Copyright is owned by the Author of the thesis. Permission is given for a copy to be downloaded by an individual for the purpose of research and private study only. The thesis may not be reproduced elsewhere without the permission of the Author. An Examination of Stock Split and Special Dividend Announcements in Relation to Market-Timing Opportunities, Business Cycles, and Monthly Patterns A thesis presented in fulfilment of the requirements for the degree of Doctor of Philosophy in Finance at Massey University May (Meixia) Hu School of Economics and Finance College of Business Massey University 2012 i ABSTRACT This dissertation investigates the explanations for the aggregate corporate activities of stock split and special dividend announcements in the United States (US) listed firms between 1926 and 2008. The study is motivated by the limitation of understanding of these two types of events, which have previously only been focused at the firm-specific level. Further, by studying stock splits and special dividends, this research seeks to find an answer to the debate regarding explanations of corporate event waves between neoclassical efficiency reasons and modern market-timing hypothesis. The study is also motivated by the lack of a link between the extensively documented January Effect and Halloween Effect in stock markets and corporate practice. In addition to the contribution of the extended dataset provided in this research, the study has examined corporate decisions to announce stock splits and special dividends from a macro-perspective, especially in relation to market-timing opportunities, economic efficiency reasons, and calendar monthly effects. Chapter 1 is the introduction of this dissertation. Chapter 2 provides a comprehensive critical literature review on this topic. Chapter 3 is the research framework, hypothesis development, data and methodology used in this research. Chapter 4 is the initial results of the patterns and frequencies for stock split and special dividend announcements. Chapter 5 first investigates whether market conditions and investor sentiment affect the aggregate activities of stock splits and special dividends. These findings indicate that firms time the market to split shares during bull markets with positive and increasing sentiment to achieve higher abnormal returns. On the other hand, special dividend distributions are more likely to happen in bear markets when sentiment decreases. Firms paying special dividends in bear markets are better performers than their counterparts in bull markets. Chapter 6 then examines whether stock split and special dividend activities are driven by the business cycle. Stock splits are more likely to happen in the economic growth stage rather than in the mature stage. On the contrary, firms tend to distribute extra cash dividends to alleviate agency problems in economic declines when profitable investment opportunities are low. Chapter 7 explores the relationship between the patterns of stock splits and special dividend announcements and the calendar anomalies of the January Effect and the Halloween Effect. Firms are more likely to split shares in January and Halloween period than in other months of a year. However, firms have a commonality to pay special dividends to their shareholders in November and December. Lastly, Chapter 8 assesses which macro-determinant has the strongest explanatory power on stock splits and special dividend activities, and the results show that the business ii cycle effect is the quantitatively strongest along with all the additional and robustness checks. Chapter 9 is the conclusion and remarks of this dissertation, including future research ideas in the related areas. iii ACKNOWLEDGEMENTS Undertaking a PhD has definitely improved my research skill, but also shaped me as a person and led me to where I am now. First, I would like to thank my supervisors, Professor Martin Young and Dr. Chris Malone for their guidance, encouragement, frankness, and help throughout my PhD journey. Without them my life would be different and I would be a different person. Thank you very much for teaching me the academic world and enlightening me to a future full of hope. I would also like to thank Professor Minsoo Lee for helping me to get a PhD scholarship. I thank Professor Ghon Rhee, Professor Reena Aggarwal, Professor Richard Roll, Professor Bruce Grundy and Professor Jay Ritter for their great comments on my PhD and future journal submissions. Thanks also to Professor Fei Wu for the opportunity to write a book chapter with him and Dr. Jing Chi for all the teaching opportunities and supports she has given to me. I thank Koli Sewabu, Jason Auvaa, Gerald Lologa, Bex Reidy and the Massey Manawatu RA team for giving me happiness, love, care, understanding, and support outside of the office. It was one of my best choices to be a RA while doing a PhD. I thank Jenny and Terry McGrath, Nane and Seti Chen for all the nice meals you provided to me so many times. Thanks to ChinLui Foo for his love, understanding, and support from the beginning of my PhD in Massey. It is my blessing to meet all these wonderful people and my pleasure to share doctoral studies and life with the amazing officemates, Azira Abdul Adzis, Jingjing Yang, and Saqib Sharif. All the best for our studies and future careers. I would also like to thank Fong Mee Chin, Jing Liao, everyone in the School of Economics and Finance at Massey University and everyone who has supported and helped me in any respect during the completion of this dissertation. I offer my regards and blessings to all those people. I thank Julia Rayner and Shalini Watson for their help with the proof reading of this thesis. Thanks to my family, my mother Yuzhen Ren and father Zhenhuan Hu who have provided endless love, support, and patience especially at the peak of my stress and depressions. Thanks to my great grandma, Suzhen Guo who brought me up and died in the beginning of this year and my great grandpa, Tiancheng Yu; the memory of them has only increased after their death. A big thank you to my dear boyfriend, Mataiasi Tu’ilautala, no words can specify iv what he has done for me. Without him it would have been much harder to finish the PhD, learning to love him and to receive his love makes me a better person. Last but certainly not least, the greatest thank to the universal Lord, my God, Jesus Christ, all the glory belongs to him. v TABLE OF CONTENTS ABSTRACT ............................................................................................................................... ii ACKNOWLEDGEMENTS ...................................................................................................... iv TABLE OF CONTENTS .......................................................................................................... vi LIST OF TABLES ................................................................................................................... xii LIST OF FIGURES ............................................................................................................... xvii CHAPTER ONE – INTRODUCTION ...................................................................................... 