the impact of asset impairments on stock price

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THE IMPACT OF ASSET IMPAIRMENTS ON STOCK PRICE

By

John S Yelvington

A DISSERTATION Submitted to

School of Business and Entrepreneurship Nova Southeastern University

in partial fulfillment of the requirements For the degree of

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UMI Number: 3058560

Copyright 2002 by Yelvington, John Stephen

All rights reserved

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A Dissertation entitled

THE IMPACT OF ASSET IMPAIRMENTS ON STOCK PRICE By

John S Yelvington

We hereby certify that this Dissertation submitted by John S Yelvington conforms to acceptable standards, and as such is fully adequate in scope and quality It is therefore approved as the fulfillment of the Dissertation requirements for the degree of Doctor of Business Administration Approved: tà» x (4 Z ¬/ { 226 2 Richard L Kelsey, PED Meg — >> ^= T3 (aee+_ e Levin, D joseph L Ballon oe oH ⁄ Director of Doctoral Research + L2 Awa tư —

/Preston Jow€š, D.B.A

Associate Bean, the Huizenga Graduate School of Business and Entrepreneurship

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CERTIFICATION STATEMENT

I hereby certify that this paper constitutes my own product, that where the language of others is set forth, quotation marks so indicate, and that appropriate credit is given where I have used the language, ideas, expressions or writings of another

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ABSTRACT

THE IMPACT OF ASSET IMPAIRMENTS ON STOCK PRICE by

John S Yelvington

This study analyzed the impact of asset impairments on the stock prices of asset- impaired firms from 1992-1999, excluding the year of transition, 1995 The two net samples of the study consisted of 1) those firms which announced asset impairments prior to the approval of SFAS (Statement of Financial Accounting Standards) 121 (BEFORE) and 2) those firms which made their asset impairment announcements afterwards (AFTER)

The research questions were to determine if unexpected returns resulted in either the before or after categories, if there were significant differences in the means of the two net samples and if there were significant variations in the means of the two net samples

The results indicated no significant unexpected returns before or after, nor any significant differences in returns between the two net samples However, after the approval of SFAS 121, negative (stock price decreasing) unexpected returns became larger and more significant over time, possibly indicating that investors required time to mull over asset impairment announcements

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ACKNOWLEDGEMENTS

This paper is dedicated to my family, my devoted and loving wife, Marie and the three most wonderful children in the world, Sarah, Bradley and Laura, all from whom I stole time to complete my degree Without the support of my mother, Allie, my father, John, brothers Paul and Joe, sisters Bradley and Fleury, sisters in law, Laurie and Kirsten, brother in law, Barry and nieces Aime and Claire, this would not have been possible

The contributions of my committee were substantial Dr Jeffrey Phillips and Dr Moshe Levin provided guidance and encouragement throughout the process My chair, Dr Richard Kelsey taught me how to write more clearly, concisely and professionally He taught me how to publish and, along the way, taught me several of life’s lessons that he didn’t realize he was teaching me at the time Dr Richard Kelsey is a credit to his profession, to his employer and a model for instructors of all disciplines at all educational! levels I am always in his debt

Thanks to Dr Joe Balloun for showing me the way to maintain a high level of professionalism and integrity in publishing He was always available for questions and guidance His encouragement ‘onward and upward’ was constantly an inspiration

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TABLE OF CONTENTS

Page 8u An Vil Chapter

I INTRODUCTION 200.0 ccc ccc cevececcc cee cnceceeenseuueaeeaereeaes l IL REVIEW OF LITERATURE TQ se i]

A i0 7.300 SA 16

B EFFICIENT MARKET HYPOTHESIS 22

I TESTS FOR PRIVATE INFORMATION 26

2 PORTFOLIO MANAGEMENT 30

3 THE MARKET FOR INFORMATION 33

C AGENCY THEORY HQ 38 1 RESTRUCTURE/BIG BATH/ASSET WRITE OFFS/ASSET WRITE DOWNS 39

D SUMMARY AND CONCLUSIONS $7

HH METHODOLOGY A RESEARCH QUESTIONS QQ su sư 60 B HYPOTHESES cece cece cece nnaeseeeeerereecesenees 65 IV ANALYSIS AND PRESENTATION OF FINDINGS 75

