Stock Analysis Consumer Discretionary Sector SONY CORPORATION

University Degree Business and Administrative studies

STOCK SPLIT ANNOUNCEMENTS: A TEST OF MARKET EFFICIENCY

ABSTRACT

An efficient market is a market where all relevant information is available to all participants at the same time, and where prices respond immediately to available information. Stock markets are considered the best examples of efficient markets. This means that possibility exists for investors to make sustainable, above normal, returns. The purpose of this study is to test market efficiency – effects of stock split announcements on stock price. This analysis will focus closely at the semi-strong form efficient market hypothesis. Particularly, is it actually possible to earn an above normal return on a publicly traded stock when the firm announces a stock split? Numerous past studies suggest a capital market is said to be efficient with respect to corporate event announcements (stock split, buyback, right issues, bonus announcement, mergers and acquisition, dividend etc). However, according to the semi-strong form efficient market hypothesis, it is not possible to consistently outperform the market by using public information such as stock split announcements. This type of information should impound stock price sufficiently fast to disallow any investor’s earning an above normal risk adjusted return. Evidence here supports the positive signal associated with the sample of stock split announcements examined. Likewise, the study results support the semi-strong form efficient market hypothesis.

INTRODUCTION

One of the most controversial issues in finance is whether the financial market is efficient in using economic resources and information or not. Yet, other financial theory issues such as volatility, predictability, speculation and anomalies are also related to the efficiency issue and are all interdependent (Hassan, Kabir, and Anisul Islam (2000)). Primarily, the term efficiency is used to describe a market in which relevant information is impounded into the price of financial assets. Many researchers have referred (and still refer) to stock splits as financial puzzles (Dimson, Elroy, and Massoud Mussavian). The nature of stock splits possibly stems from two widely held, but interesting views: stock splits are merely costly paper shuffling exercises that cannot affect the value of the firm; and the value of the firm immediately and significantly increases upon the announcement of impending stock splits (Arbel, Avner, and Gene Swanson). The second view recently has gained credibility from studies that carefully document positive effects around the time of stock split announcements. Several reasons for these announcement effects have been offered such as trading range, attention, signaling, and tax, yet important questions remain unanswered.

This study will analyze the role that information plays in stock split announcement effects by examining pure stock split announcements across a range of stocks differing in terms of their information. Often, when a company announces a stock split, it will encourage more interest in the firm. A stock split is essentially when a company increases the number of shares (Joshua Kennon). For example, if you owned 30 shares of XYZ at $20 per share, and there was a 2-1 stock split, you would then own 60 shares worth $10 each. Why do companies issue splits if you still have the same amount of money?

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Liquidity. Some companies believe that their stock should be inexpensive so more people can buy it. This creates a condition where more of the company's stock is bought and sold. And generally is viewed by investors as a positive signal about the company’s future performance. The problem, in theory, is that the increased activity will also leads to bigger gains and drops in the stock, making it more volatile (Joshua Kennon).

So, how fast does the stock market react to publicly announced information? According to Gene Fama (1970), market efficiency can take on three forms: weak form efficiency, semi-strong form ...

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So, how fast does the stock market react to publicly announced information? According to Gene Fama (1970), market efficiency can take on three forms: weak form efficiency, semi-strong form efficiency, and strong form efficiency. The efficient market hypothesis implies the stock market should immediately respond to public announcements of stock splits making it impossible for an investor to make an above normal return on their investment by acting on such information. This study investigates whether an investor can achieve an above normal return by acting on public announcements of regular stock splits. The study tests the efficient market hypothesis by assessing the investor’s ability to earn an above normal return in the short run by acting on stock split announcements.

BACKGROUND AND PURPOSE

The purpose of this event study is to test the market efficiency theory by analyzing a sample of 30 regular stock split announcements impact on the firm’s stock price. Specifically, how fast does the market price of the firms’ stock react to the sample examined? Gene Fama defined market efficiency in terms of how fast stock market reacts to information. This research tests whether the announcement of stock splits react directly to Gene Fama’s three hypothesis forms of market efficiency; strong form, semi-strong form, or weak form.

For this study 30 randomly chosen, publicly traded, two for one stock split have been analyzed. This study tests the effects of the samples stock prices using the standard risk adjusted event study methodology. If a strong correlation exists between an announcement and an immediate equity market price change, there may not be opportunity to earn an above normal return and such evidence would support the efficient market theory hypothesizes of Gene Fama.

LITERATURE REVIEW

Gene Fama, a finance researcher out of the University of Chicago, defined market efficiency in terms of how fast the stock market reacts to information. He defined the efficiency in three different forms: weak-form, semi-strong form and strong-form. Weak-form efficiency deals with the notion that stock price react so fast to all past information that no investor can earn an above normal return when acting on information. For example, if an investor receives a firms report and buys the firm’s stock after discovering the firm had high earnings for the period. If the stock does not rise after the stock has been purchased by the investor than the market is said to be efficient with respect to past information and is weak-form efficient. Many studies support the random walk theory in support of weak form efficiency. Some have chosen to concentrate on individual markets such as: study of random walks in Korea (Ayadi and Pyun 1994, Ryoo and Smith 2002) the United Kingdom (Poon 1996) and Turkey (Buguk and Brorsen 2003). However, other studies have focused on emerging markets such as: Markets in Asia (Huang 1995) and Latin America (Ojah and Karemera 1999).

