Frm fundamentals, short sellng, and stock returns Yulang Wu a and Khelfa Mazouz b* Abstract Ths study uses short sellng actvty to test whether the relaton between fundamentals and future returns s due to ratonal prcng or msprcng. We fnd that the strength of fundamentals negatvely predcts short sellng. We also fnd that short sellers explot the overprcng of growth frms whose fundamentals are ncongruent wth market expectatons (.e., growth frms wth weak fundamentals). A number of tests suggest that short sellng actvty ncreases the speed of prce adjustment to negatve nformaton and reduces the ablty of poor fundamentals to predct returns. Our fndngs are consstent wth the gradual ncorporaton of nformaton and contradct the ratonal prcng explanaton. Key words: short sellng, fundamentals, returns, ratonal prcng, msprcng JEL Classfcaton: G11; G12 a Bradford Management School, Bradford Unversty, Emm Lane, Bradford, BD9 4JL, UK, E- mal: y.wu20@bradford.ac.uk b* Correspondent author, Cardff Busness School, Colum Drve, Unversty of Cardff, Cardff, CF10 3EU, UK,. E-mal: mazouzk@cardff.ac.uk 1
1. Introducton Whle there s ample evdence that frm fundamentals (e.g. accruals, return on equty, proftablty and asset growth) predct stock returns 1, the lterature has not reached a consensus on why such patterns exst. Several researchers argue that these patterns arse because markets are slow to fully ncorporate fundamental nformaton (Potrosk, 2000; Potrosk and So, 2012; Cho and Sas, 2012). However, others contend that the relatonshp between frm fundamentals and future returns s consstent wth a rsk-based explanaton. For example, Fama and French (2006, 2008) and Chen et al. (2011) show that n the standard valuaton model, hgher expected proftablty ndcates greater rsk after controllng for book-to-market ratos and expected nvestment. As the strength of fundamentals also proxes for expected proftablty, frms wth mproved (deterorated) fundamentals may have hgher (lower) rsk and therefore hgher (lower) expected returns. Fama and French (2006) hghlght that tests based on the valuaton equatons are generally powerless to determne whether observed relatons between expected returns and fnancal strength are drven by ratonal or rratonal prcng. To overcome ths lmtaton, we develop a new test to assess whether short sellng actvty affects the relatonshp between the strength of fundamentals and future returns. Under the rsk-based explanaton, nvestors revsed expectatons about fundamentals are nstantaneously mpounded nto prces. Thus, f lower expected proftablty s assocated wth lower rsk, short sellers who sell frms wth deterorated fundamentals should expect lower future returns. Snce market prces fully and quckly ncorporate fundamental nformaton, short sellng actvty should bear no relaton to frm fundamentals after controllng for rsk and nor should such an actvty affect future returns. 1 For example, accruals (Sloan, 1996; Fama and French, 2006; Rchardson et al., 2005), return on equty (Haugen and Baker, 1996), return on asset (Fama and French, 2006; Chen et al., 2011; Novy-Marx, 2013), asset growth (Cooper et al., 2008) and nvestment (Lu et al., 2009). 2
Under the msprcng explanaton, nvestors slowly revse ther expectatons about fundamentals, partcularly followng the release of negatve sgnals (DeBondt and Thaler, 1985; Barbers et al., 1998; Danel et al., 1998; Hong and Sten, 1999) 2. Slow revsons of expectatons followng negatve sgnals would cause overprcng. When short sellers explot overprcng, we would expect short sellng actvty to correlate negatvely wth the strength of fundamentals and postvely wth the speed of prce adjustment to negatve nformaton. Slow reactons to negatve sgnals about fundamentals can also ndcate that market expectatons are based, thereby causng prces to devate from fundamental values. Several studes show that nvestors tend to over-extrapolate past growth and underweght negatve nformaton, whch contradcts ther belefs about the frms growth prospects (LaPorta, 1996; LaPorta et al., 1997; Dechow and Sloan, 1997; Lakonshok et al., 1994; Mohanram, 2005). Smlarly, growth stocks wth low Book-to-Market (BM), low earnngs-to-prce and low cashflow-to-prce ratos are customarly perceved to be overprced and are therefore more lkely to be short sold (Lee, 2012; Dechow et al., 2001; Curts and Fargher, 2014). However, valuatons based on prce multples completely gnore the strength of fundamentals, whch measures a frm s ablty to generate future cash flows. Addtonally, the dvergence of market expectatons from fundamentals can cause substantal msprcng. For example, low prce multples combned wth deterorated fundamentals would ndcate hgher market expectatons about growth compared to the growth prospects mpled by fundamentals. Frms wth such characterstcs are lkely to be overprced and may generate large negatve future returns (Lakonshok et al., 1994; LaPorta, 1996; Dechow and Sloan, 1997). The msprcng argument predcts that short sellers target frms wth expectaton errors n order to explot overprcng. In contrast, the ratonal vew suggests that, as market prces fully and quckly reflect publc 2 Msprcng can persst f market frctons can mpede nvestors from quckly ncorporatng ther revsed expectatons nto prces and/or f short sellers have constrants that lmt ther abltes to explot msprcng (Mller, 1977; Harrson and Kreps, 1978; Damond and Verreccha, 1987; Schenkman and Xong, 2003). 3
nformaton, expectaton errors should not exst and short sellng actvty should not be related to frm fundamentals. By usng Potrosk s F-score (2000) to measure the strength of fundamentals, we frst test the market response to fundamental sgnals. Consstent wth the slow prce adjustments to nformaton, we fnd that the returns on low F-score frms are nsgnfcant durng the frst four months followng the fscal year end and sgnfcantly negatve n the subsequent one-year perod. We also fnd a sgnfcantly negatve assocaton between F-score and short sellng actvty, mplyng that short sellers explot overprced low F-score frms. By usng BM rato to measure market expectatons, we construct F-score and BM based portfolos to explore how short sellers explot overprcng. The results show that short sellng actvty s concentrated n growth frms whose fundamentals are ncongruent wth market expectatons (.e., frms wth low BM and low F-score). However, we fnd that short sellng actvty s nsgnfcant n frms wth hgh market expectatons for growth (low