A RESULTS OF HYPOTHESES ] & 2 87

B RESULTS OF HYPOTHESIS 3 89

C RESULTS OF HYPOTHESTIS 4 9]

V SUMMARY AND CONCLUSIONS 94

REFERENCES CITED con nu ng kh ky vx rết 102 21151004963 ÌsybddiaiaaaaiáảảẳảỶŸ 108

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Table ae WN PID LIST OF TABLES

Table 2-1 Stock Buy and Sell Comparison .00.2:2ceeeneeeeeenes 29 Table 2-2 Restructuring Cos† TYD€S nh kh ru 50 Table 4-1 Breakdown of Computation of Net Sample 78 Taple 4-2 Distribution of Simultaneous EVentS c 83 Table 4-3 Distribution of Impairments by Number of Observations and

Percent of Total Observations e eee cece nc ec cece recta en eeeenecees 85 Table 4-4 Results of Hypotheses 1 & 2 LH nh khu 87 Table 4-5 Results of Hypothesis 3 nà, §9 Table 4-6 Results of Hypoth€SIS Ả cuc HH nh nh xa 9]

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CHAPTER I INTRODUCTION

The number of corporations accruing operational restructuring charges is increasing dramatically both in the United States and abroad Though there are a number of reasons for operational restructures, the primary reasons are escalating competition, improved skill and productivity of workers, improved cost competitiveness and dramatic increases in technology Most industries are recognizing unprecedented competitive pressures not only domestically and globally, but also the internet has removed geographic boundaries To compete effectively in the marketplace, firms are forced to reengineer or restructure ail their processcs to ensure cost competitiveness

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Smith and Lipin (1996) provided examples of prominent companies which have recently undertaken restructuring initiatives McCormick took a restructuring charge for the sale of its frozen food unit, a significant part of their operation Allied Signal took charges pertaining to the divestiture of its railway equipment and semiconductor equipment segments IBM had severe problems with its mainframe computer business, a dramatic drop in customer demand, a structural change in consumers’ needs The significant drop in demand for that equipment caused IBM to write down its assets

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the focus of this study

The remainder of this chapter is organized as follows:

® Definition of asset impairments

e Possible root causes of asset impairments e Importance of asset impairment

« Regulatory concerns on asset impairments e Theories related to asset impairments

e Research questions posed and the methodology used

e Brief description of this study’s scope, assumptions and limitations e Organization of the remaining chapters

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interest charges) is less than the carrying amount of the asset, an impairment loss is recognized.” [p I]

This statement also required those assets be reported at the lower of carrying amount or fair value less cost to sell, except for assets covered by Accounting Principles Board (APB) Opinion 30 APB 30 requires assets be reported at the lower of carrying value or Net Realizable Value (NRV)

If an asset impairment occurs, assets values are misstated and income is misstated in the same direction Improper balance sheet valuations can occur for several reasons First, there could be a conscious, intentional on the part of management to deceive investors Overvalued assets translate to overstated net worth, which in turn, translates to overstated net income

These misstatements are most likely to occur in the event of a proposed purchase of the firm by an outsider An example of such a fraudulent situation is ZZZZ Best, the carpet cleaning company, who reported overstated receivables from customers to improve the appearance of the balance sheet and reported net income to investors Second, overvalued assets can simply result from sloppy bookkeeping

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Fourth, because of the ‘big bath’ theory, according to Walsh et al (1991), restructuring firms may be anxious to communicate all the bad news at once, so firms often use this opportunity to revalue assets There is a temptation to bring in as many costs as possible to the restructuring charge as possible, even to the extent of including future charges completely unrelated to the restructuring initiative

