Profitable Anomalies in the Stock Markets
Stock Markets and investing have changed over the years since inception only getting more efficient in time. This is evident from how value investing has failed to consistently generate alpha as it once used to- majorly owing to better technology, higher participation of people (in multiple roles), and ease of flowing capital. These factors have not only made it difficult for a “Bargain” to remain available they have instead lead to the major problem of Value Traps- wherein, a visible probable value bargain actually turns out to have priced in future negative information- Information Asymmetry. That's a topic for another article.
However, there have been a series of patterns- anomalies- that have more often than not consistently performed. Anomalies- are outliers- something that does not stick in line with expectations. I was motivated to create a compilation of most anomalies with why I think they occur as I have noticed in my decade long experience.
To understand Anomalies- another major concept to understand is the Efficient Market Hypothesis (EMH)-
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a hypothesis that states that share prices reflect all information and consistent alpha generation is impossible. According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for investors to purchase undervalued stocks or sell stocks for inflated prices.
- as explained by Investopedia.com
The movement of a stock’s price from when an event is triggered until the market returns to efficiency is what I will be focussing on in this article.
1 — Corporate Actions
I have been analyzing corporate actions and finance decisions made by companies over the past and I believe they are to a company what body language is to a person.
1.A — Mergers & Expansions (M&A)
Mergers and Acquisitions should mean growth for the respective entities. However, in the case of M & A between two listed players- it has been noticed how the stock prices of the respective companies follow a pattern-viz.- Post announcement they both rally upwards and soon after the acquiree’s stock outperforms that of the acquiree till the completion post which the stock of the merged entity enters into a longer-term consolidation.
1. Stocks price in a future probability of earnings certainty. Most acquisitions & mergers are priced to be fair compensation for the future earnings that the acquiree’s shareholders would be letting go of. Such pricing factors in a fragment of information asymmetry, since the due diligence is being performed on the basis of information let on by the acquiree and for them to settle on a price the acquirer would almost always have to pay a premium over any synergistic benefit they work out.
2. Usually, the acquiree companies are smaller in size, and demand for shares by the acquirer along with the premium being offered at acquisition would propel the stock price.
3. Post-merger depending on how the previous owners of the acquiree company react suggests a lot about the future of the merged entity’s stock price. More often than not they sell-off believing future growth has been priced in and the stock is overpriced. Institutional Investors may not want to own a company as large as the merged entity considering how they originally owned a much smaller company with a focussed target market.- Both of which would create supply in the stock price.
1.B — Capacity Expansion
Most capacity expansion is “Good News” since the company would be able to manufacture more and sell more and in turn a higher profit- higher EPS- higher stock price. Most companies on commissioning an expansion show positive returns for the shorter term and enter into a consolidation that breaks out on the upside usually at the end of the expansion.
1. Most companies feel the need for expansion when they are maxing out current capacity, which also happens when their respective industry has already been in a boom.
2. Companies prefer debt-fueled expansions- either ways their DE ratio goes up (either since debt goes up or reserves go down).
The company anticipates by the end of the expansion, they would have higher demand to cater to however this brings in uncertainty and increases risk. Considering if they do not have higher demand, they will have higher fixed costs and probably a debt obligation to pay off.
Numerous companies entering into expansion around the same period of time is often an indication of how the industry is very close to having topped out.
1.C — Rewarding Shareholders
A company may choose from “Rights Issue(/Bonus) or Buyback or a Dividend” to reward its shareholders but each of them gives an insight into the company.
1.D — Revenues Correlate with Advertisement Campaigns
Companies undertaking a new advertisement campaign usually show higher revenues in the following quarters, though advertisement campaigns are a cost it has been noticed the stock price showed a positive reaction to them in the shorter term pricing in the higher revenues from the future quarters.
1.E — Availability of Derivatives
After a stock’s derivatives are made available, the stock is now available to speculators.
- Higher Liquidity- Equity shareholders often get the advantage of higher premium on stocks with low volume, However the same does not exist once derivatives of the stock are listed.
- Short Sellers- Shorting a stock with no derivatives always bear the risk of a massive short squeeze. More importantly, it is difficult to find people who would be willing to allow short sellers to borrow their shares, However, once derivatives are available a short seller can easily create positions.
- Investors holding large chunks of the stock who would not have usually been able to offload owing to the market impact can now easily hedge their positions in the derivatives segment.
2 — Other commonly known anomalies
2.A — The Carhart Four- Factor Model:
An extension of an even earlier model- the Fama French Model, the Carhart models highlights a stock’s tendency to outperform if it has:
- Size- Smaller Market Capitalisation
- Value- High Book to Market (or low PB) Multiple
- Momentum- Higher Month on Month Returns*
While the market expects such stocks to not perform, it has been noticed such stocks usually tend to outperform their respective peers.
- *Stocks that fall 20% from their highs or rises 20% from their lows usually have been seen to continue the trend.
- Similarly, while 200 DMAs are strong support/resistance signals, a breakout of over 7% marks continuation of the trend in their respective direction.
2.B — Neglected / Illiquid Stock
While it’s expected that undercovered stocks may not have superior returns, historically that has not been the case. Such stocks have few analysts tracking them, so the probability of a new interested buyer is high and since liquidity is low the demand for stock ownership can skyrocket the stock. But such stocks have higher risk owing to higher information asymmetry and low liquidity.
2.C — Calendar Anomalies
- The Monday Effect- points at a tendency of stocks to open lower on Mondays than on their previous Friday. Usually, market participants on the long side close their positions on Friday fearing uncertainty the following weekend could bring.
- Turn of the Month- Historically stocks tend to rise on the last two days of a month and the trend continues for the first three days of the following month.
- Turn of the Tax Calendar — Stock prices tend to increase along with higher trading volume in the last few weeks of the Financial Year and such trend is continued in the first few weeks of the Financial Year. Usually, such a tendency is notable in smaller market capitalization stocks.
While the market expects FY ending to have a price decrease on account of Capital Gains being realized and the same participants rushing in to buy during the first weeks of the new FY.
There are observations that suggest Institutional buying in low volume stocks to increase Fund’s Return in the last weeks of the Financial Year.
- The September/ October Effect- However, many market realists have argued this anomaly does no longer hold. Historically stock market returns have been weak for the month of September while October is usually followed by strong returns, despite being the month of the 1907 Panic, Black Tuesday, Thursday & Monday in 1929, and the second Black Monday in 1987.
2.D — Beta Anomaly
Beta is the measure of a stock’s volatility. Beta indicates the percentage change in the stock with respect to that of the benchmark (usually an index). A beta of 1.4 means the stock moves 1.4% for a percent change in the same direction in the respective benchmark. While this means high Beta stocks should have higher returns, empirical evidence suggests this relation has not held true.
A low beta implies lower volatility in the stock and in turn, implies a higher conviction of the shareholder and lower risk. It is easier to hold a low volatile stock for a longer period of time than it is to hold a higher volatility stock. While lower-risk should lower return, in the case of low beta stocks it also implies higher demand for ownership. Such stocks may remain stable for long periods in consolidation and have been noticed to skyrocket at a positive news break.
“What good is knowledge if not shared and allowed to flourish in other people’s mind”
I chose to not include statistics and data to avoid any affirmation bias with my opinions and observations stated above, one must remember these anomalies can appear, disappear, and or may reappear with absolutely no warning.
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#Disclaimer:- Equity investing risky please consult your adviser before making any decisions. Do not rely on any of the above calculations, before taking an investment decision. The above post should not be misunderstood as investment advice and is being posted strictly for educational purposes. May be invested in the stocks discussed.