The relationship between share price and returns in Australia and New Zealand

Abstract

One of the central ideas in finance is the efficient market hypothesis, which implies that a stock's price reflects all relevant information. Theoretically, price equals the present value of expected cash flows and changes when new information changes either the expected cash flows or the discount rate. Numbers such as the price level or volume traded, which are easily changed by a divisor, e.g. a stock split, should not be relevant to valuation. A stock's price reflects both the firm's value and the number of outstanding shares; the number of pieces (shares) the firm is made up of should not affect the firm's value. The manner in which cash flows are split up should not affect how information influences either expected cash flows or the discount rate. However, academics have documented a number of anomalies where the manner in which cash flows are split up affects returns. One anomaly is the small-firm effect, when firms that have small market capitalisations earn greater returns than those with large market capitalisations. There is a high positive correlation between low (high) firm value and low (high) stock price. Thus, one possible explanation for the small-firm effect is that stock price is a factor driving the difference in returns, i.e., low-priced stocks earn greater returns than high-priced stocks. A second anomaly is mean reversion, when shares that performed well (poorly) recently perform poorly (better) now. Firms that have performed poorly (well) recently tend to have lower (higher) share prices due to this poor performance, i.e. poor performance is whenever share price declines. Thus, when one looks at firms that have performed poorly a majority of these will have low-priced stock shares. Therefore, lower priced stocks may engender higher future returns. This study tests if low-priced stocks earn greater returns than high-priced stocks, using stocks from New Zealand and Australia. I also intend to explore possible explanations for any return differences between low- and high-priced stocks, e.g., differing risk levels. Hopefully, this study will be useful for portfolio management. If investors can earn greater returns by investing in low-priced rather than high-priced stocks, then, taking risk tolerance and diversification needs into account, they should hold more lowpriced stocks. This study also offers a test of the efficient market hypothesis. Price level should not be a relevant piece of information for future price changes. If there is no difference in the risk of stocks at different price levels, but the returns differ, it would indicate that the Australian and New Zealand stock markets might not be efficient. The paper is laid out in the following manner. Section two describes previous research on the relationship between share price and returns. Section three describes the data used in the study and outlines the techniques used in testing. Section four gives the results from the tests and offers analysis of these results. Section five concludes the study.