As I wrote about last week, the absolute level of a firm’s stock price is arbitrary, as it can be easily manipulated by the firm through altering the number of shares outstanding (for example, by splitting the stock). Despite this obvious fact, the research into investor behavior has found a strong preference among individuals for low-priced stocks.
For instance, the research shows that individual investors tend to hold lower-priced stocks than institutions. And there’s also evidence demonstrating that the number of small shareholders in a stock increases following a split to a lower price level.
Research demonstrates this preference for low-priced stocks by individual investors is motivated by an irrational belief that stocks with lower nominal prices possess greater upside potential (more room to grow and less to lose) and the lottery-ticket effect. As with lotteries, investors are searching for “cheap bets” with large upside potential. They prefer positive skewness even if it means lower average expected returns.
The overly optimistic expectations among investors regarding low-priced stocks predict that low-priced stocks will likely be overpriced relative to high-priced stocks, thereby delivering lower future risk-adjusted stock returns.
More Evidence On Low-Priced Stocks
Justin Birru and Baolian Wang contribute to the literature on low-priced stocks through their March 2016 paper, “The Nominal Price Premium.” The authors begin the paper by noting that “the cross-sectional relationship between raw nominal prices and future returns is likely to underestimate the real economic magnitude of the nominal price premium.” They explain that is because a sort on raw nominal price is confounded by the mechanical relationship between raw nominal price and expected returns.
Any model of prices (such as the Gordon Constant Growth Dividend Discount model) inversely links prices and expected returns—stocks with higher risk will have higher expected returns, causing future cash flows to be discounted at a higher rate, leading to a lower current valuation.
Therefore, it should not be surprising that past research has failed to document a relationship between nominal price and future returns. A sort on raw nominal price combines two countervailing forces: a nominal price premium (predicting that low-priced stocks should exhibit low future returns), and a mechanical discount-rate effect (predicting that low-priced stocks should exhibit high future returns). For this reason, using nominal price as a sorting variable will underestimate the nominal price premium.
To address this problem, Birru and Wang employed a set of nominal variables from accounting statements: assets per share, book value per share, earnings per share and dividends per share. This set of variables, while highly correlated with nominal prices, is unlikely to suffer from the mechanical relationship with expected returns discussed previously. Their accounting data set covered the period 1967 through 2012, while their returns data set covered the period 1968 through 2013.