Hogan and Jeter (1997) stated this ‘earnings manipulation’ is a main concern of the Securities and Exchange Commission (SEC) They further stated the phrase ‘restructuring charge’ recently has become both popular and ambiguous at the same time The SEC and the FASB want to know if these restructuring charges “ convey information or simply serve as a dumping ground to facilitate future manipulation of earnings ” [p 5]

Hogan and Jeter (1997) also noted, besides improved earnings in future years, the FASB’s other main concern is often firms provided neither details of the restructuring nor timing of the costs to be incurred Also, King (1996) stated, ironically, most firms justify earnings manipulations by attempting to convince shareholders operating earnings before the restructuring charges provide a more meaningful indication of trends As a result of this abuse, the SEC requires more substantial disclosure; firms must now provide details of the restructuring plans, complete with dollar estimates of each restructuring charge component

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frequency and amount of charges these firms are taking Asset valuations are impacted, since impairments are often are a significant part of the restructuring charge

As Kross et al (1996) stated, there is no formal definition of an operational restructuring, so firms have undertaken different methods of measuring and reporting such restructures This is also another concern of the FASB and the SEC

According to Smith and Lipin (1996), because impairments are generally significant and because of stockholder and investor uncertainty, the SEC and other agencies seek standardization in the way such charges are calculated, journalized and reported Standardization enables investors to properly interpret the intended meaning, the substance and the reason for the impairment, further enabling investors to make informed judgments about a security’s value

In summary, there is considerable leeway in the way restructuring charges are included in financial statements This leeway and the ambiguity of the term ‘restructuring charges’ causes concern for the SEC and other regulatory agencies Firms have the potential to abuse the definition, which could lead to earnings manipulation, multiple and excessive restructuring charges As a result, there is no standardization in reporting of such charges

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concern about this issue and its impact on firms, investors and other stakeholders The standardization this ruling provides may enable stockholders and other stakeholders to interpret properly the intended meaning and reason for the impairment Investors can, therefore, make more informed judgments about the stock’s value

As is pointed out in Chapter H, most current related literature focuses on restructuring’s impact on stock price Some authors have attempted to isolate the impact of certain restructure components on stock price However, no study has been conducted on the asset impairment issue, which makes asset impairments an appropriate area for research, particularly in light of this recent pronouncement

Three distinct yet significantly related topics form the theoretical foundation of this topic All bear some level of relationship to the issue of asset impairments First, in 1976, Jensen and Meckling stated business owners entrust managers (agents) to make such decisions in the owners’ stead Though agents may not (and sometimes there is no incentive) to act optimally, both agents and owners incur costs to ensure the agents truly represent the wishes of owners of the business This theory became known as agency theory

A reporting subset of agency theory is first, restructuring In Chapter H, significant contributions in the restructuring topic by Kross (1996), Hogan and Jeter (1997) and Halsey et al (1997) are discussed Asset impairments are generally a material portion of restructuring costs

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enterprise or undertake a big bath, are performing their duties, as they see them, under agency theory Walsh et al (1991) were contributors to this topic As well, asset impairments can be a part of the firm’s big bath announcement

Once the restructuring/big bath news is issued to the public, the announcement becomes a signal Signaling is a method firms use to convey internal decisions or internal opinions of its own future, which are, otherwise, unobservable to the investing public Though firms can signal in a variety of ways, a significant announcement such as restructuring/ big bath becomes a signal to investors about the plan and the reasons for the restructure, according to multiple works by Gonedes (1974), (1975), (1978) Typical signals noted in the literature are dividend increases or initial dividend declarations, purchases or divestitures of subsidiaries and significant capital expenditures More importantly, these signals are not simply news, but reflect a commitment to future action by management — a commitment of resources, time and strategy

Lastly, the semi-strong form of the Efficient Market Hypothesis (EMH) states current stock prices reflect all current publicly available information Once the restructure signal is sent out to the market, the market reacts to the announcement and stock prices change immediately by investors’ reactions (that is, decisions to buy and sell stock) Fama (1969) is credited with the formulation of EMH EMH also applies to asset impairments, since the announcement is likely to impact the evaluation of a company and