1 1.1 Motivation of the Study.................................................................................................... 1 1.2 Research Objective and Questions ................................................................................... 3 1.3 Significance and Importance ............................................................................................ 6 1.4 Main Findings of the Research......................................................................................... 8 1.5 Contribution of the Dissertation ..................................................................................... 12 1.6 Structure of the Dissertation ........................................................................................... 13 CHAPTER TWO – LITERATURE REVIEW ........................................................................ 14 2.1 Background to the Literature.......................................................................................... 14 2.1.1 The Efficient Market Hypothesis (EMH) ................................................................ 14 2.1.2 Anomalies ................................................................................................................ 15 2.1.3 Theories Supporting EMH ....................................................................................... 16 2.1.4 Behavioural Finance ................................................................................................ 16 2.1.5 Incomplete Revelation Hypothesis (IRH) ............................................................... 18 2.1.6 Event Studies ........................................................................................................... 19 2.2 Stock Splits ..................................................................................................................... 20 2.2.1 Definition of Stock Splits and Classification of Stock Distributions ...................... 21 2.2.2 The Market Reaction to Stock Split Announcements ............................................. 22 2.2.2.1 Short-Term Reactions ....................................................................................... 22 2.2.2.2 Long-Term Reactions ....................................................................................... 23 2.2.3 Volatility Changes Subsequent to Stock Split Announcements .............................. 25 2.2.4 Reasons for Stock Splits .......................................................................................... 26 2.2.4.1 The Signalling Hypothesis ................................................................................ 26 2.2.4.2 The Optimal Trading Range Hypothesis .......................................................... 29 2.2.4.3 The Marketability or Liquidity Hypothesis ...................................................... 29 2.2.4.4 The Bid-Ask Spread or Broker Promotion Hypothesis .................................... 31 vi 2.2.4.5 The Optimal Relative Tick Size Hypothesis ..................................................... 32 2.2.4.6 The Dispersion of Control Theory or Enlarged Clientele Hypothesis .............. 33 2.2.4.7 The Tax-Option Hypothesis .............................................................................. 33 2.2.4.8 The Manipulation Hypothesis ........................................................................... 34 2.3 Special Dividends ........................................................................................................... 35 2.3.1 The Market Reaction to Special Dividend Announcements ................................... 36 2.3.2 Reasons for Special Dividends ................................................................................ 37 2.3.2.1 The Signalling Hypothesis ................................................................................ 37 2.3.2.2 The Free Cash Flow or Excess Funds Hypothesis ............................................ 37 2.3.2.3 The Wealthy Transfer Hypothesis .................................................................... 38 2.3.2.4 The Takeover Deterrence Hypothesis ............................................................... 39 2.3.3 Special Dividends and Share Repurchases .............................................................. 39 2.3.4 The Effect of Tax Cuts on Dividends ...................................................................... 40 2.3.5 The Evolution of Dividends and Patterns of Special Dividends ............................. 41 2.4 Corporate Event Waves .................................................................................................. 42 2.4.1 The Behavioural Hypothesis ................................................................................... 42 2.4.1.1 Investor Sentiment ............................................................................................ 42 2.4.1.2 The Market Driven Theory ............................................................................... 44 2.4.2 The Neoclassical Efficiency Hypothesis ................................................................. 45 2.5 Monthly Patterns ............................................................................................................ 48 2.5.1 The January Effect ................................................................................................... 48 2.5.1.1 The Existence of the January Effect ................................................................. 48 2.5.1.2 The January Effect and Size Anomaly.............................................................. 49 2.5.1.3 Reasons for the January Effect ......................................................................... 50 2.5.1.3.1 The Tax-Loss Selling Hypothesis .............................................................. 50 2.5.1.3.2 The Window-Dressing or Portfolio-Rebalancing Hypothesis ................... 52 2.5.1.3.3 The Parking-the-Proceeds Hypothesis ....................................................... 53 2.5.1.3.4 The Risk-Return Hypothesis ...................................................................... 54 2.5.1.3.5 The Information-Release or Insider-Trading Hypothesis .......................... 55 2.5.2 The Halloween Effect .............................................................................................. 56 2.5.2.1 The Existence of the Halloween Effect ............................................................ 56 2.5.2.2 Reasons for the Halloween Effect ..................................................................... 