The Investor Recognition Hypothesis:

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1 The Investor Recognton Hypothess: the New Zealand Penny Stocks Danel JP Cha, Department of Accountng and Fnance, onash Unversty, Clayton 3168, elbourne, Australa, and Danel FS Cho, Department of Fnance, Wakato anagement School, Unversty of Wakato, Prvate Bag 3105, Hamlton, New Zealand Abstract Recent work by Kanel, L, and Starks (2005) confrms the nvestor recognton hypothess n many countres. The New Zealand stock market s among a number of developed countres whch exhbt sgnfcant hgh-volume return premums (HVRP). The skewed sze dstrbuton of NZX-lsted frms, however, suggests that the analyss n New Zealand should control for frm sze. Ths paper shows that HVRP dsappears n each of the three sze groups when sze s measured by market captalsaton. In addton, HVRP n New Zealand s found to be drven by penny stocks only. In support of the nvestor recognton hypothess, we show that penny stocks are less lqud and more neglected, and thus respond more strongly to hgh-volume shocks. 1. Introducton Stocks dffer n popularty. On the one hand, stocks wth a broad nvestor base, such as consttuent stocks n a market ndex lke the NZSE40 n New Zealand (NZ) or the Hang Seng Index n Hong Kong, are more vsble (Hyland and Swdler 2002). On the other hand, some stocks have very lmted vsblty among nvestors. Examples nclude the neglected stocks studed by Arbel, Carvell, and Strebel (1983). A dstngushng feature of the less vsble stocks s asymmetrc dffuson of ther nformaton flows. A stock, however, could ncrease ts vsblty and broaden ts nvestor base. When ths occurs, the frm s cost of captal wll declne, causng the market value of the frm to ncrease. Ths dea s frst formalsed n erton s (1987) nvestor recognton hypothess (IRH). Recent emprcal studes have found support for the IRH. In a semnal study, Gervas, Kanel, and ngelgrn (2001) fnd that there s a hgh-volume return premum 1

2 (HVRP) n the U.S., whch can be attrbuted to the lnk between a stock s abnormal tradng volume and ts vsblty. Kanel, L, and Starks (2005) further supports the IRH by documentng a persstent HVRP phenomenon n many nternatonal stock markets. The analyss of the New Zealand stock market as a whole by Kanel et al. (2005) shows that New Zealand s among a number of developed markets that exhbt sgnfcant HVRP. However, the latter cross-country study fals to consder the effect of frm sze or prce range on HVRP wthn a natonal market. Such consderatons are especally mportant for the New Zealand market, gven ts unque features and regulatons. 1 In addton, a more detaled nvestgaton wll help dentfy the underlyng causes of and possble explanatons for the HVRP phenomenon. These motvatons form the bass of ths paper. In ths paper, we extend Kanel et al. s New Zealand data (from January 1990 to June 2001) to nclude two more years (from January 1990 to December 2003). Our emprcal results on the market as a whole confrm Kanel et al. s fndng that the HVRP exsts n the New Zealand stock market. However, when we classfy all the NZX-lsted frms nto three sze categores, the HVRP vanshes n each sze category. On the other hand, addtonal tests show that the HVRP exsts only n penny stocks but not n other stocks. One possble explanaton for our fndngs s that penny stocks are among those neglected frms that are less lqud and less vsble to nvestors. As noted by Kanel et. al (2005), stocks are more lkely to be neglected f they trade n a market domnated by a few large stocks. These neglected frms are expected to have less nvestor awareness (erton (1987)). As a result, accordng to the nvestor recognton hypothess, the frm s market value should ncrease f a stock enhances ts vsblty. Our result shows that penny stocks are less lqud than non-penny stocks, whch provdes some evdence that penny stocks are less frequently traded and less vsble to nvestors. We argue that penny stocks become more vsble after a hgh volume shock, and therefore nduce HVRP. The rest of ths paper s organzed as follows. Secton 2 revews key theoretcal and emprcal papers related to the nvestor recognton hypothess. Secton 3 dscusses the data and sample perod studed and brefly outlnes the methodology used n Kanel et al. (2005). Secton 4 explans n detal the portfolo formaton procedures that produce the HVRP results. Secton 5 reports the emprcal results before secton 6 concludes. 1 For example, Bartholdy and Brown (1999) pont out that the New Zealand stock market s composed of frms wth extreme asset sze dfferentals. In terms of ts sze, NZ makes up only 0.4% of world equty (Chn, Prevost, and Gottesman, 2002). oreover, the top 10 companes represent 77% of the market, whle the top 40 represent 95% of the market. All the remanng stocks represent only approxmately 5% of the market. As a result, most of stocks n the New Zealand Stock Exchange (NZX) are thnly traded and relatvely llqud. 2

