Pricing Anomalies: Cross Sectional Anomalies
Cross sectional anomalies can be categorized into two groups, namely, Value Effect and Size Effect.
Several studies in markets across the world have yielded the following results. Stocks with below average price-to-earnings and market-to-book ratios have consistently outperformed growth stocks over a period of time. This is a contradiction of the semi-strong efficient market form as financial disclosures are used to beat the market consistently.
Fama and French used a three factor model that takes into account the size of the company as measured by the market value of its equity and the company’s book value of equity divided by its market value of equity. This model unlike CAPM (Capital Asset Pricing Model) factors elements of risk which when applied takes the anomalies away.
One study observed that on a risk-adjusted basis small-cap equities out-performed large cap equities. This anomaly was not observed in further studies and was therefore disregarded.
Other anomalies that have been observed and documented include close-end investment fund discounts, returns on initial public offerings and the predictability of returns based on prior information.
Close-end investment fund discounts
A close ended fund issues a limited number of shares during one offering, thus fixing the market capitalization till a second offering is made. In theory these shares must trade at their net asset value or NAV. In practice they usually trade at a discount in the 4-10% band. Exceptions have been documented where they traded at a large premium or at deep discounts of 50%. One of the explanations for this quandary is tax liabilities. Pre-purchase liabilities and gains means the investor has little control over the losses or gains he incurs. Another explanation is illiquidity of these shares as compared to more liquid stocks that are traded publicly.
Both these explanations explain the discounts in part and not in entirety.
Pricing anomalies studied in the context of adjustment of stock prices in relation to earnings announcement come under the purview of earning surprise.
Earnings surprise or an unexpected part of earnings that takes investors by surprise should result in a price increase of the stock. Studies have proved that while these earnings surprises have reflected in the stock prices, the actual adjustment has not always been as efficient. A major portion of the adjustment takes place prior to the surprise, but adjustments do take place post the announcement as well. Those with positive surprises have generally gone on to give good stock performances and those with negative surprises poor stock performances. Therefore the possibility of making abnormal profits based on stock surprises exist. Risk and transaction costs however are not truly accounted for in these studies and cannot be used with certainty as a method to earn abnormal profits.
Initial Public Offerings
Companies avail the services of investment banks in pricing and marketing of their shares in their first stock market foray. As the entrants are new, their selling prices are set low and tend to see an increase on the first day of trading.
Underpricing is the percentage difference between the issue price and closing price on the first day. An investor who has purchased at the offer price can make an abnormal profit by offloading their shares at closing prices. If the issue price is too high though and the prices at which they are traded on the first day are too low, losses can be incurred. In reality abnormal profits are not made since markets adjust quickly to the ‘true’ or real value.
Abnormal profits based on prior dividends
Market researchers state that equity returns are impacted by stock volatility, inflation, interest rates and dividend yields. This should indicate market inefficiency especially of weak form. This does not hold true though over a period of time. The relationship between stock prices and dividends has been found to vary from positive to negative from time to time.
Can these studies on pricing anomalies be exploited to make abnormal by the investor? Realistically, no. These studies do not truly show lacunae in market efficiency, but lacunae in the statistical methodologies used to identify the anomalies. There are best left as theory and not put in practice.