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In summary, the existing accounting literature contains a wealth of theoretical connections to the study of asset impairments To test such impact, the following research questions are posed:

e Are there unexpected returns realized by New York Stock Exchange NYSE asset-impaired firms before the implementation of SFAS 121 as measured one, three, six and twelve months after the filing of the 10K? e Are there unexpected returns realized by NYSE asset-impaired firms

after the implementation of SFAS 12! as measured one, three, six and twelve months after the filing of the 10K?

e Are unexpected returns realized by NYSE asset-impaired firms different before and after the implementation of SFAS 121 as measured

one, three, six and twelve months after the filing of the 1OK?

e Are return variances realized by NYSE asset-impaired firms different before and after the implementation of SFAS 121 as measured one, three, six and twelve months after the filing of the 10K?

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These research questions are empirically tested, using data from 1992 to 1998, excluding 1995, the transition year These time periods are consistent with those used in other event studies in the literature In fact, the time periods for prior event studies ranged from 2 days to three years

The remainder of the study is organized as follows: Chapter II is the detailed review of existing literature on the three foundational topics and their relation to asset impairments

In Chapter HI, the methodological approach is described | Specifically, this chapter contains a detailed discussion of the research hypotheses and an explanation of the importance of each research area Chapter ILI also includes sources of the data, size of the universe and a description of how the data were gathered

Chapter 1V shows what adjustments (if any) were made to the data, what data were excluded from the sample or universe and why Chapter IV also contains a detailed discussion of the statistical results, including the reporting of the significance of any relationships

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CHAPTER J]

LITERATURE REVIEW

Restructuring is a process encompassing a broad range of events, which involves a large number of certain costs associated with it Examples of types of restructuring costs mentioned in the accounting literature are disposal of a segment, permanent impairment of value of long lived assets, other unusual or infrequent events and pension curtailments

Initially, there was concern the cost of implementing rules might exceed the benefit of doing so, since measurement is a major problem To comply with any such standard would force some companies to make significant changes to their accounting systems However, after evaluating the evidence and comments from interested parties, the FASB (Financial Accounting Standards Board) ultimately decided the increased benefit of consistent reporting to users of financial information exceeded the increased cost to firms

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formalizes an issue for comment and solicits comments from the public The EITF summarizes the merits of these discussions and negotiations with the public and makes recommendations to the FASB, which may or may not accept the EITF recommendations Since they must be approved, recommendations of the EITF do not carry the weight of an SFAS pronouncement

In the case of asset impairments, the FASB (1995) stated, in March 1994, the EITF began discussion of EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” [EITF Issue 94-3 is a much broader issue than asset impairments.] However, the Board felt the resolution of EITF Issue 94-3 would have a significant bearing on asset impairments, since exiting an activity also often involves the disposition of assets Therefore, the approval of 94-3 played a role in the adoption of SFAS 121

The FASB’s EITF addressed three issues specifically pertaining to accounting for restructuring costs in 94-3 First, the EITF decided a liability for involuntary employee termination benefits should be recognized in the period management approves a plan, if certain conditions exist

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e Before the financial statement date, management must have the appropriate level of authority to execute the plan and must commit the business to the plan

e The exit plan specifically identifies all actions necessary for the exit plan to complete and identify activities which will be discontinued

e Actions required by the exit plan will begin as soon as possible after the commitment date

e A material change in competitive factors, business climate or a change in the legal or regulatory environment

e A material excess in the acquisition or construction cost of an asset

There were some ‘overlapping’ issues referenced by both EITF 94-3 and SFAS 121 The FASB’s intent was to assess the EITF’s recommendations on the overlapping issues before ruling on SFAS 121 After beginning its work in March 1994, the EITF finished discussion of the issue in January 1995 and made its recommendations to the

FASB After receiving the recommendations, the FASB made its decision on SFAS 121 SFAS 121 was issued in March 1995