3 2. Lterature Revew Poneerng work by ller (1977) and erton (1987) lays the foundaton for the nvestor recognton hypothess (IRH). ller (1977) frst contends that dfferent nvestment needs for dfferent ndvduals cause nvestors to vary n ther evaluaton of securtes. The probablty of a stock beng ncluded n an nvestor s portfolo depends frst on ts vsblty and second on the nvestor s percepton of the attractveness of the stock. A stock s vsblty may be lnked to ts prce, publcty, and the core operatons of the frm, ncludng popularty of the frm s products and the frm s socal mage. Hgh volume per se s not always assocated wth an ncrease n prce. The hgh volume could be attrbuted to heavy (or short) sellng by some nvestors (or speculators). However, f the volume does attract attenton and therefore ncrease nvestor awareness of the stock, then some nvestors may decde to buy the stock and push up ts prce. erton (1987) shows analytcally that when a stock s more publcly recognzed, ts cost of captal wll decrease. He also notes that neglected frms studed by Arbel, Carvell and Strebel (1983) are less vsble to nvestors. Accordng to Arbel et al. (1983), these neglected frms receve lttle or barely any coverage from professonal analysts on a regular bass. A number of studes have emprcally nvestgated predctons mpled by the nvestor recognton hypothess. Irvn (2003) fnds that market partcpants respond postvely to the ntaton of analyst coverage of a frm. Ths fndng s consstent wth the lqudty hypothess, whch predcts that ncreased analyst coverage mproves lqudty. Chen, Noronha and Sngal (2004) fnd a permanent ncrease n the stock prce f a frm s added nto the S&P 500 but no permanent declne for deleted frms. A smlar study by Hyland and Swdler (2002) also shows that the addton of a stock to New Zealand s NZSE40 ndex results n a permanent ncrease n the stock prce. They pont out that the tradng tme seres pattern s not related to the prce pressure hypothess because nstead of a bg jump n tradng volume just before the addton of the stock n the ndex, volume s already hgh about sx months before the event. On the other hand, because of the mechancal ndex lstng rules, lmted opportunty for ndex arbtrage, and low lqudty n the New Zealand stock market, they argue that the publcty of the stock should nstead support erton s attenton (recognton) hypothess. In ther paper, hgher prces are due to publcty but not related to extreme hgh or low volumes. Bushee and ller (2005) fnd that, by hrng an nvestor relatons frm, small and md-cap companes can attract a wder followng by nvestors and nformaton ntermedares and mprove ther market valuaton. Lehavy and Sloan (2006) fnd that contemporaneous stock returns are postvely related to change n nvestor recognton and future stock returns are negatvely related to changes n nvestor recognton. 3