BM) and mproved fundamentals (hgh F-score). Ths fndng suggests that the market requres tme to revse expectatons, consstent wth the msprcng argument but not wth the rsk-based explanaton. The explotaton of overprcng also mples that short sellng ncreases the speed of prce adjustment to negatve fundamental nformaton. To test ths, we separate low F-score frms nto quntle portfolos accordng to short nterest. The analyss reveals that the future returns to low F-score frms are nsgnfcant when short nterest s hgh and sgnfcantly negatve when short nterest s low. We also separate low F-score frms wth low BM ratos (.e., the most severely overprced frms) nto tercles based on short nterest. We fnd that the ablty of F-score to predct the returns of these stocks declnes wth short nterest, mplyng that short sellng mproves prce effcency. However, we do not expect short sellers to elmnate overprcng completely as holdng short postons s costly. More specfcally, short sellers may only ntate short sellng when they expect prce declnes to be large enough to compensate 4
them fully for the assocated costs and the rsks (Damond and Verrecha, 1987). Consstent wth ths argument, we fnd that overprcng s hgher and short nterest s lower when low F- score frms are smaller, have less nsttutonal ownershp and pay hgher cash dvdends. Overall, our results suggest that the relatonshp between the strength of fundamentals and future returns arse because fundamental nformaton s gradually mpounded nto prces. However, one may argue that short sellers trade low F-score frms because these frms have experenced poor past performance,.e. short sellers are momentum traders. To test ths, we compare the dfference n short sellng between low and hgh F-score frms condtonal upon past performance. We fnd that short sellers exhbt lttle nterest n sellng low F-score frms wth poor past performance, whereas low F-score frms wth good past performance attract hgh short nterest. Ths suggests that short sellers are contraran traders rather than momentum traders. Another potental concern s that short sellers may move the prce of low F-score frms far below fundamental values n tmes of economc downturns when poor performance s more lkely to occur. We address ths concern by comparng the dfference n short sellng between low and hgh F-score frms condtonal upon nvestor sentment. We fnd that short sellers are more actve durng hgh sentment perods, ndcatng that short sellng helps correct the overprcng nduced by the speculatve demand of nose traders (e.g. Shller, 1984). Ths study contrbutes to the lterature n three ways. Frst, we show that short sellers trade on publc nformaton. Ths evdence s nconsstent wth the ratonal prcng theores, whch predct that market prces ncorporate publc nformaton fully and nstantaneously and that the strength of fundamentals represents a rsk. Instead, our fndngs support the msprcng argument, whch suggests that nvestors are slow to revse ther expectatons about frm fundamentals. Furthermore, our results reconcle two conflctng vews on the market expectatons reflected n the BM rato (.e., () the rsk-based vew of Fama and French (1993; 1996); and () the msprcng-based vew of Lakonshok et al. (1994)) and have mportant 5
mplcatons for the recent developments n the asset prcng lterature. Specfcally, the fndng that short sellng s concentrated n low BM frms wth deterorated fundamentals ndcates that the BM rato reflects based market expectatons about fundamentals, whle the low level of short sellng actvty n low BM frms wth mproved fundamentals mples that the BM rato represents unbased market expectatons. Ths evdence suggests that BM rato s not a good proxy for future proftablty, consstent wth the recent fndngs of Fama and French (2015, p.1) that Wth the addtonal proftablty and nvestment factors, the value (BM) factor of the FF three-factor model becomes redundant for descrbng average returns n the sample we examne. Our evdence also suggests that the proftablty and nvestment factors n the Fama and French fve-factor model explan returns, at least n part, because of the ablty of these two factors to capture msprcng 3. Second, ths study enhances our understandng of the tradng behavor of short sellers. Pror studes show that short sellers are sophstcated and nformed traders (Bernard and Thomas, 1990; Doyle et al., 2003; Desa et al., 2006; Efend et al., 2005; Karpoff and Lou, 2010; Dechow et al., 2001; Drake et al., 2011; Chrstensen et al., 2014). We document evdence that short sellers are also value nvestors, who short sell expensve (low BM) stocks wth prces that are sgnfcantly above fundamental values. Ths short sellng strategy s n algnment wth the central theme of value nvestng, whch explots stocks whose prces devate from fundamental values (Graham and Dodd, 1934). Unlke pror studes, whch consder value nvestng as a long poston n cheap stocks (hgh BM) wth mproved fundamentals (e.g. Potrosk, 2000; Potrosk and So, 2012), we propose a short poston for value nvestng (.e., shortng low BM stocks wth deterorated fundamentals). Our evdence on the lnk between short sellng actvty and frm fundamentals provde further nsghts on the mechansm through whch the market processes publc nformaton. Specfcally, when market expectatons devate from 3 Also see Fama and French (2017) for nternatonal evdence. 6
fundamentals, nvestors requre tme to correct ther expectaton errors and such slow prce adjustments to fundamental nformaton, n turn, create explotatve opportuntes for value nvestng. In partcular, short sellers explot the overprcng of growth stocks wth weak fundamentals, whle other market partcpants explot the underprcng of value stocks wth strong fundamentals (Dechow et al., 2001; Potrosk and So, 2012). Thrd, we fnd that the tradng behavor of short sellers stablzes the market. The explotaton of negatve returns n economc upturns s shown to reduce prce bubbles (Dether et al., 2009; Lamont and Sten, 2004; Savor and Gamboa-Cavazos, 2011; Blau et al., 2012; Curts and Fargher, 2014). However, short sellng stocks n antcpaton of negatve returns n economc downturns rase a serous regulatory concern that short sellers may destablze the market by movng prces far below fundamental values 4. Ths concern resulted n temporary bans on short sellng durng the 2008 fnancal crss across major developed markets (Beber and Pagano, 2013) 5. Our results suggest that short sellers are not momentum traders and tend to avod tradng stocks wth deterorated fundamentals durng perods of low sentment. Instead, we fnd that short sellng prevals n economc upturns when both sentment and overprcng are hgh (e.g. Baker and Wurgler, 2006). Ths evdence s consstent wth Stamburgh et al. (2012), who show that overprcng s unlkely to occur n economc downturns and also supports Beber and Pagno s (2013) concluson that at best short-sellng bans have left stock prces unaffected. Overall, the regulatory concern that short sellers can destablze the markets s largely unwarranted. 