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evaluate the expected cash flows from the assets’ future use If the cash flow is less is less than the asset’s carrying value, an impairment loss is recognized The fair value is defined as the amount at which the asset would trade hands between willing parties other than a liquidation sale, according to O’Brien (1996) Scofield (1995) noted other nuances in the tuling Firms must identify the grouping of assets to evaluate the impairment The grouping should take place at the lowest level that cash flows can be separately be identified Significant assets can be analyzed individually, but others only on a segment basis

She provided other insights in 1995 When considering impairment, firms must understand the relationship between the impairment and the depreciation method used For example, a poorly chosen depreciation method may accidentally generate the recognition of a write-down If assets generate even cash flows, all depreciation methods should result in book value at least equal to the sum of future net cash flows However, if an asset’s cash flows are expected to be heavier in earlier years, only an accelerated depreciation of some kind results in book value at least equal to the sum of future net cash flows

Scofield (1995) continued to say the measure was different if the impaired asset

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If goodwill were related to the impaired asset, a portion of goodwill must be assigned to the carrying amount of the asset If groups of assets were involved, goodwill would be apportioned based on relative fair market values Also, the goodwill should be written down first

This statement also required those assets be reported at the lower of carrying amount or fair value less cost to sell, except for assets covered by Accounting Principles Board (APB) Opinion 30 APB 30 requires assets be reported at the lower of carrying value or Net Realizable Value (NRV)

Lastly, Scofield (1995) stated the firm must disclose the some details about the impairment loss in its financial statements Such details include a description of the impaired asset and the circumstances surrounding the impairment, the amount of the impairment, a detailed discussion on how it was determined and the financial statement caption that includes the impairment loss and the business segment (if applicable)

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Secondly, a wealth of literature exists on the EMH, which states that security prices generally reflect all currently available information As details of a specific firm’s restructuring plans are issued, these plans and the dollars associated with these plans now become publicly available information According to Fama’s EMH (1969), the investing public digests the restructuring details and makes investment decisions accordingly Then prices of the restructured firm’s stock change to reflect investors’ perceptions of the plan

Lastly, agency theory, offered by Jensen and Meckling (1976), is related conceptually to the reporting issues of restructuring and the big bath theory The big bath theory essentially states troubled or operationally restructuring firms have a tendency to publicize bad news to investors all at once, take the ‘big bath’ and ‘clean the slate’ so business can start anew Since the bad news revolves around poor earnings, there is usually a substantial charge against earnings in the current period, to account for the quantification of the bad news to investors This chapter is split into three remaining subsections and the existing literature on each topic is reviewed and analyzed in turn

Signaling

Signaling is the key philosophical concept in this study very simply because disclosures about restructuring charges are, to a degree, discretionary Therefore, restructuring disclosures clearly serve as potential signals about the details of a firm’s

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Signaling is a method firms use to convey internal decisions or internal opinions of its own future, which are, otherwise, unobservable to the investing public The classical signaling model was articulated by Levy and Lazarovich-Porat in 1995

If information were equally distributed among all managers and investors, signaling would have no economic value But firms’ managers obviously know more about their firm’s financial viability, financial outlook, risks, opportunities, etc., than investors, so an informational gap develops between managers and investors Managers often emit signals to communicate internal information to investors

According to Levy and Lazarovich-Porat (1995), investors classify firms as high or low quality based on signals sent by firms High quality firms send honest (accurate) signals about these unobservable characteristics to investors to distinguish themselves from lower quality firms

Levy and Lazarovich-Porat (1995) continue by saying, at equilibrium, this additional information provides enhanced value to investors Investors can now make intelligible inferences about a firm’s unobservable characteristics Signals, therefore, help investors distinguish security values of firms whose decisions have different attributes and, therefore, enable investors to classify firms with respect to quality Signals also help investors determine the value of the firm’s securities and the distribution of expected returns

Realizing the benefits of signaling, investors then accept the signal, and pay a higher price for the high quality firm’s security According to Ross (1977), low quality