4 Other studes n ths research area use perods of unusual tradng value to proxy for changes n vsblty. Gervas et al. (2001) fnd that the prces of stocks undergong extremely hgh (low) tradng volume over a day or a week tend to rse (fall) over the next month. They argue that the (postve or negatve) return premum s solely caused by the abnormal tradng volume. Ths mples that abnormal tradng volume thus contans nformaton about the future drecton of stock prces. Gervas et al. further establsh the robustness of ther results by emprcally refutng other possble explanatons. Specfcally, the authors show that ther HVRP results are not drven by: (1) the mpact of tradng volume on return autocorrelaton, (2) the momentum effects documented by Jegadeesh and Ttman (1993), (3) company announcements, (4) compensaton for low lqudty, or (5) compensaton for bearng excessve rsk. They postulate that the volume-based premum can be attrbuted to changes n the vsblty of the stocks and s consstent wth ller s IRH. A recent study by Kanel, L, and Starks (2005) also establshes the emprcal lnk between the IRH, vsblty, and the HVRP. They assume that vsblty can change from an extreme volume shock and that as predcted by erton s (1987) hypothess, the prce of the stock should change as a consequence, resultng n a hgh volume return premum. Kanel et al (2005) show that the magntude of the HVRP s assocated wth market characterstcs that are related to the mportance of a stock s vsblty. Ther results also suggest that the HVRP s a persstent phenomenon among almost all nternatonal markets. However, due to the dfferent macroeconomc, stock market, and demographc characterstcs across nternatonal stock markets, Kanel et al. (2005) argue the IRH can vary across markets. In Kanel et al. (2005), the New Zealand stock market s among the G7 and other developed countres to show sgnfcant HVRP. The wdely documented extreme sze dfferental of the New Zealand stock market, however, suggests that a more vgorous analyss should dfferentate stocks based on the sze of ther market captalsaton. The man contrbuton of ths paper addresses ths concern and seeks to dentfy the causes of the HVRP phenomenon n New Zealand establshed by Kanel et al (2005). The current paper fnds that only penny stocks experence HVRP. Next, we dscuss the data and methodology used to obtan that fndng. 3. Data and methodology We collect daly stock prce and tradng volume of NZX-lsted stocks from Datastream spannng from January 1990 to December There are a total of 178 companes that have tradng hstory durng ths perod. To ensure that each tradng nterval has enough stock data, stocks wth less than one year of tradng hstory on the NZX are excluded. The fnal sample has 161 companes, all of whch are publcly traded n

5 The HVRP s a measure of the mean stock return due to extreme volume shocks. We employ Kanel et al. s (2005) methodology to measure ths premum. Each tradng nterval has 70 days comprsed of three dfferent perods: the reference, formaton, and testng perods. The frst 49 days consttute the reference perod, whch s to provde a dstrbuton of the tradng volumes of each stock. Then there s a 1-day formaton perod, whch s used to measure whether the stock experences extreme volume shocks on that date compared to the prevous 49 volume fgures n the reference perod. In each tradng nterval, we elmnate stocks for whch less than 40 daly consecutve tradng data are avalable. 2 We also elmnate stocks for whch any data s mssng. 3 The frms whch experenced a merger or a delstng durng, or one year pror to, the tradng nterval are also removed. There s an average of 51 stocks avalable, that experence normal, hgh and low volumes, across all tradng ntervals. It should be noted that there are relatvely fewer stocks n the earler perods. The remanng stocks are defned as havng extreme tradng volumes durng the formaton perod f a stock s tradng volume s among the top or bottom 20% of the volume dstrbuton n the 49 days reference perod. Each stock that satsfes ths crteron s defned as a hgh- or low-volume stock. The rest of the stocks are classfed as havng normal tradng volume n the formaton perod. The last 20 days of the nterval are the testng perod, whch s used to measure the subsequent return. Gervas et al. (2001) focus on testng one-day, ten-day, and twenty-day returns after the formaton date. In ths study, we calculate portfolo returns of one, fve, ten, ffteen, and twenty days n our testng perod. Ths enables us to examne a wder spectrum of portfolo returns after extreme volume shocks. The (smple) returns of each stock are calculated as follows: R t = P P t Formaton Day 1 where t represents the number of days after the formaton day. Smlar to Kanel et al. (2005), our next tradng nterval (70 days) begns one day after (the frst day of?) the reference perod of the prevous tradng nterval so that the next testng perod begns one day after the prevous testng perod. Ths splts the full sample perod nto 155 tradng ntervals. The advantage of ths approach s to make 2 By elmnatng the nterval durng whch tradng frequency s less than 40 days, we can exclude the non-tradng stocks n our sample. Snce New Zealand stock market contans a lot of nfrequently traded stocks, we allow for lttle non-tradng because we do not want to lose too many observatons n each nterval. Ths procedure follows that used n Kanel et al. (2005). 3 If a stock s mssng a prce or tradng volume durng the tradng nterval, we smply exclude that stock from the tradng nterval. 5

