Niklas Kohl
*Abstract
Firms which issue new equity have lower returns than other rms subsequent to issue. A prominent behavioral explanation holds that opportunistic rms exploit information asymmetry at issue time to sell overvalued equity (Loughran and Ritter, 1995). However, this pa-per shows that the most overvalued issuers, and those which are least constrained in the sense that they do not need to issue to continue operations or service current debt, have as high or higher long-run run returns than other issuers. Instead, I show that event returns, and in particular negative evnet returns (bad news) at event time predicts long-run abnormal return. This result is consistent with in-vestor underreaction to available information, rather than information asymmetry at event time.
∗Department of Finance, Copenhagen Business School, Solbjerg Plads 3, 2000 Fred-eriksberg, Denmark. E-mail: nk. @cbs.dk. I am grateful for comments and suggestions received from Søren Hvidkjær and Ken Bechmann. Any errors remain mine.
1 Introduction
Listed rms which issue new equity subsequently have low returns. This has been documented in numerous studies, initially by Loughran and Rit-ter (1995), in the context of seasoned equity oerings (SEOs), and laRit-ter in the broader context of rms which issue or retire equity, regardless of rea-son ((Daniel and Titman, 2006), (Ponti and Woodgate, 2008), (Fama and French, 2008b), (Fama and French, 2008a), (McLean et al., 2009)).
The reasons for the low returns are, however, disputed. Loughran and Ritter (1995), suggest that rms announce issues when their equity is grossly overvalued and the market does not revalue the stock appropriately, and the stock is still substantially overvalued when the issue occurs. According to the authors, their ... evidence is consistent with a market where rms take advantage of transitory windows of opportunity by issuing equity when, on average, they are substantially overvalued. Several more recent papers, in-cluding Ponti and Woodgate (2008), also fail to nd risk-based explanations for low returns post-issue.
A competing stream of literature argues that the apparent underperfor-mance subsequent to issue is due to exposure to known risk factors or at least known priced factors, which may or may not proxy for risk. Examples include Eckbo et al. (2000), Lyandres et al. (2008), and Bessembinder and Zhang (2013).
Billett et al. (2011) nd that repeating issuers, regardless of the type of security issued, underperform signi cantly, while rare issuers do not. A recent paper by Fu and Huang (2015) argues that signi cant issuer underper-formance has ceased to exists during the period of 2003-2012 because rms
become less opportunistic in stock repurchases and oerings due to more e cient pricing of stocks.
This paper contains two main results. First, I show that a large portion of issuer long-run performance is explained by exposure to priced factors beyond the Fama-French three factor model (Fama and French (1992), Fama and French (1993)). However, some signi cant underperformance remains unexplained.
Second, and more importantly, I investigate whether issuer long-run un-derperformance, as suggested by Loughran and Ritter (1995), is due to op-portunistic rms' exploitation of information asymmetry at event time. If information asymmetry is high at event time opportunistic rms may at-tempt to exploit this and, unless investors have rational expectations, rms may be successful at it. Thus, information asymmetry in combination with opportunistic issues and deviation from rational expectations at event time may explain long-run underperformance.
As an alternative to this explanation, I consider the possibility that in-formation asymmetry is low at event time. If inin-formation asymmetry is low at event time, rms will have less opportunity to be opportunistic in their issuance behavior. Nonetheless, long-run underperformance is possible due to investor underreaction at event time. There may be several reasons for investor underreaction. Barberis and Thaler (2003) survey a number of psy-chological biases which may aect how investors form their beliefs. In partic-ular, conservatism, belief perseverance, and anchoring may all explain why investors do not fully incorporate new information in prices immediately. Al-ternatively, delayed price reactions (under- as well as overreaction) can occur in models with gradual diusion of information (Hong and Stein, 1999) and
models with inattentive investors (Du e, 2010). Empirically delayed price reaction is found in a number cases, including post earnings announcement drift (Bernard and Thomas, 1989) and post dividend change announcement drift (Michaely et al., 1995).
For these two possibilities, information asymmetry and investor underre-action, I derive testable implications. Empirical results are consistent with the investor underreaction hypothesis but not the information asymmetry hypothesis. I nd no empirical evidence of the exploitation of information asymmetry because the most overvalued issuers and the least constrained issuers, which do not need to issue to nance operations or service current debt, overperform or have similar performance compared to less overvalued issuers and more constrained issuers. In contrast, I nd that the market does not fully absorb information conveyed at event time, in particular bad news at event time. This causes long-run return predictability, in particular when event returns are negative. To the best of my knowledge, this is a new
nding.1
While early research focused on the performance of seasoned equity of-fering (SEO) rms, most recent work on the relation between issuance and return considers the full cross-section of rms to capture the impact of equity issues and repurchases, regardless of reason. This approach has the advan-tage of a much larger sample than studies focused on SEOs and, according to Ponti and Woodgate (2008), ... results are essentially unaected by data associated with seasoned equity oerings ..., documenting that the low returns subsequent to SEOs is part of a broader issuance eect.
1Apart from the preliminary version of this result found in the rst paper of this dissertation.
However, McKeon (2015) shows that in around 90% of rm-quarters where new equity is issued, the rm itself did not initiate any stock is-sues. These are issues due to, for example, utilization of employee options and other decisions beyond the control of the rm. McKeon denotes these investor-initiated issues as opposed to rm-initiated issues, typically in the form of SEOs, where the rm takes initiative to issue new equity. McKeon (2015) shows that relative issue size, i.e. proceeds of the issue relative to
rm market value, is an empirically strong indicator of rm-initiated issues since quarters with a relative issue of at least 3% nearly always contain a
rm-initiated issue whereas quarters with a relative issue of less than 2%
almost never include a rm-initiated component.
Since the objective of this paper is to test whether information asymme-try explain subsequent issuer performance, I limit the sample to situations where this may possibly have occurred, i.e. to rm-initiated issues. Limiting the sample to SEOs has the further advantage that an announcement event can be clearly identi ed. I recon rm that SEO announcements do, in fact, convey information, since event returns are, on average, strongly signi cantly negative. To measure the sign of the information conveyed, I interpret neg-ative event return as bad news and the less frequent positive event return as good news. This enables me to determine to what extent information conveyed at event time is fully incorporated in prices at event time.
The outline of the remainder of the paper is as follows. In Section 2, I discuss what could drive issuer underperformance. I show how information asymmetry at event time can cause underperformance at event time and subsequently, and I present an alternative - that underperformance is caused by underreaction to news at event time. Section 3 presents data and
vari-ables used. Section 4 presents average issuer returns before and after issue, con rming high abnormal return pre-issue, negative abnormal event return, and negative abnormal return post-issue. In Section 5, event returns are regressed on characteristics hypothesized to explain event return. Section 6 examines the explanations behind issuer long-run abnormal returns. Two dierent methodologies are applied. First, buy and hold abnormal returns, calculated relative to dierent factor models, are regressed on characteris-tics hypothesized to explain long-run return. Second, issuers are sorted on these characteristics and calendar-time portfolios of issuers, and long-short calendar-time portfolios of issuers matched with non-issuers, are constructed.
Finally, Section 7 concludes.