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As Castagna and Matolcsy (1989) pointed out, the dependency of stock returns on a signal is generally detined as the information content of the signal and is measured by the statistical correlation between the investor’s realization of the signal and the change in the stock’s return

In related literature, Gonedes (1974) found special accounting items (such as restructuring charges) effectively convey information which affected security prices Many special accounting items require separate disclosure in order to enhance their value to users of financial information Though Gonedes was referencing a broader universe of transactions (restructuring charges are a subset of special accounting items), restructuring charge disclosures undoubtedly fall into this category

Gonedes (1978), in a separate article, narrowed the scope to extraordinary items only and viewed dividends, net income and extraordinary items as signals to investors (restructuring is typically included in the extraordinary category) Viewing extraordinary items as potential signals stemmed from the assumption net income numbers gave signals about the attributes of a firm’s decisions and was impacted because of management’s latitude in what to disclose and what not to disclose The decomposition of net income into ordinary and extraordinary affected users’ ability to predict net income and appeared to have influenced the Securities and Exchange Commission’s (SEC’s) views on income reporting

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Talmor (1981) pointed out signaling is costly to firms, but it is often in these firms’ benefits to signal instead of directly releasing confidential information It is also more beneficial for firms to signal then to disclose no information, directly or indirectly, at all

Increases or changes in capitalization, some special accounting information and dividend changes were a few of the more commonly used signals in the existing literature However, any material aspect of a firm’s reporting may serve as a signal For example, Ravid and Sarig (1991) studied total committed cash flows as a corporate signal

Standish and Ung (1982) analyzed fixed asset revaluations and found such signals, by themselves, had a very small positive impact on stock returns of 232 listed British companies around the time of disclosure However, they then partitioned the sample into groups, depending on other signals, such as dividend policy and capital structure changes When asset revaluations pointed to other signals, the positive impact became dramatically more significant

Over the last 30 years, however, dividend policy is by far the most popular corporate signal in the literature today Lintner (1965), Bhattachrya (1980) and Miller and Rock (1985) researched various aspects of dividend policy as a signal, but they generally argued a primary rationale for dividends was their signaling value

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valuable to investors, yet not competitively damaging) in much the same way there is an

optimal dividend structure, capital structure, etc

Realizing this phenomenon, Daves and Tucker (1993) found, in searching for the optimal signaling policy, a high valued firm released some firm-specific information and signaled the more proprietary, but nonetheless, useful information to investors Their main conclusion was the higher the degree of competition, the higher the level of signaling for the reasons mentioned above

Spence (1974) discussed competitive responses to signals in the context of buyers and sellers of labor Many of his conclusions were applicable to signals sent and received by firms in relation to the perceived value of their stock

Management in high quality firms engaged in signaling because they wanted to convey meaningful information to investors Signals’ impacts on investors’ perceptions were affected by the relevance of the unobservable characteristics of the firm, the applicability of the signals to the characteristics and the perceived honesty of the firm

Gonedes et al (1976) described situations where management sent dishonest signals There were some short-term incentives for management to send such signals Dishonest signals were defined as situations where managements expected the signals to be interpreted in a different way than their own beliefs about the unobservable characteristics of the firm

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quality firms) Also, firms have an incentive not to be dishonest, since investors eventually ignored signals sent by chronically dishonest signalers

Earnings were considered an indicator of stock returns, but there was some theoretical disagreement about its explanatory value Easton and Harris (1991) analyzed stock return data from 1969-1986 and showed the ratios of earnings to the beginning of period stock price was a significant explanatory variable for unexpected stock returns In multivariate regressions of returns on current earnings and changes in earnings, both coefficients were significantly different from zero These results were consistent with Ohison (1989) and Demski and Sappington, (1989) who also used earnings divided by stock price as an independent variable

Ali and Zarowin (1992) pointed out several earlier studies used earnings changes as a proxy for unexpected earnings, assuming annua! earnings are strictly permanent Instead, they split earnings into permanent and transitory components and showed the limitation in prior assumptions ~ earnings may not be strictly permanent