6 full use of the sample data. Even though we have overlapped reference perods, the testng perods do not overlap. 4. Portfolo Formaton We form portfolos based on the stock s tradng volume classfcaton for that tradng nterval. We use two dfferent portfolo formaton procedures outlned below. 4.1 The Zero Investment Portfolo A zero nvestment portfolo s formed by takng a long poston for a total of one dollar n all the hgh-volume stocks, and a short poston for a total of one dollar n all the low-volume stocks. Each stock n the hgh/low volume category s gven equal weght. We adopt the subscrpt jt to denote the tradng nterval ( = 1,, 155), the stock j n that tradng nterval ( j = 1,, ), and the t-th day of the testng perod, where denotes the number of stocks avalable n the th tradng nterval. R jt s defned as the daly holdng return of stock j n tradng nterval over the t-th day followng the formaton perod. The cumulatve buy and hold return of stock j n tradng nterval over the t days followng the formaton perod s computed as t = ( 1+ τ ) 1 R jt r j τ= 1 and the average return n nterval over the t-th day as R t j= = 1 R jt The testng perod returns of the long and short postons at the end of each nterval are denoted as R Ht = j= 1 R H jt H and R Lt = j= 1 R L L jt where H and H and L denote the number of long and short postons n the th nterval. L must both be postve for a zero nvestment portfolo to be defned. R ( R ) denotes the cumulatve buy-and-hold return of stock j whch experences a H jt L jt 6

7 hgh (low) volume shock n the tradng nterval over t days. The net return n nterval s the return from combnng the two postons based on hgh and low volume: NR = R + R t Ht Lt We expect the mean hgh (low) volume return R H ( R L ) to be postve (negatve). Thus, the emphass wll only be on the analyss of the net return from the combnaton of long and short postons. 4.2 The Reference Return Portfolo The reference return portfolo requres that each dollar longed n the hgh-volume stock be offset by one dollar shorted n the sze-adjusted reference return portfolo. Smlarly, each dollar shorted n a low-volume stock s offset by the sze-adjusted reference return portfolo so that the net nvestment remans zero. The sze-adjusted reference return s R t defned n secton 4.1. Agan, a reference return portfolo s left unbalanced for the test perods subsequent to the formaton date. The average t-day return for all the reference return portfolos constructed from hgh volume stocks s gven by R th 155 H ( Rjt Rt) = 1 j= 1 = 155 = 1 H and the average t-day return for all the reference return portfolos constructed from low volume stocks s gven by R tl 155 L ( Rt Rjt) = 1 j= 1 = 155 = 1 L Fnally, the average proft from the combnaton of long postons n the hgh volume reference return portfolos and short postons n the low reference return portfolos s defned as: 7

8 NR t 155 H L ( Rjt Rt) + ( Rt Rjt) = 1 j= 1 j= 1 = 155 H L ( + ) = 1 5. Emprcal results In ths secton, we frst show that the HVRP exsts n the New Zealand stock market. We then show that the HVRP s ndependent of announcement effects. ost of the New Zealand frms are of small sze. In partcular, about forty percent of our sample frms are small frms whch are together worth only one percent of the total market captalzaton. We thus classfy all frms nto large, medum, and small frms. It s perhaps surprsng to fnd that the HVRP actually vanshes n each of the sze categores. On the other hand, when we classfy all our sample frms nto penny and non-penny stocks, we fnd that the HVRP exsts n the penny stocks but not the non-penny stocks. Fnally, we provde some evdence that penny stocks are generally more neglected than others. 5.1 HVRP exsts n the New Zealand stock market The results of the HVRP for all sample frms are presented n Table 1. Panel A shows the returns on zero nvestment portfolos whle the reference nvestment portfolo returns are shown n Panel B. The mean number of hgh-volume shocks s 12 whle that of low-volume shocks s 13 across all tradng ntervals. The mean number of stocks avalable across all tradng ntervals s 51. Both the zero nvestment portfolos and the reference return portfolos yeld sgnfcantly postve net returns n all testng perod horzons except for the 1-day perod. Furthermore, most of the long postons of hgh-volume stocks n the reference return portfolos generate sgnfcantly postve returns, whch ndcate that stocks experencng hgh-volume shocks subsequently generate postve abnormal returns. Short postons of low-volume stocks n the reference return portfolos also generate sgnfcantly postve returns n most of the cases. Ths ndcates that stocks generate negatve returns after low-volume shocks. The sgnfcantly postve returns after hgh- and low-volume shocks renforce the exstence of HVRP. Overall, these results renforce the fndngs of Kanel et al. (2005) that HVRPs exst n the New Zealand stock market. 8