4 The Securtes and Exchange Commsson (SEC) suggested that short sellng manpulates frms unquely vulnerable to panc (Cox, 2008). 5 For example, the SEC n the U.S. ssued a temporary ban on the short sellng of 799 fnancal frms n 2008 (from September 17 to October 8) n response to the sharp prce declnes n several fnancal frms. More recently, n 2010 the SEC revsed Regulaton SHO by restrctng short-sellng actvty f a frm s prce declnes by 10% or more n a sngle tradng day. Beber and Pagano (2013) provde more detals on short sellng bans durng the 2008 fnancal crss n the world. 7
The remander of the paper s organzed as follows. Secton 2 presents the research desgn and dscusses the emprcal predctons. Secton 3 descrbes the data and defnes the varables. Secton 4 dscusses the emprcal results. Secton 5 concludes. 2. Research desgn and our emprcal predctons Ths study uses short sellng actvty to test whether the relaton between the strength of fundamentals and future returns s due to ratonal prcng or msprcng. Usng US data for the perod 1972-2016, we annually sort our stocks nto portfolos based on the strength of fundamentals (F-score) and nto portfolos based on prce multples. We then examne varaton n short sellng actvty, expectaton errors and future returns wthn and across these portfolos. Our am s to test whether short sellng affects the ablty of the strength of fundamentals to predct returns. 2.1. The strength of fundamentals and market expectatons We use F-score to measure the strength of fundamentals (Potrosk, 2000; 2005). Fama and French (2006, p496) pont out that F-score s a composte measure of frm strength. Specfcally, F-score s an aggregate statstc, whch s based on nne fnancal sgnals that measure three dmensons of frms fnancal condton: () proftablty, () change n fnancal leverage and lqudty, and () change n operatonal effcency 6 (see Appendx 1 for further detals). A good sgnal contrbutes one pont to the F-score, whereas a bad sgnal contrbutes zero and correspondngly, the F-scores range from zero to nne. Followng pror studes (e.g., Cho and Sas, 2012; Potrosk and So, 2012), we categorze frms wth F-scores of less than or equal to three, between four and sx, and greater than or equal to seven, as low, mddle and hgh F-score frms, respectvely. F-score s a leadng predctor of future returns 6 In F-scores, seven of nne sgnals are based on changes n fnancal condton from the last fscal year to the current fscal year. Strctly speakng, F-score can be nterpreted as changes n fundamentals. 8
even after controllng for sze, book-to-market, and asset growth (Potrosk and So, 2012; Cho and Sas, 2012; Fama and French, 2006). F-score can also predct future fnancal performance. Specfcally, low F-score frms experence deteroraton n future proftablty, whle hgh F- score frms ncur an overall mprovement n proftablty (Potrosk and So, 2012). Gven the strong predctablty for future proftablty, F-score can proxy for expected proftablty (Fama and French, 2006). BM rato captures market expectatons about future performance. Low BM frms are expected to grow faster and are therefore more expensve than ther hgh BM counterparts. Consstent wth ths nterpretaton, Fama and French (1995) and Penman (1996) fnd that BM rato s negatvely assocated wth both expected and realsed proftablty and earnngs growth. In partcular, low BM frms (.e. growth frm) tend to have hgh future earnngs growth, whereas hgh BM frms (.e. value frms) are assocated wth low future proftablty. We measure a frm s BM rato as the book value of equty scaled by the market value of equty at fscal yearend. Followng Fama and French (1993) and Ptrosk and So (2012), we categorze frm-year observatons wth BM ratos below the 30 th percentle, between the 30 th and 70 th percentle, and above the 70 th percentle as growth, neural and value frms, respectvely 7. 2.2. The explotaton of overprcng Pror studes show that short sellers are nformed and usually short sell stocks pror to major negatve corporate events, such as negatve earnngs announcements (Chrstophe et al., 2004 and Akbas et al., 2008), earnngs restatements (Desa et al., 2006), fnancal msconduct (Karopp and Lou, 2010), analyst downgrades (Chrstophe et al., 2010), msleadng pro forma dsclosures (Chrstensen et al., 2014) and credt ratng downgrades (Henry et al., 2014). There 7 BM rato s our man measure although we also nclude earnngs-to-prce and cash-flow-to-prce as alternatve measures n our emprcal analyss. 9
s also evdence that short sellers possess superor ablty to process publc nformaton. For example, Engelberg et al. (2012) fnd that short sellers ncrease ther tradng on the day of negatve news announcements and that abnormal short sellng predcts future negatve returns. Boehmer and Wu (2013) show that short sellers explot negatve earnngs surprse and mtgate negatve earnngs announcement drfts. Lee and Pquera (2017) fnd that short sellers explot other nvestors anchorng bases by sellng stocks wth prces far from the 52-week hgh. Collectvely, exstng evdence suggests that short sellers are nformed and sophstcated traders who sell overprced stocks ahead of other nvestors. Departng from prevous studes, we are nterested n the relaton between frm fundamentals and short sellng, an ssue that has not yet been explored n the lterature. Ths analyss should enhance our understandng of the tradng behavor of short sellers and shed lght on whether the lnk between F-score and future returns s due to ratonal prcng or msprcng. It has been wdely documented that markets are slow to fully reflect publc nformaton (see, e.g., Bernard and Thomas, 1989; Doyle, 2006; Balakrshnan et al., 2010; Dchev and Potrosk, 2001; Chen et al., 1996; Gleason and Lee, 2003; Sloan, 1996; Bradshaw et al., 2006). For example, Cho and Sas (2012) fnd that F-score predcts subsequent nsttutonal demand and conclude that nsttutonal nvestors suffer from slow reactons to fundamental sgnals. Such slow reactons may occur ether because behavoral bases nduce market partcpants to underweght new nformaton or because frctons prevent prces from fully and quckly ncorporatng nvestors revsed expectatons (e.g., DeBondt and Thaler, 1985; Danel et al., 1998; Hong and Sten, 1999). As slow prce adjustment to negatve sgnals about fundamentals causes overprcng, we expect short sellng actvty to be manly concentrated n low F-score frms. Mohanram (2005) fnds that the negatve returns to growth frms are generated by a subset of growth frms wth poor fundamentals. As value stocks are often gnored by the market, mprovements n fundamentals are slowly reflected n ther prces to nduce underprcng 10
