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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