Academic journal article International Advances in Economic Research

Returns of Small Growth Stocks: An Empirical Analysis

Academic journal article International Advances in Economic Research

Returns of Small Growth Stocks: An Empirical Analysis

Article excerpt

Abstract

I investigate the mean reversion tendency of small growth stocks. Using a carefully articulated research design employing established and empirically tested principles, my findings should support or refute the anecdotal evidence that small growth stocks make superior investments. The primary motivation for the study springs from the documented differential preference among investors for value and growth stocks. Despite evidence that value stocks tend to outperform growth stocks, investors retain strong interest in growth stocks. Yet in examining the performance of Business Week's (BW), smaller capitalization companies (called "Hot Growth Companies") with respect to the overall financial market, Bauman et al. [2002] found positive excess returns in the pre-publication period but negative excess returns in the post-publication period. A limitation of their study is that their analyses relied on only three criteria: sales, BW rank and return on capital, which do not represent completely a firm's financial health. I replicate Bauman et al. 's study but use a more robust and representative variable set to test the mean reversal hypothesis--Forbes' financial criteria--and I focus on six variables. In the current study, I look at 4,200 companies listed in Forbes from 1980 to 2000. The results of the expanded study substantiate Bauman et al.'s [2002] study showing that there are positive excess returns in the pre-publication period, but negative excess returns in the post-publication period. An expanded future study will look at five additional variables to see if they make a significant difference on the effects of the returns of small growth stocks. (JEL G20, G30, MOO)

Introduction

I seek to ascertain if the investment performance of Forbes' firms offers good investment opportunities. Expanding the research related to growth and value-investing, styles can provide practical investment insights to investors that follow such business magazine trends. Studying Forbes stocks can provide comparative performance with BW firms. The study will, thus, corroborate or refute Bauman et al.'s [2002] hypothesized behavior of small cap stocks. Including alternate definitions of income calculation provides additional evidence of their explanatory power for small cap firms.

Motivation and Project Description

Investors often support companies and their corporate managements because these companies usually exhibit recent financially strong performance such as high past growth in corporate sales and profits and high rates of return on capital. However, Clayman [1987] challenged the notion that good companies make good investments after examining the investment performance of a sample of companies featured in Peters and Waterman's [1982] In Search of Excellence, who, in turn, identify financial criteria that distinguish excellent from poor companies. Clayman [1987] compared the subsequent investment performance of predominately large cap companies that were judged to be excellent with a sample of companies considered to be financially mediocre, finding that the mediocre companies' stocks not only outperformed a stock market index by a wide margin but also outperformed the so-called excellent companies as well. Clayman [1987] concluded that:

  The 'good' companies underperform because the market overestimates
  their future growth and future return on equity and, as a result,
  (overvalues) the stocks ... the converse is true of 'poor' companies.

Bannister [1990] empirically reconfirmed these results. Solt and Statman [1989] and Shefrin and Statman [1995] also found inverse relationships between companies with excellent reputations and high past growth rates relative to their subsequent stock price performance. Many studies have also shown that the stocks of companies with high past growth rates have underperformed value stocks that had low price-earnings ratios or low past growth rates [Graham and Dodd, 1934; Basu 1977; Fama and French, 1992; Haugen, 1995; Bauman and Miller, 1997]. …

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