Stock Returns,"
Relative Price-Earnings Ratios as Indicators of
op. dt. and "Dividend Yields and the January
Investment Returns," Finandal Analysts Journal,
Effect," op. dt.
July/August 1983.
See, for example, F. Black, "Yes, Virginia, There 53. N. Chen, "Some Empirical Tests of the Theory of
Arbitrage Pridng," Journal of Finance 38, pp.
is Hope: Tests of the Vahie Line Ranking Sys1393-1414; K. C. Chan, N. Chen and D. Hsieh,
tem," Finandal Analysts Journal, September/Octo"An Exploratory Investigation of the Firm Size
ber 1973, pp. 10-14; C. Holloway, "A Note on
Effect," Journal of Finandal Economics 14, pp. 451Testing an Aggressive Investment Strategy Using
472; and S. Ross, "The Arbitrage Theory of CapiValue line Ranks," Journal of Finance, June 1981,
tal Asset Pricing," Journal <^ Economic Theory 1976,
pp. 711-719; and T. E. Copebnd and D. Mayers,
pp. 341-360.
"Tlie Value Line Enigma (1965-1978): A Case
Study of Performance Evaluation Issues," Journal 54. Stoll and Whaley, 'Transactions Costs and the
of Financial Economics, November 1982, pp. 289SmaU Firm Effect," op. dt.
321.
55. P. Schultz, "Transactions Costs and the Small
Firm Effect: A CcMnment," Journal of Finandal
S. E. Stickel, "The Effect of Value Line Investment
Economics, June 1983, pp. 81-88.
Survey Rank Changes on Ctanmon Stock Prkes,"
Joumd of Financial Eamomics 1985, pp. 121-144. 56. R. Roll, "A Possible Explanation of the SmaU
Firm Effect," Journal of Fimnce 1981, pp. 8/^888;
Discussed most recently by B. Rosenberg, K.
M. R. Reinganum, "A Direct Test of Roll's ConReid and R. Lanstein, "Persuasive Evidence of
jecture on the Firm Size Efect," Journal of Finance
Maricet Ineffidency," Jourml of Portfolio Mamge1982, pp. 27-35.
mmt, pp. 9-17.
57.
A.
Christie and M. Hertzel, "Capital Asset PricSee M E. Blume and F. Husic, "Price, Beta and
ing 'Anomalies': Size and Other Correlations"
&cduinge listing," Journal of Fimnce 1973, pp.
(University of Rochester, 1981).
^3-299; StoD and Whaley, "Transactions Costs
HNANOAL ANALYSIS JOURNAL / MAY-JUNE 1986 D 33
58. K. Chan, "Leverage Changs and Size-Related
Individual Investors at ttie Turn of the Yean
Anomalies" (University of Chicago, 1983).
Evidence of Price Pressure Effects" (University of
59. Blume and Stambaugh, "Biases in Computed
Midiigan, November 1985).
Returns," op. dt. A ^milar argument is presented 72. R. A. Arid, "A Monthly Effect in Stock Returns"
in R. RoU, "On Computing Mean Returns and
(Massachusetts Institute of Technology, 1984).
the Small Firm Premium," Joumal of Financial 73. F. Cross ("The Behaviw of Stock Prices on FriEconomics, November 1983, pp. 371-386.
days and Mondays," Financial Analysts Joumal,
60. P. Brown, D. B. Keim, A. W. Kleidon and T. A.
November/December 1973, pp. 67-69) and K.
Marsh, "Stock Return Seasonalities and the TaxFrench ("Stock Returns and the Weekend Effect,"
Loss Selling H)'pothesis: Analysis of the ArguJoumal of Financial Economics, March 1980, p p . 5 5 ments and Australian Evidence," Joumal of Finan69) document the effect using the S&P composite
cial Economics, June 1983, p. 107.
index begriming in 1953. M. Gibbons and P. Hess
("Day of the Week Effects and Asset Returns,"
61. Roll, "Vas ist das?" op. dt.
Joumal of Business, October 1^1, pp. 579-5%)
62. Brown et al., "Stock Return Seasonalities/' op.
document it for the Etow Jones industrials index
dt.
of 30 stocks for 1962-78. Keim and Stambaugh
63. G.M. Constantinides, "Optimal Stock Trading
("A Further Investigation of the Weekend Efwith Personal Taxes: Implications for Prices and
fect," op. dt.) extend the findings for the S&P
the Abnormal January Returns," Joumal of Financomposite to include the 1928-82 period and also
cial Economics, March 1984, pp. 65-90.
find the effect in actively traded OTC stocks. J.
64. M. R. Reinganum, "The Anomalous Stock MarJaffe and R. Westerfield ("The Week-end Effect in
ket Behavior of Small Firms in January: Empirical
Common Stock Returns: The Intemational EviTests for Tax-Loss Selling Effects," Joumal of
dence," Joumal of Finance 1985, pp. 433-454) find
Financial Economics, June 1983, pp. 89-104 and
the effect on several foreign stock exchanges.
RoU, "Vas ist das?" op. dt.
65. P. Schultz, "Personal Income Taxes and the Janu- 74. L. Harris, "A Transactions Data Study of Weekly
ary Effect: Small Firm Stock Returns Before the
and Intradaily patterns in Stock Returns" (UniWar Revenue Act of 1917: A Note," Joumal of
versity of Southern California, 1985) and M.
Finance, March 1985, pp. 333-343.