(LaPorta, 1996; LaPorta et al., 1997; Dechow and Sloan, 1997). Potrosk (2000) and Potrosk and So (2012) fnd that postve returns to value frms are drven by a subset of value frms wth strong fundamentals. However, Fama and French (1992; 1996; 2006) fnd that growth frms have hgher future earnngs and hgher growth rates than value frms, thus mplyng less bas n market expectatons about future performance. In the study, we lnk F-score wth BM to reconcle two conflctng vews on the market expectatons reflected n BM ratos. F-score s based on the strength of fundamentals and measures the frm s ablty to generate future cash flows, whle BM ratos measure market expectatons about earnngs growth (e.g. Lee, 2014). Market expectatons could be unbased f the mproved (deterorated) fundamentals are congruent wth the strong (weak) expected growth. However, when fundamentals are not strong enough to support the expected growth prospects (e.g. low F-score and low BM), t may lead to based expectatons about future performance. Such bases may cause overprcng and large negatve future returns. Correspondngly, the short sellers may explot the overprcng by sellng frms whose prces are perceved to be hgher than the values mpled by fundamentals. Thus, we predct low BM frms to have hgher short nterest when ther F-scores are relatvely low. In contrast, hgh F- score combned wth low BM mples that prces fully reflect the mproved fundamentals. Ths subset of growth frms s unlkely to be attractve to short sellers, as the hgh growth expectatons are congruent wth fundamentals. To llustrate our predctons more clearly, we defne the growth expectatons mpled by BM and fundamentals as E[Growth BM] and E[Growth F-score], respectvely. When E[Growth BM] s above E[Growth F-score], the dfference n expectatons s referred to as expectaton errors about growth. Conversely, when E[Growth BM] s below E[Growth F-score], the dfference n expectatons s called expectaton errors about value. That s, the market 11
underestmates fundamental value. The followng table presents expectaton errors across value/growth characterstcs and the strength of fundamentals 8. Growth/Value based on BM Growth-Low BM Neutral BM Value-Hgh BM Low F-score E[Growth BM]> Potental expectaton E[Growth BM] Weak fundamentals E[Growth F-score] errors for growth E[Growth F-score] Expectaton errors No expectaton errors for growth (1) (2) (3) Mddle F-score Potental expectaton E[Growth BM] Potental expectaton errors for growth E[Growth F-score] errors for value No expectaton errors (4) (5) (6) Hgh F-score E[Growth BM] Potental expectaton E[Growth BM]< Strong E[Growth F-score] errors for value E[Growth F-score] fundamentals No expectaton errors Expectaton errors for value (7) (8) (9) In ths framework, portfolo (1) should have the hghest short nterest among the nne portfolos. Investors who have long postons n these stocks are lkely to underreact to nformaton that contradcts ther belefs about the frm s growth prospects (Mohanram, 2005; Lakonshok et 8 Ptrosk and So (2012) use a smlar table to llustrate expectaton errors. We further refne these errors nto expectaton errors for growth and the errors for value. 12
al., 1994). Portfolo (9) ncludes stocks wth expectaton errors about value. Ths subset of value stocks s lkely to be neglected by the market despte ther strong fundamentals (Lakonshok et al., 1994; Potrosk, 2000; Potrosk and So, 2012). We do not expect ths subset of value stocks to attract short sellers because short sellng strateges cannot be used to explot underprcng and an analogous reasonng s applcable to portfolos (6) and (8). In addton, the market expectatons about the growth of the frms n portfolos (3), (5) and (7) are congruent wth fundamentals, thus renderng these frms unattractve to short sellers. Therefore, we expect short sellng to be concentrated n growth frms wth market prces hgher than fundamental values.e. portfolos (1), (2) and (4). Thus, by establshng lnks between F-score, BM and short sellng, we are able to answer the followng mportant questons: Do growth frms wth dfferent F-scores attract the same level of short nterest? How can short sellers explot overprcng? Are the market expectatons reflected n BM always based? Our central predcton s that short sellers wll target frms wth strong expected growth but wth deterorated fundamentals. We also expect short sellng to ncrease the speed at whch negatve nformaton s mpounded nto prces and, therefore, correct overprcng. 3. Data and varables Our sample conssts of all common stocks (share codes of 10 and 11 n CRSP) lsted on NYSE, AMEX and NASDAQ over the perod 1972-2016. Stock prce and fnancal statement data are extracted from CRSP and Computstat, respectvely. For each frm, we measure the market value of equty, BM ratos and the components of F-score at the fscal year-end. We obtan the number of analysts provdng frms earnngs forecasts from I/B/E/S. Smlarly, the quarterly nsttutonal ownershp s obtaned from the Thomson Reuters database. Followng Fama and 13