Semi-Strong form efficiency deals with the notion that stock price react so fast to all public information that no investor can earn an above normal return when acting on information. Public announcements of stock splits, repurchases, dividend increases are examples of public information. So for example, if an investor buys stock on the announcement and still does not make and above normal return (higher than the S&P 500) then the market is semi-strong form efficient. Studies which test semi-strong form efficiency consist of: Berry and Howe (1994) who looked for association in pattern of hourly public information arrival and aggregate measures of intraday market activity and Ball and Brown (1968) which documents the claim that no investor can earn and above normal return on publicly available information such as accounting statements, stock split announcements, dividend announcements, sale of stock announcements, repurchase of stock announcements, block trades, and earnings announcements.

Strong-form efficiency deals with the notion that stock price react so fast to all information (public and private) that no investor can earn an above normal return when acting on information. The market reacts to an event within the confines of the firm (secret information) when it occurs even before it is publically announced. For example, an investor must act on inside information, which is illegal. If an investor buys the stock on the event and still does not make an above normal return, then the market is strong-form efficient. To date some work which has already been done in evaluating strong-form efficiency are Jaffe (1974), Pratt, Givoly and Palmon (1985).

Weak form efficiency expresses that a company’s stock price is based on past prices and information, while strong form efficiency states that the stock price is a reflection of all information, public and private. Both of these theories have great importance however; this study focuses on stock split announcements. Stock split announcements are reflected in the company’s stock price according to the semi-strong form of efficiency, stating that all public information available determines stock price.

METHODOLOGY AND STUDY SAMPLE

The study sample analyzes 30, randomly selected, two for one stock split announcements between the time period January 1, 2007 and January 1, 2008. The random sample was selected from two for one stock split announcements traded either on the NYSE or NASDAQ. Table 1 describes the sample.

Table 1: DESCRIPTION OF STUDY SAMPLE

To test semi-strong market efficiency with respect to public announcements of stock splits and to examine the effect of stock split announcements on stock return around the announcement date, this study proposes the following null and alternate hypotheses. The null hypothesis is the values you do not expect (H0: β ≤ 0); the alternative hypothesis is the values you expect (HA: β ≥ 0).

H10: The adjusted stock price return of the sample of firms announcing stock splits is not significantly affected by information on the announcement date.

H1A: The adjusted stock price return of the sample of firms announcing stock splits is significantly positively affected by information on the announcement date.

H20: The adjusted stock price return of the sample of firms announcing stock splits is not significantly affected by information around the announcement date as defined by the event period.

H2A: The adjusted stock price return of the sample of firms announcing stock splits is significantly positively affected by information around the announcement date as defined by the event period.

This study uses the standard risk adjusted event study methodology from the finance literature. The announcement date (day 0), obtained from http://finance.yahoo.com/, is the date of the firm’s announcement of the stock split. The required historical financial data, i.e. the stock price and S&P500 index during the event study period was also obtained from the internet website http://finance.yahoo.com/.

The historical stock prices of the sample companies, and S&P 500 index, for the event study duration of -180 to +30 days (with day –30 to day +30 defined as the event period and day 0 the announcement date) were obtained.
Then, holding period returns of the companies (R) and the corresponding S&P 500 index (Rm) for each day in this study period were calculated using the following formula:

Current daily return = (current day close price – previous day close price)

previous day close price

A regression analysis was performed using the actual daily return of each company (dependent variable) and the corresponding S&P 500 daily return (independent variable) over the pre-event period (day –180 to –31 or period prior to the event period of day –30 to day +30) to obtain the intercept alpha and the standardized coefficient beta. Table 2 shows alphas and betas for each firm.

Table 2: ALPHAS AND BETAS OF STUDY SAMPLE

For this study, in order to get the normal expected returns, the risk-adjusted method (market model) was used. The expected return for each stock, for each day of the event period from

day -30 to day +30, was calculated as:

E(R) = alpha + Beta (Rm),

where Rm is the return on the market i.e. the S&P 500 index.

Then, the Excess return (ER) was calculated as:

ER = the Actual Return (R) – Expected Return E(R)

Average Excess Returns (AER) were calculated (for each day from -30 to +30) by averaging the excess returns for all the firms for given day.

AER = Sum of Excess Return for given day / n,

where n = number of firms is sample i.e. 30 in this case

Also, Cumulative AER (CAER) was calculated by adding the AERs for each day from -30 to +30.

Graphs of AER and Cumulative AER were plotted for the event period i.e. day -30 to day +30. Chart 1 below depicts Average Excess Return (AER) plotted against time. Chart 2 below depicts Cumulative Average Excess Return (CAER) plotted against time.

REFERENCES

Dimson, Elroy, and Massoud Mussavian. "A brief history of market efficiency." European Financial Managment 4 (1998): 91-193. Web.

Arbel, Avner, and Gene Swanson. "Quarterly Journal of Business and Economics." The role of information in stock split announcement effects 32 (1993). Web.

Hassan, Kabir, and Anisul Islam. "Market Efficiency, Time-Varying Volatility and Equity Returns in Bangladesh Stock Market." Applied Financial Economics 6 (2000). Print.

Jaffe, Jeffrey J. “The Effect of regulation Changes On Insider Trading.” Bell Journal of Economics and Management Science.

Raja, M., and M. Selvam. "Testing the Semi-Strong form Market Efficiency of the Indian Stock Market." International Research Journal Finance and Economics 25 (2009). Web.

Worthington, Andrew, and Helen Higgs. "Weak-form market efficiency in European emerging and developed stock markets." School of Economics and Finance. Web.

Syed, Salman, and Khalid Mustafa. "Testing Semi-strong Form Efficiency of Stock Market." Tha Pakistan Development Review II 40.4 (2001): 651-74. Web.

Islam, Sardar, and Colin Clark. "Are Emerging Financial Markets Efficient?" Web.

Pillotte, Eugene. "Earnings and Stock Splits in the Eighties." Journal of Financial and Strategic Decisions 10.2 (1997). Web.