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Abstract:
We test the predictions of the three main behavioral finance theories of market under- and overreaction using out-of-sample data conditional on the nature of the news using the going-concern audit opinion (bad news event) and its withdrawal (good news event). We find strong support for the Daniel, Hirshleifer and Subrahmanyam (1998) model for our bad news as well as the good news case suggesting that market underreaction to going-concern opinions is a consequence of prior market overreaction resulting from incorrect classification of going-concern firms by investors into trending regimes. In contrast, we find no support for the Barberis, Shleifer and Vishny (1998) or Hong and Stein (1999) models in our event-study setting in either the bad or good news cases. Our results have a number of implications relating to the value of such theoretical behavioral finance models in practice. We also highlight the central role of the limits-to-arbitrage assumption when testing such behavioral finance theories.

finance, under- and overreaction models, limits to arbitrage, going-concern

Abstract:
Recently developed corporate bankruptcy prediction models adopt a contingent-claims valuation approach. However, despite their theoretical appeal, tests of their performance compared with traditional simple accounting-ratio-based approaches are limited in the literature. We find the two approaches capture different aspects of bankruptcy risk, and while there is little difference in their predictive ability in the UK, the z-score approach leads to significantly greater bank profitability in conditions of differential decision error costs and competitive pricing regime.

failure prediction, credit risk, option-pricing models, z-score, bank profitability

Abstract:
This paper identifies the firm-specific information events that drive economically relevant stock price and trading volume changes. It employs a novel methodology that is not constrained by an arbitrarily determined set of information events and allows for event anticipation and information leakage prior to public disclosure.

We find that no less than 65% of significant price changes and trading volume movements in our sample can be readily explained by public domain information. In addition, we find that a parsimonious set of news categories represent the key drivers.

Sell-side analyst stock recommendations and earnings forecast revisions as a class, unaccompanied by other newsreleases, dominate all other news categories in terms of significant market reaction. They explain 17.4% of major market-adjusted price changes and 16.1% of significant trading volume activity triggered by reported corporate news events. In particular, this compares with 17.0% (15.2%) of economically significant price changes (trading volume movements) driven by firms' formal accounting releases.

However, taking into account the relative magnitude of market response to different news releases, firms' formal accounting disclosures dominate within this domain. As such, we conclude these are not fully anticipated by apparently more timely market disclosures, and that the existence of news services and the activities of the sell-side analyst are not substitutes for a firm's interim and preliminary results.

Abstract:
In this first study to test formally the market value of investor relations (IR) activity, we employ the annual US Investor Relations Magazine Investor Relations Awards from 2000 to 2002 to proxy for the quality of firm investor relations. We find firms perceived to have the most effective IR strategies earn superior abnormal returns, both before and after the nominations. This shows that while the nominations themselves may be influenced by past performance to some extent, they are nonetheless also associated with subsequent positive abnormal returns. We also find that not surprisingly, higher analyst following is associated with more nominations suggesting analysts tend to favour the stocks they follow. Consistent with effective IR leading to lower information risk, liquidity of nominated firms increases in the year subsequent to the nominations. Overall, our evidence is consistent with effective IR successfully reducing risks associated with high information asymmetry, as predicted by information risk and agency theories.

investor relations, stock liquidity, asymmetric information

Abstract:
The relative merits of schematic faces for the communication of multivariate information have been explored in a number of disciplines. Existing studies in the financial environment suggest that they may be superior to conventional methods in both their communications and decision-making qualities.

This paper employs an innovative research design to demonstrate the relative usefulness of schematic faces in the failed/non-failed decision-making context compared to accounting statements and financial ratios. An optimum assignment of financial variables to facial characteristics is suggested, one which demonstrates the usefulness of schematic faces as a decision tool in the financial environment. Schematic faces are shown to be processed more quickly and with no loss of accuracy, compared to more traditional means of presenting financial information.

Existing applications of schematic faces have been deficient in a number of areas. This study employs a complex research design involving multiple treatments to overcome the confounding problems of subject variability while also addressing the impact of differential priors and differential misclassification costs.

Abstract:
Financial economists are unable to provide plausible explanations for Internet stock valuations during the recent asset pricing bubble consistent with market rationality. Adopting a psychoanalytic perspective, this paper argues that investors became caught up emotionally with the drama leading to market prices departing in such an extreme way from fundamental value. Specifically, we propose a psychoanalytic theory of mental objects and show how this helps explain what actually took place during the different phases of dot.com mania. The paper concludes, more generally, that an understanding of how emotions determine psychic reality in stock valuations can usefully complement the contribution of conventional normative asset pricing models.