9 Table 1 ean returns of zero nvestment portfolo and reference return portfolo The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that the t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh Low NR Panel B: Reference return portfolo (1.8817) (3.1691)** (2.3924)* (2.1007)* (2.0982)* Hgh ( ) ( )** ( )* ( )* ( )* Low (1.8467) (3.3409)** (1.9664)* (1.7729) (1.9922)* NR (1.7871) ( )** ( )* (1.9923)* (2.1366)* Note: * and ** denote sgnfcance at the 5% level and the 1% level respectvely. 9

10 5.2 The HVRP s ndependent of announcement effects A number of studes have documented the effects of frm announcements on tradng volume and stock returns. Bamer and Cheon (1995) fnd that when earnngs announcements are accompaned by large tradng volume wth small prce changes, they tend to be followed by prce ncreases. It s therefore possble that the HVRP s drven by frm announcements. In ths study, we remove from each tradng nterval of our sample those stocks that had a dvdend or an earnngs announcement on ether the day before, the day, or the day after the formaton perod. We consder the day precedng and followng the formaton perod because some announcements may be recorded on the next day followng the actual announcement date. The emprcal results are dsplayed n Table 2. The results are smlar to those before excludng frm announcements n Table 1. In the zero nvestment portfolos, the fve-day, ten-day, ffteen-day, and twenty-day net returns are sgnfcantly postve at the 1% or 5% level. Smlarly, n the reference return portfolos, the fve-day, ten-day, and twenty-day net returns are sgnfcantly postve at the 1% or 5% level. These results ndcate that frm announcements do not explan the HVRP n the New Zealand stock market. 10

11 Table 2 ean returns of zero nvestment portfolo and reference return portfolo after controllng for frm announcements The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that the t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh Low NR Panel B: Reference return portfolo (1.8626) (3.1604)** (2.3799)* (2.0388)* (2.0837)* Hgh (1.6991) ( )** ( )* (2.1415)** ( )** Low (1.8316) (3.3462)** (1.9552) (1.7357) (1.9824)* NR (1.7613) (3.1898)** ( )* (1.9348) ( )* Note: *and ** denote sgnfcance at the 5% level and the 1% level respectvely. 11

12 5.3 The HVRP vanshes n every sze category Ths secton conducts an addtonal test to examne whether the above fndngs have been nfluenced by frm sze. We classfy all the sample frms nto three categores by ther market captalzaton. We use a classfcaton procedure that reflects the fact that the sze dstrbuton n the New Zealand stock market s skewed to large frms. In order to defne approprate sze categores, we rank the market captalzaton of all sample frms n descendng order. A sze break pont s found n the lst of ranked sample frms whenever there s a substantal decrease n sze. We then classfy each sample frm nto the large, medum, or small category. The classfcaton method results n the large, medum, and small frms comprsng, on average, 90%, 9%, and 1% of the total market captalzaton, respectvely. Ths s summarzed n Table 3, whch also shows the average percentage of frms n each sze category across the sample years. Table 3 Average representaton of the market by each sze category Percentage of total market captalzaton Percentage of total number of frms Large 90% 15%-20% edum 9% 30%-35% Small 1% 40%-45% Table 4 below shows the mean market captalzaton of each sze category across all sample years. The results ndcate that the mean market captalzaton of large frms s very large (relatve to the other two groups) and s sgnfcantly dfferent to the medum frms and small frms. We dagram the natural logarthm of the mean market captalzatons n Fgure 1. The fgure shows that the log of mean market captalzatons for the three sze groups do not overlap, supportng that the classfcaton s approprate n the New Zealand stock market. Table 4 ean market captalzaton of each sze category n each year Large edum Small

13 Fgure 1 Logarthm of mean market captalzaton Log of average market captalzaton Log of m arket captalzaton Year Large edum Small The mean stock prce and mean tradng volume for each sze category are dsplayed n Table 5 below. The average prce s $6.25 for large frms, $3.04 for medum frms and $1.54 for small frms. The mean tradng volume s partcularly hgh n large frms and smallest n small frms. On average, medum frms have the most number of stocks avalable across all tradng ntervals whle large frms have the least. The average numbers of hgh-volume shocks for large, medum, and small frms are 3, 6, and 4, respectvely. On the other hand, the average numbers of low-volume shocks for large, medum, and small frms are 2, 7, and 5, respectvely. The small numbers of hgh- and low-volume shocks are due to the few observatons avalable n the earler sample perods. Table 5 ean prce, volume and number of stocks avalable ean prce ean volume (thousand of shares) ean number of stocks avalable Large frm $ edum frm $ Small frm $ As for the full sample, a HVRP analyss s done on each of the three sze groups. The results for large, medum and small frms are dsplayed n Tables 6, 7, and 8 n the Appendx. One consstent fndng emerges from the sze-based results. After controllng for frm sze, we fnd that the HVRP dsappears n each of the sze 13

