Return Reversal in UK Shares

Abstract

We investigate whether shares that have experienced extreme stock market performance over a five year period become mis-priced leading to opportunities for exploiting that mis-pricing. The results cast serious doubt on the efficiency of the UK stock market to price these shares. This means that managers of these companies may be receiving distorted signals from the market, which will have a knock-on effect on a range of managerial decisions, from the estimation of the equity cost of capital to the timing of share issues. More specifically we find that the 10 per cent of shares with the worst total share return record over five years go on to produce the highest returns in the subsequent five years with an average out-performance of 8.9% per year - defying those who would write these companies off as the 'dogs' of the market. Those that are currently flying high on the market (the 10% best performers over five years) go on to under-perform by 47% over the next five years - suggesting that the 'darlings' of the market tend to become over-priced leading to the possibility of excessive resource allocation in their favour. This systematic long-term reversal of share returns is observed over the entire period 1960-2002. Loser shares (the worst performing shares in the prior five years) out-perform winner shares (the best performing shares over the prior five years) by about 14% per year. By separating the firm size (market capitalization) effect from the return reversal effect we show the presence of both. This evidence is in direct contradiction to Clare and Thomas (1995), who found no return reversal in UK shares following an adjustment for size. Return reversal is a feature of large as well as small companies and a seven-part consideration of risk does not substantiate the argument that loser out-performance is compensation for risk. We also consider some the arguments concerning the behavioural and institutional constraints that may permit the continuance of the return reversal effect over a long period with insufficient arbitrage pressure to eliminate it.

Keywords: Return reversal, Overreaction, Market inefficiency, Market efficiency, information and market efficiency

JEL Classification: G14