The post-merger performance of acquiring firms

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overreaction or underreaction as the dominant phenomenon. The random split predicted by market efficiency holds up rather well.

Two recent papers, Barberis et al. (1998) and Daniel et al. (1997), present behavioral models that accommodate overreaction and underreaction. To their credit, these models present rejectable hypotheses. Section 3 argues that, not surprisingly, the two behavioral models work well on the anomalies they are designed to explain. Other anomalies are, however, embarrassing. The problem is that both models predict post-event return reversals in response to long-term pre-event abnormal returns. In fact, post-event return continuation is about as frequent as reversal — a result that is more consistent with market efficiency than with the two behavioral models.

Section 4 examines the problems in drawing inferences about long-term returns. Foremost is an unavoidable bad-model problem. Market efficiency must be tested jointly with a model for expected (normal) returns, and all models show problems describing average returns. The bad-model problem is ubiqui- tous, but it is more serious in long-term returns. The reason is that bad-model errors in expected returns grow faster with the return horizon than the volatility of returns. Section 4 also argues that theoretical and statistical considerations alike suggest that formal inferences about long-term returns should be based on averages or sums of short-term abnormal returns (AARs or CARs) rather than the currently popular buy-and-hold abnormal returns (BHARs).

In categorizing studies on long-term returns, Sections 2 and 3 do not question their inferences. Dissection of individual studies takes place in Section 5. The bottom line is that the evidence against market efficiency from the long-term return studies is fragile. Reasonable changes in the approach used to measure abnormal returns typically suggest that apparent anomalies are methodological illusions.

2. Overreaction and underreaction: An overview

One of the first papers on long-term return anomalies is DeBondt and Thaler (1985). They find that when stocks are ranked on three- to five-year past returns, past winners tend to be future losers, and vice versa. They attribute these long-term return reversals to investor overreaction. In forming expectations, investors give too much weight to the past performance of firms and too little to the fact that performance tends to mean-revert. DeBondt and Thaler seem to argue that overreaction to past information is a general prediction of the behavioral decision theory of Kahneman and Tversky (1982). Thus, one could take overreaction to be the prediction of a behavioral finance alternative to market efficiency. For the most part, however, the anomalies literature has not accepted the discipline of an alternative hypothesis.

An exception is Lakonishok et al. (1994). They argue that ratios involving stock prices proxy for past performance. Firms with high ratios of earnings to

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price (E/P), cashflow to price (C/P), and book-to-market equity (BE/ME) tend to have poor past earnings growth, and firms with low E/P, C/P, and BE/ME tend to have strong past earnings growth. Because the market over-reacts to past growth, it is surprised when earnings growth mean reverts. As a result, high E/P, C/P, and BE/ME stocks (poor past performers) have high future returns, and low E/P, C/P, and BE/ME stocks (strong past performers) have low future returns.

I also classify the poor long-term post-event returns of initial public offerings (IPOs) (Ritter, 1991; Loughran and Ritter, 1995) and seasoned equity offerings (SEOs) (Loughran and Ritter, 1995; Spiess and Affleck-Graves, 1995) in the overreaction camp. Mitchell and Stafford (1997) show that SEOs have strong stock returns in the three years prior to the issue. It seems safe to presume that these strong returns reflect strong earnings. It also seems safe to presume that IPOs have strong past earnings to display when going public. If the market does not understand that earnings growth tends to mean revert, stock prices at the time of the equity issue (IPO or SEO) are too high. If the market only gradually recognizes its mistakes, the overreaction to past earnings growth is corrected slowly in the future. Finally, Dharan and Ikenberry (1995) argue that the long- term negative post-listing abnormal stock returns of firms that newly list on the NYSE or Amex are due to overreaction. Firms list their stocks to take advant- age of the market’s overreaction to their recent strong performance.

If apparent overreaction was the general result in studies of long-term returns, market efficiency would be dead, replaced by the behavioral alternative of DeBondt and Thaler (1985). In fact, apparent underreaction is about as fre- quent. The granddaddy of underreaction events is the evidence that stock prices seem to respond to earnings for about a year after they are announced (Ball and Brown, 1968; Bernard and Thomas, 1990). More recent is the momentum effect identified by Jegadeesh and Titman (1993); stocks with high returns over the past year tend to have high returns over the following three to six months.

Other recent event studies also produce long-term post-event abnormal returns that suggest underreaction. Cusatis et al. (1993) find positive post-event abnormal returns for divesting firms and the firms they divest. They attribute the result to market underreaction to an enhanced probability that, after a spinoff, both the parent and the spinoff are likely to become merger targets, and the recipients of premiums. Desai and Jain (1997) and Ikenberry et al. (1996) find that firms that split their stock experience long-term positive abnormal returns both before and after the split. They attribute the post-split returns to market underreaction to the positive information signaled by a split. Lakonishok and Vermaelen (1990) find positive long-term post-event abnormal returns when firms tender for their stock. Ikenberry et al. (1995) observe similar results for open-market share repurchases. The story in both cases is that the market under-reacts to the positive signal in share repurchases about future perfor- mance. Finally, Michaely et al. (1995) find that stock prices seem to under-react