French (2006) and Cho and Sas (2012), we exclude fnancal frms n our sample and requre frms to have total assets of at least $25 mllon and book equty of at least $12.5 mllon. Short nterest data s provded by the Computstat s Supplemental Short Interest Fle. 9 Followng Dechow et al. (2001), we measure the raw short turnover averaged between three and four months after the fscal year end (see Fgure 1) to allow suffcent tme for short sellers to process fnancal nformaton. The raw short turnover s defned as the number of shares shorted as a percentage of shares outstandng. Snce short sellng actvty has shown a sgnfcant ncrease over the last two decades (Asquth et al., 2005; Boehmer and Wu, 2013), we use market-adjusted short turnover (mkt_adj_sh), defned as raw the frm s short turnover n a gven month mnus the market average short turnover n the same month, to control for the market-wde mpact. Followng pror studes (e.g., Cho and Sas, 2012; Potrosk and So, 2012; Potrosk, 2000), we defne the nformaton perod as four months followng the fscal year-end and the post F- score perod as the year begnnng four months followng the fscal year-end (see Fgure 1). We measure market-adjusted buy-and-hold returns,.e., a frm s buy-and-hold returns less the CRSP value-weghted buy-and-hold return, over the nformaton and post F-score perods. 10 Moreover, followng the studes conducted by Bushee and Goodman (2007) and Cho and Sas (2012), we truncate the top and bottom one percent of frms wth the hghest and lowest marketadjusted returns over the nformaton perod and the post F-score perod to ensure that return estmates are not drven by outlers. Our fnal sample conssts of 127,836 frm-fscal year observatons wth an average of 2,857 unque frms per fscal year. 9 NYSE, AMEX and NASDAQ frms are requred to report ther short nterest as of settlement on the 15 th each month. Snce September 2007, the short nterest reports must also be fled as of settlement on the last busness day of the month. 10 We calculate returns n the post F-score perod from four months followng the fscal year-end to ensure that nvestors have the necessary nformaton to calculate F-score (Potrosk, 2000, 2005). 14
Fgure 1: Tmelne Informaton Perod Post F-score Perod -4-3 -2-1 0 1 2 12 Fscal year end Mkt_adj_SH 4. Results 4.1. Prelmnary results Panel A n Table 1 reports the man characterstcs for the ten portfolos sorted by F-score. We document a monotoncally postve assocaton between F-score and future returns. We also show that low F-score frms (.e., frms wth F-score between one and three) have postve market-adjusted short turnover, whle the short turnover of the remanng frms s below the market average. Our results, n addton, suggest that low F-score frms are generally smaller than hgh F-score frms. Furthermore, we show that frms wth F-score equals nne are smaller than those wth F-scores between four and eght, suggestng that a subset of mddle-sze frms has strong fundamentals. The dstrbuton of BM rato exhbts an nterestng pattern: The two hghest BM ratos (0.99 and 1.04) appear n frms wth the lowest and hghest F-score, whle the two lowest BM ratos (0.79 and 0.80) are observed for frms wth F-scores between fve and seven and those wth F-score equals one. These fndngs mply that value and growth frms vary consderably n the strength of ther fundamentals. Moreover, we fnd that hgh F-score frms have hgher nsttutonal ownershp and more analysts followng than low F-score frms. Lastly, we document a negatve assocaton between F-score and past performance (.e., the returns over the wndow [-8, -2]). Ths mples that the relaton between F-score and future returns can be tanted by the momentum effect. 15
In Panel B, we compare the market-adjusted returns and the market-adjusted short turnover assocated wth hgh and low F-score frms across the nformaton perod and the post F-score perod. Followng Cho and Sas (2012), we defne low, mddle and hgh F-score frms as frms wth F-scores between zero and three, between four and sx, and greater or equal to seven, respectvely. The average market-adjusted returns assocated wth hgh and low F-score frms n the nformaton perod are 4.38% and -0.11%, respectvely. These fndngs are n support of Hong et al. s (2000) argument that postve nformaton s ncorporated nto prces faster than negatve nformaton. Correspondngly, slow reactons to negatve nformaton should attract short sellers as the prce of low F-score frms s expected to declne n the future. Consstent wth ths conjecture, we show that low F-score frms not only have sgnfcant market-adjusted short turnover (1.98%) but also have a sgnfcantly hgher short turnover than ther hgh F- score frms. The dfference n market-adjusted short turnover between hgh and low F-score frms s -2.79% and s sgnfcant at less than the 5% level. Ths evdence lends some support to the vew that short sellers explot the overprced low F-score stocks. On the rght-hand sde of Panel B, we present the market-adjusted returns and short turnover n the post F-score perod. The results reveal that low F-score frms sgnfcantly underperform hgh F-score frms by 9.09% per year. However, the nsgnfcant dfference n the market-adjusted short turnover between low and hgh F-score frms suggests that short sellers do not perceve low F-score frms as beng overprced n the post F-score perod. 4.2. Short sellng and F-score In the prevous secton, we have dscussed and presented corroboratng evdence to show that low F-score frms attract hgher short nterest than hgh F-score frms. In ths secton, we formally test whether F-score can predct short nterest after controllng for other determnants of short sellng. Followng prevous studes (Dechow et al., 2001; Boehmer and Wu, 2013; Lee 16
and Pquera, 2017), we use the Fama-MacBeth (1973) procedure to estmate the followng model: Mkt _ adj _ SH F llqudt y 5 1 _ socre sze IO 6 2 7 BM 3 Mom DP analyst 8 4 9 (1) where Mkt_adj_SH s the market-adjusted short turnover for frm for the perod from the thrd to the fourth month followng the fscal year end (.e.[-1,0]). Sze and BM are frm s market value and the book-to-market rato at the fscal year-end, respectvely. Mom s frm s past 6- month buy-and-hold return endng up to the second month followng the fscal year end. Illqudty s calculated as the monthly average of the daly rato of absolute stock return to dollar volume over a three-month perod ncludng the month of fscal year end and the subsequent two months (Amhud, 2002). σ s a volatlty measure calculated as the dfference between the hghest and lowest prces durng the three month perod scaled by the hghest prce (Boehmer and Wu, 2013; Lee and Pquera, 2017). IO s the percentage of nsttutonal ownershp n frm at the end of fscal year 11. DP s frm s cash dvdend yeld (.e., cash dvdend pad per share dvded by stock prce) used as a proxy for the cost of short sellng. It has been reported that short sellers are less wllng to short cash dvdend-payng stocks because dvdends must be pad out of ther own captal (D Avolo, 2002; Dechow et al., 2001). Analyst s the number of analysts followng frm at the fscal year end (Boehmer and Wu, 2013). The set of control varables ncluded n Equaton (1) are prevously shown to affect short sellng and may also relate to rsk 12. Further detals on the defnton of these varables are presented n Appendx 2. 11 If frms have fscal year ends other than January, March, June, September and December, we match the calendar quarter of fscal year end wth the quarter of 13-F flng. 12 For example, nsttutonal holdngs (IO) and analyst followng (Analyst) can be proxes for rsk of lmt-toarbtrage (Boehmer and Wu, 2013). Our volatlty (σ) and llqudty (Illqudty) measures can be proxes for total rsk and lqudty rsk, respectvely. 17