Smirlock and L. Starks, "Day of the Week Effects
in Stock Returns: Some Intraday Evidence" (Uni66. See K. C. Chan, "Can Tax-Loss Selling Explain
versity of Pennsylvania, 1984).
the January Seasonal in Stock Returns?" (Ohio
State University, August 1985) and W. F. M. 75. R. Rogalski, "New Findings Regarding Day-ofDeBondt and R. Thaler, "Does the Stock Market
the-Week Returns over Trading and Non-TradOverreact?" Joumd of Finance, July 1985, pp. 793ing Periods: A Note," Joumal of Finance, Decem806.
ber 1984, pp. 1603-1614.
67. Brown et al. ("Stock Return Seasonalities," op. 76. Keim and Stambaugh, "A Further Investigation
dt.) examine Australia, which has a June tax yearof the Weekend Effect," op. dt.
end. The U.K. (which has an April tax year-end) 77. D. B. Keim, "The Relation Between Day of the
is examined in M. R. Reinganum and A. Shapiro,
Week Effects and Size Effects," Joumal of Portfolio
'Taxes and Stock Return Seasonality: Evidence
Management, forthcomirjg.
from the London Stock Exchange" (Uruversity of 78. Measurement error is treated in Gibbons and
Southern CaHfomia, 1983).
Hess, "Day of the Week Effects," op. dt.; Keim
68. A. Berges, J. McConnell and G. Schlarbaum,
and Staml^u^, "A Further Investigation of the
"The Tum-of-the-Year iri Canada," Joumal of FiWeekend Effect," op. dt.; and Smirlock and
nance, March 1984, pp. 185-192.
Starks, "Day of the Week Effects in Stock Returns," op. dt. Trading delays are treated in
69. K. Kato and J. S. Sdiallheim, "Seasonal and Size
Gibbons and Hess, and in J. Lakonishok and M.
Anomalies intf»eJapanese Stodk Market," Joumal
Levi, "Weekend Effects on Stock Returns: A
of Financial and Quantitative Analysis 1985, p p .
Note," Jourml of Finance, June 1982, pp. 883-889.
107-118.
Specialist trading is dealt with in i^im and Stam70. M. S. Ro2«ff, "The Tax-Loss SeUing Hypotitesis:
baugh.
New Evidence from Share SWfts" (Univeraty of
Iowa, April 1985).
79. Ariel, "A Monthly BS&A in Stock Returns," op.
71. J. R. FUtter, "Tlie Buying and Selling Behavior of
dt.
FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1986 D 3 4
by Robert A. Taggart, Jr.
Corporate Rnanclng: Too Much
Dobt?
Are U.S. corporations overburdened with debt? Since 1970, internal funds have been taking
wider swings as percentages of total funds sources, as comjmred with the 1950s and 1960s.
Furthermore, use of debt financing has been consistently higher since the mid-1960s than
during previous periods throughout the century. And short-term debt has accounted for
most of this rise.
After adjustment for inflation, however, the figures indicate that, since 1974, corporations have relied heavily on internal funds and cut their cost of debt financing to levels that
are not high by historical standards. Despite fluctuations in internal funds and increased use
of short-term debt, corporations do not appear to have significantly riskier capital structures
than they've had in the past.
An examination of determinants of the composition of capital structure reveals that
corporate reliance on debt financing increases as capital expenditures rise relative to available
internal funds. Use of debt financing is limited, however, by investors' perceptions of the
riskiness of the business environment and by relative supplies of federal government
securities. Over long periods, furthermore, the tax system seems to affect the level of debt
financing; corporate borrowing increases as personal income tax rates rise above corporate
levels.
I
N 1984, NEW DEBT accounted for 45 per
cent of total sources of funds for U.S. nonfinancial corporations. Less than one-quarter
of this new debt came from long-term bonds
and mortgages; the rest represented short-term
debt from a variety of sources. Moreover, 15 per
rent of net funds sources went, not for investment in new plant and equipment, but for the
repurchase of outstanding common stock.
Do such developments reflect increasing financial weakness of U.S. business? Many observers seem to tiiink so. Their fears have been
stimulated by such highly publicized trends as
the levered buyout boom, tfie growth of "junk"
bond financing, and the shrinkage of equity
bases that often accompanies corporate restruc-
turing. In addition, the current period is only
the latest in a series of surges in corporate debt
financing. Previous notable episodes occurred
in 19^-69, 1973-74, and 1978-:^.
Each of these surges gave rise to similar fears
over corporations' financial condition. It has
been argued that corporations' reliance on debt
financing, particularly short-term debt, has
made them increasingly vulnerable to economic
shocks. This reliance on debt financing is in turn
blamed on a combination of factors, including
the tax system's favored treatment of debt over
eqmty, reduced availability of internally generated funds dudng inflationary peritxis, and
unrealistic assessments of business risk by executives, entrepreneurs and corporate raiders.
This article examines more closely these allegations
of corporate financial weakness 1^ comRt^Krt Tag^rt, Jr. is Profossor of Finance, Boston Univerparing
recent corporate financing patterns
sity, and Bxsemk Associate, National Bttreau of Economic
against
long-term
trends and by analyzing the
Siesectrdi.
The au^r tiumks the Natimud Bureau of Emtmmk link between these patterns and potential causal
£act(HS. n ^ conclusion emerges that, in many
for partkl financial support of this resairch.
FINANOAL ANALYSTS JOURNAL / MAY-JUNE 1^6 D 3 5