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Chapter Ten

Chapter Ten. Investments in Special Situations. Learning Objectives. 1. Understand the potential for abnormal returns in special investment situations. 2. Explain how abnormal returns might occur.

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Chapter Ten

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  1. Chapter Ten Investments in Special Situations

  2. Learning Objectives 1. Understand the potential for abnormal returns in special investment situations. 2. Explain how abnormal returns might occur. 3. Explain the controversy related to the small-firm and low P/E ratio on stock market returns. 4. Be familiar with the latest theories about about the relationship of book value to superior returns. 5. Explain timing effects such as January effect or weekend effect on stock market returns. 6. Discuss distinguishing between superior returns and incorrect measurement of returns.

  3. Mergers and Acquisitions • Abnormal returns: greater than Market % • Premiums for Acquired Company • Average premium paid in a recent time period is approximately 60% and there was an associated price increase of a similar magnitude. • Merger price premium represents the difference between the offering price per share and the market price per share for the candidate, before the impact of the offer.

  4. Average premium = 67.9%

  5. Mergers and Acquisitions (cont’d) • Two-thirds of the price gain takes place prior to the public announcement. • Try to identify merger candidates before public announcement to capture maximum profits - NOT easy. • Investor must assess the likelihood of merger being cancelled.

  6. Effect of Cancelled Mergers After concellation, acquiree stock price returns to level of preannouncement price.

  7. Mergers and Acquisitions (cont’d) • Acquiring Company Performance. • Stock price does not show abnormal market gains. • Long term economic studies have indicated that many of the anticipated results from mergers may be difficult to achieve. • Synergy is offset by inability of management to mesh divergent philosophies.

  8. New Stock Issues New Stock Issues • When a firm goes public by selling privately held shares to new investors, underpricing usually takes place because the investment banker makes a firm commitment to buy the shares when distributing the issue. • Studies by Miller and Reilly (1987), Ibbotson, Sindelar and Ritter (1988) indicate that positive excess returns in the order of 10% are associated with initial public offerings.

  9. New Stock Issues (cont’d) New Stock Issues Barry and Jennings (1992) show that 90% of that gain took place on the opening transaction. IPO shares are usually available only to good customers of brokerage houses.

  10. New Stock Issues (cont’d) • Performance of Investment Bankers • Research indicates that prestigious investment banking houses do not generally provide the highest initial returns to investors in the new issues they underwrite. • These investment bankers typically serve strongest firms that can shop around and negotiate good terms..

  11. Company moves stock to a higher listing. O-T-C -----> AMEX or NYSE AMEX -----> NYSE Issue will now be assigned a specialist who has responsibility for maintaining a continuous and orderly market. Ying, Lewellen, Schlarbaum and Lease (1977) indicate that there may be an opportunity for abnormal returns on a risk adjusted basis in the many weeks between the announcement of listing and actual listing (4.4%-16.26% above normal market returns depending on the time period involved). Exchange Listing

  12. Delisting • Delisting is the formal removal from an exchange and the resumption of trading in the O-T-C market. • Merjors (1963) reports an average decline of 17% between the last day of trading on an exchange and the resumption of trading O-T-C.

  13. Stock Repurchase Effects • A firm may buy back its shares through a repurchase program. The purchase price is generally over current market price and increases the demand for shares while effectively decreasing supply. • Research of Ikenberry, Lakonishok and Vermaelen (1995) reports only a conditionally positive market response.

  14. Stock Repurchase Effects • Average gain is about 3.5% because 90% of stock repurchases are made through open market purchases not tender offers. • For value stocks, the average abnormal returns were 45.3% over the four-year time, horizon compared to the glamour stocks that had neutral or slightly negative returns.

  15. The Small Firm and Low-P/E Effect • Banz (1981) and Reinganum (1981) show that the key to superior risk-adjusted rates of return rests with investing in low market capitalization. • Banz, in a study of NYSE firms covering 1936-1975, indicates that the lowest quintile firms in terms of value provide the highest risk-adjustedreturns.

  16. The Latest Theory The Book Value to Market Value Market • Fama & French (1992) report that the ratio of book value to market value is more important than either the size or P/E ratio in explaining superior stock performance. • The higher the ratio of book value to market value the higher the potential return on the stock.

  17. The Latest Theory The Book Value to Market Value Market • Stocks that have a book value close to market value are more likely to be undervalued than stocks which have book values that are substantially below market values.

  18. Other Stock-Related Special Situations • The January Effect • Investors sell off losers in Dec., leading to undervalued stocks • The Weekend Effect • Stocks end high on Friday, go lower on Monday • The Value Line Ranking Effect • Value line category 1 stocks tend to strongest performance

  19. Other Stock-Related Special Situations • The Surprise-Earnings Effects • Truly Superior Returns or Mismeasurement? • Is the Capital Asset Pricing Model valid?

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