Table 2 reports the tme-seres means for each coeffcent and Newey-West (1987) adjusted t- statstcs. Column (1) reports the results wth F-score as the only ndependent varable n the regresson. The coeffcent on F-score s sgnfcantly negatve, ndcatng the nverse relatonshp between short sellng and the strength of fundamentals. Column (2) shows that the coeffcent on F-score remans negatve and hghly sgnfcant after controllng for frmspecfc characterstcs. It also presents a sgnfcantly postve relatonshp between frm sze and the market-adjusted short turnover, mplyng short sellers target large frms. The coeffcent on BM s negatve and sgnfcant, suggestng that growth stocks are more lkely to attract short sellng than value stocks (Dechow et al., 2001). The nsgnfcant coeffcents on the momentum and llqudty varables suggest that the pattern of past returns and lqudty characterstcs do not mpact the tradng behavor of short sellers. The coeffcent on σ s postve and sgnfcant, ndcatng that volatle stocks are more lkely to be sold short. A possble explanaton for ths fndng s that volatle stocks experence more frequent dramatc prce ralles and declnes, and short sellers are able to dentfy when the prce of these stocks devates from ther fundamental values. In the last column of Table 2, we nclude IO, DP and analysts as addtonal varables n the regresson. The coeffcent on F-score s stll sgnfcantly negatve. The coeffcent on IO s postve and sgnfcant, reflectng the fact that nsttutonally owned shares are easer to short sell. We also fnd that DP s sgnfcantly and negatvely assocated wth short nterest, consstent wth the vew that cash dvdends are a proxy for shortsale constrants (Dechow et al., 2001). Overall, the results of ths secton suggest that F-score s nversely related to short sellng actvty. Ths evdence s consstent wth the vew that short sellers explot overprcng and contradcts the ratonal prcng paradgm, whch suggests that the strength of fundamentals should bear no relatonshp to short sellng. 4.3. Short sellng, F-score and growth expectatons 18
Our fndng that short sellng s sgnfcantly negatvely assocated wth F-score rases the queston of whether all low F-score frms are attractve to short sellers. The explotaton of expectaton errors predcts that short sellers are only nterested n tradng low F-score frms wth hgh expectatons for growth. However, we do not expect hgh short nterest when growth expectatons are congruent wth fundamentals. To test these predctons, we sort frms by ther BM ratos (.e. growth, neutral and value) and then by ther F-scores (.e. low, mddle and hgh F-score frms as defned n Secton 2.3) to form nne BM and F-score based portfolos. Panel A n Table 4 reports the averaged market-adjusted short turnover for the nne portfolos across the sample perod. The results reveal several nterestng short sellng patterns. We fnd that both growth and neutral stocks wth low F-score have a sgnfcantly hgher short nterest than the market average, mplyng that short sellers explot overprcng by short sellng frms whose prces are perceved to be hgher than fundamental values 13. Furthermore, we show that the short nterest of value frms wth low F-score s not sgnfcantly dfferent from the market average, whle the short nterest of the value frms wth mddle and hgh F-score s sgnfcantly lower than the market average. These results are expected, as short sellng cannot be used to explot underprcng, whch s more lkely to occur n value frms (Potrosk and So, 2012; Potrosk, 2000). We also fnd the dfference n short nterest between growth and value frms to be postve and hghly sgnfcant across the three F-score portfolos. Ths fndng s consstent wth Dechow et al. (2001), who show that growth frms are more attractve to short sellers than value stocks. However, growth frms wth hgh F-score have no sgnfcant level of short nterest relatve to the market, consstent wth our conjecture that short sellers avod shortng hgh F-score frms when the mproved fundamentals are congruent wth hgh market expectatons for growth. The dfference n short turnover between low F-score and hgh F- 13 In unreported results, we estmate returns to the nne BM and F-score sorted portfolos. We fnd smlar results to Potrosk and So (2012) that the value-growth strategy s only proftable when expectaton errors are large. 19
score frms s postve (3%) and sgnfcant at less than 5% level. Ths evdence contrasts wth the fndngs of Dechow et al. (2001) that all growth frms attract short shellng. Instead, our results suggest that short sellers only explot growth frms wth weak fundamentals. Fnally, we fnd that the short nterest assocated wth the hgh F-score and low BM, mddle F-score and mddle BM and low F-score and hgh BM portfolos s not sgnfcantly dfferent from the market average, suggestng that short sellers beleve that the prces of the frms n these portfolos are algned wth fundamentals. In Panels B and C, we use two alternatve measures for growth/value, namely earnngs-to-prce and cash-flow-to-prce. Consstent wth the results n Panel A, Panels B and C also show that growth frms attract sgnfcantly hgher short nterest when ther F-scores are relatvely low. Overall, our results are consstent wth our vew that short sellers explot expectaton errors about earnngs growth. However, the results of the portfolo analyss may be based due to omtted frm characterstcs. To mtgate ths concern, we follow Potrosk and So (2012) and use the Fama and MacBeth (1973) procedure to estmate the followng cross-sectonal regresson: Mkt _ adj_ SH F1 1 F2 7 F2 2 F3 Value F3 3 8 F1 Growth F1 Neutral F2 Growth 4 Neutral F3 9 5 Value Sze Mom 10 6 11 (2) The ntercept n Equaton (2) s suppressed to ensure non-collnearty among dfferent F-score groups. The dependent varable s the market-adjusted short nterests defned as before. F1, F2 and F3 are dummy varables wth values of one f a frm s F-score s less than or equal to three, between four and sx, or greater than or equal to seven, respectvely, and zero otherwse. Growth, Neutral and Value are dummy varables wth values of one f the frm s BM rato s the bottom 30%, the mddle 40% and the top 30% of BM at the fscal year-end, respectvely, and zero otherwse. We annually and ndependently rank frm sze (Sze) and momentum (Mom) 20
