The authors test their hypothesis that observable momentum in stock returns is
the result of imperfect diffusion of company-specific information to the
investing public. They find that except for the very smallest stocks, the
potential profitability of momentum trading declines with company size. They
also find that when they hold company size fixed, momentum strategies work
better for stocks with low analyst coverage than for those with high analyst
coverage. Finally, they find that the importance of analyst coverage is far
greater for recent stock losers than it is for stock winners.
Many research studies have confirmed that stock returns show momentum over medium-term
horizons of 3–12 months: Past winners continue to perform well, and poor
performers continue to perform poorly.
The authors empirically investigate reasons for this phenomenon. They focus on the impact
of how quickly and efficiently company-specific information is diffused to the general
investing public. Their central thesis is that return momentum exists when
company-specific information is not rapidly spread to investors, and they suggest that
stocks with lower information diffusion exhibit greater momentum.
Because direct measurements of the efficiency of a company's information diffusion are
unavailable, the authors use a company's market capitalization and the amount of its
sell-side analyst coverage as primary proxy indicators. They suspect that investors are
more apt to seek out information about larger companies, for which they can take larger
positions; hence, diffusion will be faster for larger companies than it is for smaller
companies. Furthermore, the authors suspect that the amount of analyst coverage reflects
the extent that financial intermediaries are facilitating the diffusion of
company-specific information.
The authors look at virtually all publicly traded U.S. stocks for the 1976–96
period and use reported monthly returns and analyst-coverage data. Extremely small,
thinly traded companies are excluded, and the remaining stocks are grouped according to
their periodic short-term performance. Rigorous regression and sensitivity analysis
techniques are then applied, and the results confirm the main thesis: The profitability
of momentum in trading declines with size, and when holding the size fixed, momentum
strategies work best when analyst coverage is low. Moreover, those two factors appear to
reinforce each other, because the greatest return momentum came from small stocks with
low analyst coverage.
This information diffusion effect seems to be particularly pronounced for poor-performing
stocks that have low analyst coverage. For these stocks, trading momentum lasts longer
because the market appears to react more sluggishly to negative news on these companies.
The authors explain this asymmetry by noting that a company's management is apt to
aggressively release and publicize good news, whereas bad news diffuses more slowly.
Therefore, short-selling recent losers may be a profitable trading strategy.