14 categores HVRP exsts only n penny stocks Bowman and Iverson (1998) document that stock prces n the New Zealand stock market manly le between the range of $1 to $4 wth prces below $1 not unusual. Prce movements n low stock prces could yeld hgh returns. In other words, small absolute prce changes n low prce stocks can be large changes n terms of ther returns. It s also lkely that these penny stocks attract less attenton from nvestors and thereby become neglected. In ths secton, we nvestgate the mpact of penny stocks on the HVRP. Note that penny stocks are not necessarly stocks of small frms; there are qute a number of stocks n the medum frm-sze category wth prces below $1.00. Followng Bowman and Iverson (1998), we splt all sample stocks n the reference perod nto penny stocks (wth mean stock prce less than $1) and non-penny stocks (wth mean stock prce greater than or equal to $1). Table 9 and 10 report the HVRP results for non-penny stocks and penny stocks, respectvely. There are approxmately 38 stocks on average avalable for the non-penny stock group and 16 for the penny stock group across all tradng ntervals. On average, there are 8 hgh-volume and 9 low-volume shocks for the non-penny group, whle the penny group has 4 hgh-volume and 4 low-volume shocks. For non-penny stocks, all net returns on both zero nvestment portfolos and reference return portfolos are not statstcally sgnfcant. For penny stocks, the net returns on the zero nvestment portfolos are sgnfcantly postve at the fve-day, ffteen-day, and twenty-day test perod returns. The net returns on the reference return portfolos are sgnfcantly postve at the fve-day and ffteen-day test perod returns; the returns after extreme volume shocks are sgnfcantly postve at the 5% level or better n three out of the fve testng-perod cases. When we more closely compare each return fgure n Table 9 wth the correspondng fgure n Table 10, we observe that the magntudes of the returns after extreme volume shocks are generally hgher for the penny stocks. Ths means that the response of penny stocks to volume shocks, n general, domnates the response of non-penny stocks to volume shocks. 4 There s only one excepton: the postve net return on medum frms zero nvestment portfolos s sgnfcant n the fve-day testng perod. However, there s no evdence of HVRP for medum frms for two reasons. Frst, the HVRP for ths sze group lacks sgnfcance at all other testng-perod horzons. Second, the net return on medum frms reference return portfolos also lacks sgnfcance at all testng-perod horzons, ncludng the fve-day horzon. 14

15 Table 9 ean returns of zero nvestment portfolo and reference return portfolo for non penny stocks The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that the t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh Low NR Panel B: Reference return portfolo ( ) (1.5259) (1.6562) (1.0069) (1.3313) Hgh ( ) ( ) ( ) ( ) (1.2374) Low ( ) ( ) (1.5349) (0.8227) (1.2084) NR ( ) (1.4699) (1.4104) (0.9762) (1.2294) Note: * and ** denote sgnfcance at the 5% level and the 1% level respectvely. 15

16 Table 10 ean returns of zero nvestment portfolo and reference return portfolo for penny stocks The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that the t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh Low NR Panel B: Reference return portfolo (1.8553) (3.2482)** (1.8951) (2.6330)** (2.1813)* Hgh (1.9366) (2.8593)** (2.0058)* (2.4338)* (1.8625) Low (1.6222) (3.3164)* (1.5590) (2.5355)** (2.3299)* NR (1.7036) (3.0030)** (1.7705) (2.4827)* (1.9471) Note: * and ** denote sgnfcance at the 5% level and the 1% level respectvely. 5.5 Penny stocks are neglected In general, a less vsble stock can beneft consderably from a hgh volume shock (Kanel et al. (2005)). An abnormally hgh volume can cause the nvestng publc to notce the otherwse less vsble stock. The heghtened nvestor awareness wll therefore nduce HVRP. As a result, we argue that the above fndngs for penny stocks can be attrbuted to the argument that penny stocks are more neglected than others and thereby respond more strongly to extreme volume shocks. One way to valdate ths neglect argument s to show that penny stocks are less lqud. We acknowledge that a more drect test of neglect should focus on analyst coverage. However, obtanng nformaton on analyst coverage s costly n the New Zealand market. We therefore use the lqudty of a stock to proxy for the level of neglect experenced by the stock. The use of ths measure s justfed by the two-way relatonshp between lqudty and analyst coverage establshed by Brennan and Tamarowsk (2000). Frst, lqudty s an mportant consderaton to analysts when makng equty nvestment decsons. Second, the amount of analyst coverage negatvely affects nformaton asymmetry and thus has a postve effect on the lqudty. 16

