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A Contrarian Play on Small Profitability Laggers?

Posted in Size Effect

Why do small capitalization stocks as a group tend to outperform the broad market? Do small firms represent relatively high risk of financial distress (with attendant reward), or are they victims of systematic investor overreaction to past poor performance? In the 2006 update of their paper entitled “Can Overreaction Explain Part of the Size Premium?” Ozgur Demirtas and Burak Güner investigate irregularities in the historical returns of small capitalization stocks to identify the source of the size effect. Using returns and financial data for NYSE/Amex/Nasdaq stocks over the period July 1971 through June 2001, they conclude that:

  • Among small-capitalization stocks, profitability mean reversion is stronger for laggers (low past profitability) than for leaders (high past profitability).
  • Consequently, the stocks of small laggers produce significantly higher future returns (about 0.3% per month) than those of small leaders.
  • The recovery of laggers generates at least part of the excess returns of small stocks overall.
  • Outperformance of laggers is pronounced around earnings announcement dates, with more than one-third of the annual small-stock lagger premium coinciding with firm-specific news during just 12 days of the year. Systematic earnings surprises may therefore explain excess returns for small laggers.
  • The small-stock lagger premium is distinct from a book-to-market effect (value premium).

The following chart, taken from the paper, shows the average differences by year in the change in profitability (CP) of small-stock laggers minus CP for small-stock leaders. Stocks are classified as laggers or leaders in year t-1. The chart demonstrates that small laggers on average outperform small leaders in terms of mean future-profitability change for every year in the sample.

In summary, small capitalization stocks with low past profitability may be key to exploiting the size effect.

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