What dictates returns in foreign stocks? Is it driven by corporate events, a country’s market dynamics, or the attributes of the company? In a novel study of foreign stocks, SMU Cox Finance Professor Feng Zhang and coauthors upend the finance literature. “A motivation for our paper was to see whether firms earn abnormal returns after major corporate events,” says Zhang. “We’re testing whether information is understood by the market, in the manner of Nobel Prize winner Eugene Fama, renowned for his efficient markets hypothesis.”
In an international context, the authors developed the most comprehensive analysis to date about whether returns are “abnormal,” or unusually positive or negative, after corporate events. Many studies consider some countries, certain corporate events and specific firm characteristics. In this study, a massive undertaking, Zhang and coauthors analyze nearly 52,000 stocks across 58 foreign countries from January 1996 to December 2020. The study’s events include share repurchases, dividend initiations, stock issuances, mergers and acquisitions, and stock splits.
Importantly, while academic research often cites what an “abnormal” return is, they ask what is normal? “That’s hard to get at,” Zhang says. Prior literature he notes, when discussing what is normal, often reveals it through simple analysis. However, the authors use a much more comprehensive set of variables, utilizing 14 firm characteristics, from which to benchmark future returns. Examples of firm characteristics include size, debt, asset growth and liquidity.
In a 2019 predecessor paper focused on U.S. stocks, the authors looked at U.S. firms and the type of benchmarking to predict returns; this paper does the same in a foreign stock setting. The study also considers the 2015 research by Lewellen, which indicates that firm characteristics predict future returns in U.S. stock markets. Interestingly, the conclusions are the same across their three-year event window; firm characteristics can predict post-event stock returns in their global stock setting. The study reports some results for stocks from developed and emerging European economies, developed and emerging Asian economies, Australasia, Canada, Latin America, the Middle East and Africa.
Through more comprehensive benchmarking, the authors found, in fact, after their main corporate events, firms do not earn “abnormal” returns. “We overturn the whole literature,” Zhang mentions.
Interestingly, within the international stock sample, both share repurchases and dividend initiations display a positive and “normal” return effect. One finding suggested that when firms initiate stock splits, both U.S. and Canadian firms experience positive abnormal returns afterwards, as was expected. However, with foreign stocks, not so much, which was surprising to Zhang. Another notable finding related to firms after initial public offerings (IPOs). In Latin American and Middle Eastern financial markets, IPO firms earn higher returns than seasoned firms. In other markets, including the U.S., they earn lower returns.
Furthermore, after stock splits, in an apples-to-apples comparison (of the study’s 14 characteristics of firms), whether U.S. or foreign, the sample’s global stocks do not display abnormal returns, when compared against a properly constructed benchmark. That is contrary to findings in prior literature. In other words, the abnormal returns wash away when you apply the more accurate and comprehensive benchmark. Returns are then “normal.”
Essentially, it’s the benchmarking that is inaccurate in earlier research. “For example, as often the case in research, studies consider two characteristics like firm size and book-to-market ratios. Thus, the finding of abnormal returns is inaccurate if a more thorough benchmark or similar firm was used from which to compare the return. “It’s a multi-dimensional matching problem. It is like saying that a partner should match on 100 criteria. It’s not possible.” So, it’s easier to compare based on two dimensions but the result is lacking.
“Our innovation is that we reduce the idea of multi-dimensions into one dimension, that is, we essentially match on the expected return,” Zhang explains. “We reduce multi-dimensionality to one.” Once you better match on a comprehensive set of dimensions, it is as if the returns do not differ, i.e., they are not in excess or abnormal.
Additionally, the authors show that firm characteristics like liquidity, profitability, and return on assets, etc., do in fact matter for future returns in the global setting, as in the U.S. In other words, firm characteristics matter for future returns in the global market too. Local-level economic activity within countries was quite salient in assessing return prospects too.
The authors find that once proper comprehensive benchmarks are used, then after these main types of corporate events, then the abnormal returns do not exist. They are just normal. Also what matters are firm characteristics, not corporate events. “The Noble Prize winner Eugene Fama would be happy with our study,” Zhang muses. “Our study shows that the market seems to be more efficient than prior long-run event studies have shown.”
Still, an unanswered question for Zhang is: why do firms’ characteristics then predict future returns? This is currently a blank slate. Zhang expects many new research trails to follow from their study.
The paper “Firm Characteristics, Return Predictability, and Long-Run Abnormal Returns in Global Stock Markets” Feng Zhang of Southern Methodist University’s Cox School of Business, Hendrik Bessembinder of Arizona State University, Michael Cooper of University of Utah, and Wei Jiao of Rutgers University is under review.
Written by Jennifer Warren.