17 We follow Lesmond, Ogden and Trzcnka (1999) and use the proporton of daly zero returns wthn a month to measure lqudty of a stock. 5 Lesmond et al. (1999) argue that f the value of an nformaton sgnal s nsuffcent to outwegh the transacton cost, market partcpants wll choose not to trade, resultng n an observed zero return. The advantage of usng ths lqudty measure s that t s easy to obtan and yet hghly correlated wth more tradtonal measures of lqudty such as bd-ask spread and turnover (Bekaert, Harvey and Lundblad (2003)). Snce our 49-day reference perod s overlapped, t s thus dffcult for us to calculate our lqudty measure usng the reference perod across tme. Therefore, the proporton of zero returns s calculated each month. Our purpose s to determne whether penny stocks are on average less lqud than non-penny stocks. We calculate the monthly proporton of zero returns for each stock. They are averaged across stocks n each month, and then average across tme. The results are summarzed n Table 11. Note that penny stocks make up more than one thrd of the New Zealand stock market. As expected, proporton of zero returns s 71% for penny stocks and 44% for non-penny stocks. Ths ndcates that penny stocks are less lqud than non-penny stocks and supports our neglect argument. The result of our lqudty analyss s thus consstent wth the fndng by Kanel et al. (2005) that stocks are more lkely to be neglected f they trade n a market domnated by a few large stocks. Table 11 Average proporton of zero returns for penny and non-penny stocks. Penny Stocks Non-Penny Stocks Average Zero Observatons In short, the HVRP phenomenon n New Zealand s drven by penny stocks that are more neglected and thus react more aggressvely to volume shocks. Specfcally, snce penny stocks n NZ have low lqudty and lmted vsblty to nvestors, a hgh volume shock would attract nvestors attenton and generate greater demand for the affected penny stocks. Other more vsble (non-penny) stocks are less senstve to hgh volume shocks. The fndngs of ths paper mply that the nvestor recognton hypothess n the New Zealand stock market apples only to penny stocks. 5 Proporton of zero returns s defned as number of zero returns wthn a month dvded by number of tradng days n that month. 17

18 6. Concluson Ths study more closely explores the nvestor recognton hypothess n the New Zealand stock market. In ther cross-country study, Kanel et al. (2005) fnd that the HVRP exsts n the overall New Zealand stock market. However, the skewed sze dstrbuton of New Zealand stocks warrants a more vgorous analyss of the HVRP phenomenon based on sze. In ths paper, we fnd that the HVRP actually dsappears n each of the three sze groups. We then try a dfferent classfcaton crteron related to sze: the magntude of stock prce. We classfy our sample frms nto two groups, penny stock group and non-penny stock group. Our emprcal results reveal that the HVRP s never sgnfcant for non-penny stocks. On the other hand, the HVRP s sgnfcantly postve for penny stocks n most of the testng perod horzons. Ths paper provdes emprcal evdence that hgh volume shocks nduce penny stocks to generate large net returns. We further show that penny stocks are less lqud than non-penny stocks, ndcatng that penny stocks are generally less vsble to nvestors n New Zealand. As a result, penny stocks can ncrease ther vsblty more consderably from volume shocks and nduce more sgnfcant hgh volume return premums. Ths leads us to conclude that erton s (1987) nvestor recognton hypothess apples only to penny stocks n the New Zealand stock market. 18