Dot.com stocks, mania, valuation models, psychoanalysis, mental objects

Abstract:
This study examines the comparative information content of the going-concern opinion in very similar auditing and capital market environments but divergent legal regimes. We hypothesize that, ceteris paribus, investors in a creditor-friendly bankruptcy regime (the U.K.) react more adversely to a first-time going-concern audit opinion indicating increased risk of loss associated with bankruptcy than do investors in a debtor-friendly bankruptcy regime (the U.S.). Our empirical results are consistent with this expectation. Our findings have clear implications for standard-setters and regulators who, in pursuing international harmonization of accounting and auditing standards, need to take into account how such standards interact with local legal regimes, and consequently their informativeness to capital market participants.

bankruptcy codes, going concern, international capital markets, international accounting standards

Abstract:
Using a unique database of management ratings over a 14 year period, we find that quality of management is value relevant in that better managed firms have lower cost of equity, higher market valuations, more stable earnings, and higher profitability that persists over time. Paradoxically, while good management appears to be associated with lower subsequent market returns, this is entirely consistent with an informationally efficient market.

cost of equity, expected returns, management reputation, resource based view, Management Today, efficient market hypothesis

Abstract:
We explore the differential market reaction to the unambiguous bad news and good news signals provided by the going-concern audit opinion and its withdrawal for 845 firms from 1994 to 2002. Results show asymmetric market response to these news events. The market underreacts to such bad news disclosures, resulting in a downward drift of around -16% over the one-year period subsequent to the going-concern opinion, but treats good news consistent with theory. This post-going-concern announcement drift is also distinct from other established anomalies; however, we find no such evidence for going-concern cases with positive earnings surprise. Adjusting for transactions costs, the opportunity to earn profits by trading on this anomaly is limited and highly risky. Additional analyses of stockholder trading activities reveal that institutional investors reduce their holdings in such stocks on a timely basis in contrast to retail investors. Our results indicate that despite clear adverse signals about the firm's continuing financial viability being conveyed by the auditor to investors, this information is not being fully impounded by the market on a timely basis, in contrast to the good news conveyed by going-concern withdrawals. Our findings add to the existing literature calling into question the ability of the market to rationally price stocks in the case of acute public-domain bad news disclosures, as opposed to good news releases.

Market underreaction, going-concern, behavioral finance, limits to arbitrage

Abstract:
We explore the medium-term market reaction to going-concern modified audit opinions and their withdrawal for a large sample of firms from 1994 to 2002. Results show asymmetric market response to these accounting system disclosures. The market underreacts to going-concern opinions, resulting in a subsequent downward drift of around -16% over the one-year period subsequent to the going-concern opinion, but fully anticipates their withdrawal. This post-going-concern announcement drift is distinct from other established anomalies; however, it is limited to those going-concern cases with negative earnings surprise. Nonetheless, adjusting for transactions costs, the opportunity to earn profits by trading on this anomaly is limited and risky. Analysis of stockholder trading activities reveals that institutions reduce their holdings in such stocks on a timely basis in contrast to retail investors. Our results are original, and indicate that auditors are providing clear messages to financial statement users in the going-concern context but their information content is not being fully impounded by the market on a timely basis.

Market anomalies, Investor Biases, Limits to arbitrage, Going-concern

Abstract:
This paper brings together the evidence on two asset pricing anomalies - continuation of prior returns (momentum) and the market pricing of distressed firms. Our empirical analysis demonstrates both these effects are driven by market underreaction to bad news, and that momentum is largely subsumed by our distress risk factor. We also extend the extant literature on the market pricing of distress risk by considering this conditional on market state and GDP growth rate, and find little evidence that financial distress risk is a priced risk factor.

Asset pricing, risk factor, momentum, market classification

Abstract:
Kosowski, Timmermann, Wermers, and White (2006) find that certain growth-oriented fund managers have substantial skill but do not stipulate the particular skills that they possess. We use novel factor timing models to examine in detail the timing skills of 3,181 US equity mutual funds classified as having a growth investment objective by Standard & Poor's, over the period from 1993 to 2006. To control for idiosyncratic variation in mutual fund returns, the bootstrap method of Kosowski et al. is used to analyze the significance of alpha and timing beta estimates. To exclude the possibility that the observed timing ability is due to good luck, synthetic funds are examined as in Busse (1999). Our results indicate that growth-oriented fund managers who earn abnormal returns demonstrate substantial growth timing skill, i.e. successful timing activity across the growth/value spectrum. This observed growth timing ability accounts for at least 45% of abnormal returns and is persistent; the top 10% of funds which demonstrate growth timing ability in the past three years also demonstrate the best growth timing ability in the following year. Successful growth timing is confined to those managers who invest primarily in growth stocks. However, there is little evidence of successful market timing (i.e. forecasting future market states and weighting equity exposure accordingly), size timing (i.e. adjusting exposure between small and big capitalization stocks) or momentum timing (i.e. switching between momentum investing and contrarian investing strategies). The models employed clearly distinguish between growth timing and market timing, thereby avoiding a common misidentification problem.