58 vii 2.5.2.2.1 The Summer Holiday Hypothesis .............................................................. 58 2.5.2.2.2 The Seasonal Affective Disorder (SAD) .................................................... 58 2.5.2.2.3 The Temperature Effect ............................................................................. 58 2.6 Summary ........................................................................................................................ 59 CHAPTER THREE – RESEARCH FRAMEWORK, DATA AND METHODOLOGY ....... 61 3.1 Hypotheses ..................................................................................................................... 61 3.1.1 Stock Market Conditions ......................................................................................... 61 3.1.2 Business Cycles ....................................................................................................... 63 3.1.3 Monthly Patterns...................................................................................................... 65 3.2 Data Source .................................................................................................................... 66 3.3 Event Selection ............................................................................................................... 66 3.4 Logistic Model for the Likelihood of Corporate Event Occurrence .............................. 68 3.4.1 Market Condition and Corporate Decision to Split or Initiate Special Dividends .. 68 3.4.2 Business Cycle and Corporate Decision to Split or Initiate Special Dividends ...... 70 3.4.3 Monthly Pattern of Corporate Event Occurrence .................................................... 72 3.4.4 The Dominant Macro-Determinants for the Occurrence of Corporate Events ....... 72 3.5 Event Study Methodology .............................................................................................. 74 3.5.1 Short Run Abnormal Returns .................................................................................. 74 3.5.1.1 The Mean Adjusted Model ............................................................................... 74 3.5.1.2 The Market Adjusted Model ............................................................................. 74 3.5.1.3 The Market Model Adjusted Model ................................................................. 75 3.5.2 Long Run Abnormal Returns .................................................................................. 75 3.5.2.1 The Fama-French (1993) Three-Factor Calendar Time Portfolio .................... 77 3.5.2.2 The Carhart (1997) Four-Factor Calendar Time Portfolio ............................... 77 3.6 Multivariate Regression on Abnormal Returns .............................................................. 77 3.6.1 Market Condition Affects Abnormal Returns ......................................................... 78 3.6.2 Business Cycle Affects Abnormal Returns ............................................................. 79 3.6.3 Monthly Pattern of Abnormal Returns .................................................................... 81 3.6.4 The Dominant Macro-Effect on the Abnormal Returns of Stock Splits and Special Dividend Announcements ................................................................................................ 81 3.7 Summary ........................................................................................................................ 83 CHAPTER FOUR – INTRODUCTION TO RESULTS ......................................................... 84 viii 4.1 Patterns of Stock Splits and Special Dividend Announcements .................................... 84 4.2 Ratios of Stock Splits ..................................................................................................... 85 4.3 Frequency and Size of Special Dividends ...................................................................... 86 4.4 Intra-Industry Effects of Stock Splits and Special Dividends ........................................ 87 4.5 Descriptive Statistics and Correlation Matrix between Regression Variables ............... 89 CHAPTER FIVE – RESULTS AND DISCUSSIONS OF MARKET CONDITIONS .......... 91 5.1 Stock Split Announcements ........................................................................................... 91 5.1.1 Frequency of Stock Splits in Bull and Bear Markets .............................................. 91 5.1.2 Likelihood of Occurrence of Stock Splits in Bull Markets ..................................... 93 5.1.3 Abnormal Returns of Stock Splits in Bull and Bear Markets.................................. 95 5.1.4 Multivariate Regression Results for Abnormal Returns of Stock Splits ................. 98 5.1.5 Robustness Check .................................................................................................. 102 5.2 Special Dividend Announcements ............................................................................... 103 5.2.1 Frequency of Special Dividends in Bull and Bear Markets .................................. 103 5.2.2 Likelihood of Occurrence of Special Dividends in Bull Markets ......................... 103 5.2.3 Abnormal Returns of Special Dividends in Bull and Bear Markets...................... 106 5.2.4 Multivariate Regression Results for Abnormal Returns of Special Dividends ..... 109 5.2.5 Robustness Check .................................................................................................. 113 5.3 Summary ...................................................................................................................... 114 CHAPTER SIX – RESULTS AND DISCUSSION OF THE EFFECT OF THE BUSINESS CYCLE .................................................................................................................................. 116 6.1 Stock Split Announcements ......................................................................................... 116 6.1.1 Frequency of Stock Splits in Expansions and Contractions .................................. 116 6.1.2 Likelihood of Occurrence of Stock Splits in Economic Expansions..................... 118 6.1.3 Abnormal Returns of Stock Splits in Expansions and Contractions ..................... 120 6.1.4 Multivariate Regression Results for Abnormal Returns of Stock Splits ............... 123 6.1.5 Robustness Check .................................................................................................. 130 6.2 Special Dividend Announcements ............................................................................... 132 6.2.1 Frequency of Special Dividends in Expansions and Contractions ........................ 132 6.2.2 Likelihood of Occurrence of Special Dividends in Economic Expansions ........... 133 6.2.3 Abnormal Returns of Special Dividends in Expansions and Contractions ........... 135 6.2.4 Multivariate Regression Results for Abnormal Returns of Special Dividends ..... 138 ix