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Strong and Walker (1993) found improvement in the explanatory significance of earnings after correcting for the poor specification of the estimating equation The authors allowed for time series and cross sectional variation in the regression parameters Another improvement on prior studies was they partitioned earnings into pre-exceptional, exceptional (essentially one-time charges and credits) and extraordinary components They found pre-exceptional earnings exhibited a strong influence on stock returns

Efficient Market Hypothesis

Like the market for any other commodity produced in a free market economy, the capital market ts the mechanism for allocation of an economy’s capital (Fama, 1969) Security prices serve to allocate capital among the ultimate owners of capital, that is, investors Investors make these investment decisions assuming current securities’ prices reflect available information This is the foundation of the oft- referenced EMH Thus capital market equilibrium is dependent on information

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which were concerned with whether certain investor groups have monopolistic access to price-affecting information Essentially, Fama found support of the EMH in all three subsets

Subsequently, Fama improved his 1969 hypothesis In 1991, he admitted there was one main obstacle to his initial efficient markets theory Costs of information and costs of trading (such as brokerage commissions) were essentially ignored in his first study However, Jensen (1968) shortly afterwards included the commissions costs in his analysis Often, these costs were material and should have been included in any financial analysis of this type Subsequent to Fama’s 1969 study, virtually all studies of this type netted out some transaction costs out of the securities’ returns He also contributed to the signaling theory as shown below

Nonetheless, Fama (1991) found considerable support for the efficient markets hypothesis from several perspectives He cited several authors Charest (1978), Aharony

and Swary (1980) and Asquith and Mullins (1983), all of whom found positive correlation

between unexpected dividend changes and stock price changes

Charest (1978) noted dividend news conveyed information to investors about future earnings prospects, at the very least He analyzed 1,720 cash dividend changes between 1947-1967; of these, 1,193 were increases and 527 were decreases and found a systematic trader in dividend changing stocks would have realized unexpected returns, (about 1%) compared to the market average return during this time The only caveat to his findings was the results could have been impacted by contemporaneous earnings

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Aharony and Swary (1980) analyzed dividend announcements at least 11 days from the earnings announcements They found excess returns of 1% over the two- day announcement period

Corroborating the results of Charest (1978) and Aharony and Swary (1980), Asquith and Mullins (1983) found dividend increases increased shareholder wealth Essentially, this was a test of the semi-strong form of the EMH Specifically, they viewed 168 firms who either initiated dividends or resumed dividends after at least a 10-year hiatus, from 1963-1980 In addition, they found the increase in shareholder wealth was positively related to the magnitude of the dividend

Asquith and Mullins (1983) also confirmed the value of dividend as a signal to investors and potential investors and gave several reasons for dividend announcements’ significance The dividend was a unique signal because was backed by a commitment of cash, and was, therefore, a very credible signal Since the announcement was a cash commitment, the firm had to acquire the cash from the capital market if the firm did not internally generate enough cash to pay the dividend Lastly, dividend announcements were among the most visible of corporate signals

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Also, once initiated, it became difficult to stop dividend payment, definitely a negative signal,

These findings were inconsistent with some thinking that dividends (during periods studied) were taxed at higher rates than capital gains The findings were understandable, however, from the perspective that higher dividends generally meant higher than expected cash flows and/or earnings and a concomitant willingness of management to distribute this cash

The positive effect of dividend changes on stock prices was also confirmed in signaling models, which Fama (1991) cited These models were studied by Miller and Rock (1985), Easterbrook (1984) and Jensen (1976)

Fama also cited Asquith and Mullins (1986), Masulis and Korwar (1986), and Vermaelen (1981), all of whom found the announcement of new stock issues had a negative effect on current stock price Though one might have expected new stock issues to signal capital expansion for planned construction, etc and positive perceptions about the future, some reasons for this finding were plausible One was the fact that operating cash flows were, at the point of issuance of the new securities, presumably low

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26

Another type of event was studied by Dann in 1981 He focused on common stock repurchases’ impact on stock returns He found significant positive returns to stockholders within one day of common stock repurchase announcements