Growth-oriented equity mutual funds, Growth timing, Timing skill

Abstract:
Bankrupt firms’ stock displays unique lottery-like characteristics: for only a few cents per stock one can engage in an investment strategy that offers a low probability of huge future reward, and a very high probability of a small loss. Kumar (2009 a) shows that this type of stock is likely to be attractive to large numbers of relatively less sophisticated individual investors. Using a sample of 351 firms filing for Chapter 11 bankruptcy reorganization and that continue trading on a major stock exchange we confirm that individual investors like to trade in such lottery-like stocks. To be precise, individual investors own, on average, 90% of the stock of firms undergoing Chapter 11 reorganization. More importantly, we explore the market pricing implications of gambling-motivated trading. We find a strong, negative, and statistically significant post-bankruptcy drift of at least -28% over the following year, which is robust to a range of alternative measurement approaches, and is distinct from other known market-pricing anomalies. When investigating the potential role of arbitrageurs in the market for bankrupt firms we find that implementation costs and risk are very high. As such, sophisticated investors will likely have a hard time if they try to exploit the mispricing of bankrupt firms we uncover.

bankruptcy, lottery stocks, limits to arbitrage, retail investors, institutional investors, event study

Abstract:
This paper explores whether firm-specific information events drive economically relevant positive and negative stock price changes and trading volume and, if so, the nature of such information. We find that no less than 65% of significant price changes and trading volume movements in our sample of FTSE 350 companies can be readily explained by public domain information contradicting the thesis that corporate news is not a primary driver, and that share price changes and trading volume activity are driven by factors unrelated to information flows per se. In addition, we find that a parsimonious set of news categories represent the key drivers. Sell-side analyst stock recommendations and earnings forecast revisions as a class, unaccompanied by other news releases, dominate all other news categories in terms of significant market reaction. However, taking into account the magnitude of market response to different news releases, firms' formal accounting disclosures dominate within this domain. As such, we conclude these are not fully anticipated by apparently more timely market disclosures, and that the existence of news services and the activities of the sell-side analyst are not substitutes for a firm's interim and preliminary results.

Abstract:
The UK regulatory requirements relating to going-concern disclosures require directors to report on the going-concern status of their firms. Such directors have incentives not to report fairly in the case of financially-distressed firms. We expect effective corporate governance mechanisms will encourage directors to report more truthfully in such situations. This paper tests this proposition explicitly using a large sample of going-concern cases over the period 1994-2000. We find that whereas auditors' going-concern opinions predict the subsequent resolution of going-concern uncertainties directors' going-concern statements convey arbitrary and unhelpful messages to users. However, robust corporate governance structures and high auditor reputation constrain directors to be more truthful in their going-concern disclosures, bringing these more into line with the more credible auditor opinions.

Abstract:
This paper tests whether sell-side analysts are prone to behavioural errors when making stock recommendations as well as the impact of investment banking relationships on their judgments. In particular, we analyse their report narratives for evidence of cognitive bias. We find first that new buy recommendations on average have no investment value whereas new sell recommendations do, and take time to be assimilated by the market. We also show that new buy recommendations are distinguished from new sells both by the level of analyst optimism and representativeness bias as well as with increased conflicts of interest. Successful new buy recommendations are characterised by lower prior returns, value stock status, smaller firms and weaker investment banking relationships. On the other hand, successful new sells do not differ from their unsuccessful counterparts in terms of these measures. As such, we provide evidence that analysts are prone both to behavioural bias as well as potential conflicts of interest in their new buy stock recommendation decisions. We also show that these two explanations of analyst behaviour are to a great extent independent of each other. Consequently, the recent attempts by regulators to address potential conflicts of interest in analyst behaviour may have only limited impact.

Abstract:
We investigate the stock price reaction to UK going-concern audit report disclosures in the calendar year subsequent to publication. Over this period our firm population underperforms by between 24% and 31% depending on the benchmark adopted. This market underreaction to such an unambiguous bad news release is not a post-earnings announcement drift phenomenon; it is also robust to other potentially confounding explanations. However, whatever the reasons for such stock mispricing, we find costly arbitrage prevents rational investors forcing prices back into line with fundamental value. Our results have implications for the market's ability to impound bad news appropriately and the incompleteness of arbitrage in such small "loser" firm situations.

Market anomalies, Investor biases, Behavioral finance, Limits to arbitrage

Abstract:
Although there is an extensive literature on the market's anticipation of, and short-term reaction to, the bankruptcy event, the longer-term reaction to Chapter 11 filing has not been properly examined to date. We investigate the subsequent performance of the 351 non-financial, non-utility firms entering into bankruptcy protection between 1979 and 2005, and which continue trading on a major exchange. Consistent with previous research, we find negative abnormal and raw returns both before, and at the Chapter 11 date. However, more importantly, we find a strong, negative and statistically significant post-bankruptcy abnormal return of at least -28% over the 12-month period after the event date. Such market underreaction is consistent with research in other domains suggesting that the market has difficulty in dealing appropriately with extreme bad news events. We also find that the post-Chapter 11 drift is distinct from other reported market anomalies. Potential explanations for our anomalous results are presented.

market-pricing anomaly, bankruptcy, event study, efficient market hypothesis