Underreaction to Self-Selected News Events: The Case of Stock Splits

Abstract

In the last decade, an emerging body of research looking at self-selected, corporate news events concludes that equity markets appear to underreact. Recent theoretical papers have explored why or how underreaction might occur. However, the notion of underreaction is contentious. Concern has focused on two issues-spurious results from unusual time periods and/or misspecified return benchmarks or methods. In this paper, we revisit the issue of underreaction by focusing on one of the most simple of corporate transactions, the stock split. Prior studies that report abnormal return drifts subsequent to splits do not appear to be spurious, nor a consequence of misspecified benchmarks. Using recent cases, we report a drift of 9% in the year following a split announcement. We consider fundamental operating performance as a source of the underreaction. Splitting firms have an unusually low propensity to experience a contraction in future earnings. The evidence suggests that investors underreact to this information. Analyst earnings forecasts are comparatively too low at the time of the split announcement and appear to revise sluggishly over time, a result consistent with underreaction by markets to corporate news events.

Divergence of Opinion Surrounding Extreme Events

“…Yet, financial markets sometimes appear to have difficulty correctly interpreting new information on publicly traded firms. Kang et al (1999), Houge et al (2001), Ikenberry and Ramnath (2002) and Lamont and Thaler (2003) all provide recent evidence of apparent capital market failure to properly price equity shares.…”

Knowledge discovery in corporate events by neural network rule extraction

“…Such events include dividend initiations, resumptions, and omissions [1,2]; earnings forecast revisions [3]; stock repurchases [4]; and stock splits [5,6]. The prices continue to drift in the same direction as the announcement date reaction.…”

Impact of Public Announcements on Stock Prices: the Example of Lithuanian Stock Market Considering Values of Stock Prices

“…However, a growing amount of studies show that the activity of financial markets reflected by movements of stock prices does not always comply with the Efficient Market Hypothesis as determined by Fama [6]. While the results of some studies show that stock markets overreact to news [2], [15], [1], the others observed an underreaction [21], [7], [11]. Thus in many cases the role of information in stock markets could not be determined as unambiguous.…”

“…Bearing in mind the fact that the main source of new information about any company gained by the concerned parties usually are the public announcements which companies deliver in various ways, the stock prices on an efficient market should react directly to all the new information announced by companies [6], [7]. However, a growing amount of studies show that the activity of financial markets reflected by movements of stock prices does not always comply with the Efficient Market Hypothesis as determined by Fama [6].…”