nto decles and nclude ther decle ranks n Equaton (2) to mtgate the mpact of ntertemporal dstrbuton changes n the two varables. The coeffcents on F1, F2 and F3 measure the mpact of F-score on short turnover for the frms whose market expectatons reflected n BM are congruent wth the strength of ther fundamentals. The sx nteracton terms measure the dfferental effects of F-score on the short sellng of frms that are lkely to suffer from expectaton errors. Smlar to our earler analyss, we also use earnngs-to-prce and cash-flow-to-prce as alternatve measures of value/growth. Table 4 reports the average coeffcents estmated from annual cross-sectonal regressons and the Newey-West adjusted t-statstcs. Column (1) n Table 4 shows that the coeffcents on F1, F2 and F3 are sgnfcantly negatve, mplyng that frms whose fundamental characterstcs are fully and accurately mpounded nto ther prces are less lkely to be attractve to short sellers. The coeffcents on the three nteracton terms (.e. F1 Growth, F1 Neutral and F2 Growth) are sgnfcantly postve, ndcatng that short sellers explot stocks wth market prces perceved to be hgher than fundamental values. However, the remanng three nteracton terms (.e. F2 Value, F3 Neutral, and F3 Value) are sgnfcantly negatve, suggestng that short sellng s less useful when strong fundamentals are not fully reflected n prces. Column (1) also shows that sze s sgnfcantly and postvely related to market-adjusted short nterest. As short sellers need to borrow stocks from nsttutons, who usually hold stocks wth large market captalzaton, large stocks are more lkely to be shortable than small stocks. The coeffcent on momentum s nsgnfcant, suggestng that the pattern of past returns has no materal mpact on short sellng. Fnally, we document smlar result when we use E/P and cash-flow-to-prce, nstead of BM rato, to defne value/growth features (see columns (2) and (3)). Overall, our results suggest that short sellers explot overprcng by sellng frms whose prces are perceved to be hgher than the fundamental values. 21
4.4. Short sellng and future returns Ratonal prcng and msprcng dsagree on the ablty of short sellng actvty to nfluence low F-score frms future returns. Ratonal prcng emphaszes that negatve fundamental nformaton s fully mpounded nto prces and therefore low F-score represents low rsk leadng to low future returns. However, the msprcng argument suggests that markets are slow to fully ncorporate the negatve nformaton about fundamentals. The explotaton of overprcng by short sellers would ncrease the speed of prce adjustments to negatve sgnals, postulatng that hgh levels of short nterest should reduce or even elmnate the ablty of low F-score to predct returns. We formally test the prce mpact of short sellng by confnng our analyss to low F-score frms and low F-score frms wth low BM ratos, whch are lkely to be of nterest to short sellers 14. We frst sort low F-score frms nto quntles based on ther market-adjusted short turnover and then calculate the dfference n returns between the bottom quntle (Q1: lghtly shorted) and the top quntle (Q5: heavly shorted). We also sort low F-score frms wth low BM ratos nto tercles on the bass of ther market-adjusted short turnover and calculate the dfference n returns between the bottom tercle portfolo (T1: lghtly shorted) and the top tercle portfolo (T3: heavly shorted). In addton to market-adjusted returns, we also use szeadjusted returns 15 to take nto account short sellers preferences for large stocks over small stocks. We calculate our portfolo returns over several tme horzons, ncludng holdng perods 14 Investors can react to strong fundamental sgnals n two ways: ether by reducng shortng or by ncreasng purchasng. However, t s more lkely that nvestors do not have a short transacton planned for strong fundamental frms, causng more ntense purchases rather than less ntense shortng. Unfortunately, we cannot observe the long transactons of the short sellers n our sample, whch make the response of short sellng upon strong fundamental sgnals hard to nterpret. 15 Sze based decles are derved from unverse-crsp stocks. The assgnment of each stock n a portfolo s based on ths stock s market-cap at the end of the last calendar year (.e. annually rebalanced). Monthly return seres for each decle portfolo are provded by CRSP and we then compound returns nto 3, 6, 9, 12, 15, 18, 21 and 24 months perods. 22
of 3, 6, 12, 15, 18 and 24 months 16, to test the short- and long-term mpact of short sellng on the stock prce dscovery process. Table 5 reports the returns on the quntle portfolos of lghtly (Q1) and heavly (Q5) shorted low F-score frms. Panel A shows that the market-adjusted returns on all low F-score frms and Q1 are negatve and sgnfcant over all of the holdng perods, whle the market-adjusted returns on Q5 are only sgnfcantly negatve for the sx-month holdng perod. The marketadjusted return dfferental between Q1 and Q5 s also negatve and hghly sgnfcant across all holdng perods, suggestng that short sellng largely reduces the predctablty of low F- score to returns. We obtan smlar results usng sze-adjusted returns n Panel B. Specfcally, we fnd that Q1 experences sgnfcantly negatve sze-adjusted returns across all horzons, whle the returns on Q5 s only sgnfcant over three-month and the sx-month horzons. The sze-adjusted return dfferental s sgnfcantly negatve across all holdng perods, mplyng that short sellng ncreases the speed of prce adjustment to negatve sgnals about fundamentals. Table 6 reports the returns on the tercle portfolos of low F-score frms wth low BM ratos. The frst row n Panel A shows that the market-adjusted returns on low F-score frms wth low BM ratos are sgnfcantly negatve and larger n magntude than those of the low F-score frms reported n Panel A of Table 5. Ths fndng s consstent wth the presence of market expectaton errors about the growth prospects of low F-score frms. When fundamentals are far worse than the market expectatons, nvestors wll have greater dffcultes n tmely correctng ther prors, leadng to persstent negatve returns (Lakonshok et al., 1994; Cho and Sas, 2012; Potrosk and So, 2012). Addtonally, Panel A shows that the market-adjusted returns on T1 and T2 are sgnfcantly negatve for almost all horzons, whle the market-adjust returns on T3 are statstcally nsgnfcant. The return dfferental between T1 and T3 are hghly sgnfcant, 16 Potrosk (2000) fnd that the outperformance of hgh F-score frms over low F-score frms can persst up to a two-year perod 23