19 Appendx Table 6 ean returns of zero nvestment portfolos and reference return portfolos for large sze frms The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that the t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh NA NA NA NA NA Low NA NA NA NA NA NR ( ) (1.2101) (0.3893) (0.4006) (1.3561) Panel B: Reference return portfolo Hgh ( ) ( ) (1.0900) ( ) ( ) Low ( ) ( ) ( ) ( ) ( ) NR ( ) ( ) ( ) ( ) ( ) Note: * and ** denote sgnfcance at the 5% level and the 1% level respectvely. 19

20 Table 7 ean returns of zero nvestment portfolos and reference return portfolos for medum sze frms The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh Low NR (0.3053) (2.0824)* (1.6352) (1.0014) (1.2746) Panel B: Reference return portfolo Hgh ( ) ( ) ( ) ( ) ( ) Low ( ) ( )* ( ) ( ) ( ) NR ( ) ( ) ( ) ( ) ( ) Note: * and ** denote sgnfcance at the 5% level and the 1% level respectvely. 20

21 Table 8 ean returns of zero nvestment portfolos and reference return portfolos form small sze frms The returns after hgh/low-volumes and the net return are defned n the portfolo formaton secton. T-statstcs are shown n parentheses. For the cases where returns should not be compared to zero, NA ndcates that t-statstc s not applcable. Panel A: Zero nvestment portfolo Hgh Low NR (0.9277) ( (0.9948) (1.0584) (0.4598) Panel B: Reference return portfolo Hgh (1.4861) ( ) ( ) (1.2294) (0.5273) Low (0.4100) (0.8057) (0.3542) (0.730 ) (0.3229) NR (1.2650) (1.4187) (0.9315) (0.8242) (0.1852) Note: * and ** denote sgnfcance at the 5% level and the 1% level respectvely. 21

22 References Arbel, A., S. Carvell, and P. Strebel (1983). Graffes, Insttutons and Neglected Frms, Fnancal Analysts Journal (ay/june), 2-8. Bekaert, G., Harvey, C., and Lundblad, C., Lqudty and expected returns: Lessons from emergng markets. Columba Unversty. Bamer, L. S. and Y.S. Cheon (1995). Dfferental prce and volume reactons to accountng earnngs announcements, Accountng Revew 70, Bartholdy, J. and Brown K. (1999) Ex-dvdend day prcng n New Zealand, Accountng and Fnance, 39, Bowman, R.G. and D. Iverson (1998). Short-run overreacton n the New Zealand stock market, Pacfc-Basn Fnance Journal 6, Brennan,.L and Tamarowsk, C. (2000), Investor relatons, lqudty, and stock prces. Appled corporate fnance, 12. Bushee, B., and G. ller, 2005, Investor Relatons, Frm Vsblty, and Investor Followng, Workng Paper, Unversty of Pennsylvana. Chen, H., G. Noronha, and V. Sngal, 2004, The Prce Response to S&P 500 Index Addtons and Deletons: Evdence of Asymmetry and a New Explanaton, The Journal of Fnance, Vol. 59, Chn, J., A., Prevost and A., Gottesman (2002). Contraran nvestng n a small captalzaton market: Evdence from New Zealand, The Fnancal Revew 37, Gervas, S., R. Kanel, and D. H. ngelgrn (2001). The hgh-volume return premum, Journal of Fnance 56, No. 3, Hyland, Davd C. and Steve Swdler (2002). Tradng behavour of stocks added to New Zealand s NZSE40 ndex. Appled Economcs Letters 9, Irvne, P.J., 2003, The Incremental Impact of Analyst Intaton of Coverage. Journal of Corporate Fnance 9, Jegadeesh, N. and S. Ttman (1993). Returns to buyng wnners and sellng losers: Implcatons for stock market effcency, Journal of Fnance 48, Kanel, R., D. L, and L. Starks (2005). Investor vsblty events: Cross-Country evdence, workng paper, Unversty of Texas. Lehavy, R., and Sloan, R., 2006, Investor recognton and stock returns, workng paper, Unversty of chgan. Lesmond, D., Ogden, J., and Trzcnka, C., A new estmate of transacton costs, Revew of Fnancal Studes 12, erton, R. C. (1987). A smple model of captal market equlbrum wth ncomplete nformaton, Journal of Fnance 42, ller, E. (1977). Rsk, uncertanty, and dvergence of opnon, Journal of Fnance, 32/4, September,

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