Dann’s interpretation of these findings was such announcements “ constitute a revelation by management of favorable new information about the value of the firm’s future prospects.” [p 136] He found the rationale for the repurchase did not reveal any expected improvement in the firms’ cash flows, but related the return increase to the information provided by the signal to the repurchasing firm

One last category in event studies is mergers and acquisitions As expected, stock returns bore a significantly positive relationship to companies considered targets of mergers and acquisitions Fama (1991) noted several analyses corroborating this proposition Mandelker (1974), Dodd and Ruback (1977), Bradley (1980), Dodd (1980) and Asquith (1986) all found significantly positive unexpected returns of securities of target firms These findings were not unexpected, since purchasers of a company’s stock generally had to pay a premium to persuade enough stockholders to sell

Tests for Private Information

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Insider Trading

This subsection explores the question ‘Do insiders have special information which is not reflected in current prices, and, therefore, results in unexpected returns to insiders?’ First, Jaffe (1974) studied insider trading and found the stock market was not necessarily efficient with respect to insider trading He found insiders have information that was not reflected in market prices and further discovered the market was slow to react to public information about insider trading In some cases, he found outsiders could have profited up to eight months after information about insider trading became public

However, subsequent rebuttals to Jaffe’s findings revolved around analyses by Seyhun (1986) and Banz (1981) Seyhun agreed insiders may profit from insider trading, but did not confirm outsiders profited in this manner, presumably by attempting to emulate insider’s trading patterns Seyhun’s study analyzed 769 firms (he broke firms down by size) who had 59,148 open market sales and purchases of their own securities by insiders from 1975-1981 Several interesting implications of his analysis were first, insiders generated unexpected stock price changes, but contrary to Jaffe’s (1974) findings, he did not find outsiders fared as well The last sentence in his study supported the EMH “This evidence is consistent with market efficiency: Outside investors can not use the publicly available information about insiders’ transactions to earn unexpected profits.” [p 211]

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28

Banz (1981) studied the relationship between the return and market value of common stocks listed on the New York Stock Exchange (NYSE) He analyzed price and return data for all common stocks quoted on the NYSE for at least five years between 1926 and 1975 and used three different types of return indices - the Center for Research in Security Prices (CRSP) equally- and value- weighted common stock indices The third was a value-weighted combination of the CRSP value-weighted common stock index and return data on corporate bonds

What cast doubt on Jaffe’s findings was the size effect discovered by Banz (1981) Small NYSE firms’ risk adjusted returns were higher than large NYSE firms The size effect was not linear, but was most apparent in the smallest firms in the sample Also, the effect was not stable through time He concluded by saying “ the size effect exists, but it is not at all clear why it exists.” [p 17]

On the basis of Seyhun’s and Banz’ findings, Fama (1991) concluded Jaffe’s high outsider profit could have resulted from this size effect Therefore, the EMH should not be discarded according to Fama

Private Information Services

Second, do information services, such as Value Line, have private information that is not reflected in stock prices, so does private information yield unexpected returns to its clients?

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prices, as evidenced by the relative movement of stocks after issuance of the report Surprisingly, he found the market takes as many as three days to respond to Value Line’s rankings Studies by Lloyd-Davies and Canes (1978) and Liu, et al (1990) showed similar results, though the research approaches were somewhat different

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Trading volumes more than two days before or two days after the announcements were much lower than the periods immediately surrounding the recommendation publication

After sorting through the evidence, Fama (1991) conceded, when private information was involved, capital markets were less than efficient (i e., stock prices did not reflect all private information) However, this was consistent with rational behavior by all investors, since unexpected returns to holders of private information at least partially compensated these investors for the costs they incurred for the information service subscription

Portfolio Management

Do professional portfolio managers have access to special information not reflected in stock prices and, therefore, yield unexpected returns to their clients and/or subscribers? If not, then why would investors pay professional portfolio management unless such management did not yield returns higher than the market?