mplyng that short sellers help correct overprcng. The results of the sze-adjusted returns n Panel B are largely consstent wth those reported n Panel A. Panel B shows that, wth the excepton of the nne-month horzon, T1 generates sgnfcantly negatve sze-adjusted returns, whle the returns on T3 are statstcally nsgnfcant. Over the nne-month horzon, the szeadjusted return on T3 s negatve but ts magntude s consderably smaller than that of T1. Overall, our evdence that short sellers are able to change the ablty of low F-score to predct returns s consstent wth the msprcng-based argument. 4.3. Addtonal analyss 4.3.1. Short sellng and momentum Our prevous results show that low F-score frms have poor past performance, whle hgh F- score frms have good past performance. If short sellers chase downward momentum, low F- score frms should experence hgher short nterest than hgh F-score frms. To test the momentum-based explanaton, we frst calculate the dfferences n returns between low and hgh F-score frms over the three-month perod followng fscal year-end (.e., the wndow [- 4,-1] n Fgure 1). Subsequently, we rank the dfferences n returns across the sample years and separate them nto two groups. The frst group ncludes the 22 annual observatons n whch the underperformance of low F-score frms relatve to hgh F-score frms s partcularly large, whle the second group contans the remanng 22 annual observatons. If downward momentum chasng drves short nterest, we would expect that dfferences n short nterest between low and hgh F-score frms to be larger n the frst group than n the second group. The results n Panel A of Table 7 show that the average return dfferental between low and hgh F-score frms n the frst group s -6.42%. The dfference n short nterest between low and hgh F-score s postve (1.29%), but statstcally nsgnfcant. In the second group, although low F-score frms slghtly underperform hgh F-score frms by -0.14%, the dfference 24
n short nterest between low and hgh F-score frms s postve (3.49%) and hghly sgnfcant. The last row n Panel A shows the dfference-n-dfference (DID) of short nterest and returns between low and hgh F-score frms across the two groups. We fnd that the DID n returns and the DID n short nterest are negatve and sgnfcant. The fndng that low F-score frms attract more short sellng actvty when they underperform hgh F-score frms s nconsstent wth the vew that short sellers chase downward momentum. Our second test s based on the cross-sectonal analyss of past returns. Smlar to our prevous analyss, we rank all sample frms on the bass of the three-month returns over the nformaton perod (.e. the wndow [-4,-1] n Fgure 1) n each fscal year. Subsequently, we dvde the frms nto two groups wth an equal number of observatons. The frst group contans stocks wth hgher past returns (.e., wnners) and the second group conssts of stocks wth lower past returns (.e., losers). Each of these two groups s then dvded nto low, mddle and hgh F- scores to form sx F-score and past return portfolos. If short sellers chase poor past performance, we would expect losers to have hgher short nterest than wnners across both hgh and low F-score portfolos. Panel B n Table 7 reports the results. Column (1) shows that low F-score losers have sgnfcantly lower short nterest than low F-score wnners. The dfference n short nterest s negatve (-3.80%) and hghly sgnfcant (t-value = -2.68). Low F-score wnners have the hghest short nterest n the sx portfolos. Ths evdence contradcts the momentum based explanaton, whch predcts short sellng actvty to be concentrated n low F-score losers. Instead, ths fndng s consstent wth our hypothess that short sellers explot overprced low F-score stocks. Specfcally, our results mply that a subset of low F-score stocks may have performed well n the past, but such good performance s not sustanable due to deterorated fundamentals. The overprcng n ths subset of low F-score stocks, therefore, attracts short sellers. In the mddle and hgh F-score portfolos, dfferences n short nterest between losers 25
and wnners are all nsgnfcant, mplyng that short sellng actvty s not drven by poor past performance. Overall, our fndngs ndcate that short sellers are contraran traders rather than momentum traders. 4.3.2. Short sellng and nvestor sentment In ths secton, we examne the nterecton between short sellng and nvestor sentment. Baker and Wurgler (2006) argue that, n perods of hgh nvestor sentment, speculatve demand nduces stock prces to devate further and more frequently from fundamental values. Consstent wth ths argument, Stambaugh et al. (2012) fnd that the returns on the short-leg of most asset-prcng anomales are sgnfcantly lower n hgh sentment perods. If the relatonshp between fundamentals and future returns s drven by msprcng, overprcng should be more prevalent when sentment s hgh. Ths, n turn, would mply that hgh sentment perods offer short sellers greater opportuntes to explot overprced low F-score frms. As such, we predct a postve assocaton between the explotaton of overprcng and nvestor sentment. To test ths predcton, we examne the varatons n short sellng actvty assocated wth low and hgh F-score frms and low F-score frms wth low BM rato across dfferent sentment perods. We use the nvestor sentment ndex ntroduced by Baker and Wurgler (2006) 17 to classfy our sample years nto hgh, medum, and low sentment perods. Table 8 provdes the results. Panel A shows that the dfference n the market-adjusted short turnover between low F-score (mkt_adj_sh F1 ) and hgh F-score frms (mkt_adj_sh F3 ) s nsgnfcant durng low sentment perods. It also shows that the market-adjusted short turnover of low F-score frms wth low BM ratos (mkt_adj_sh F1_lowBM ) s postve but only sgnfcant at 10% level. Durng hgh sentment perods, (mkt_adj_sh F1 -mkt_adj_sh F3 ), 17 We obtan data on annual nvestor sentment ndex from Jeffery Wurgler s webste: http://pages.stern.nyu.edu/~jwurgler/. We use the Baker and Wurgler nvestor sentment ndex orthogonalzed to macroeconomc factors for our results. 26