The role of firm size and per ratio in explaining short-term return reversal and continuation for stocks quoted at the Nairobi Stock Exchange

Abstract

The random walk theory (Samuelson, 1965) suggests that changes in prices of common stocks over time are randomly distributed. Past price movements are not related to future price movements. More recently, studies have shown negative autocorrelation between past and future returns after 3-5years e.g. De Bondt and Thaler (1985) and positive autocorrelation for periods between 3 and 12 months e.g. Jegadeesh and Titman (1993).

This study sought to establish whether the nature of the past return effect at the NSE in the short term is dependent on firm size and price earnings (PE) ratio. We found no past return effect for the one year test period. When the test period was three months, we found that winners continue outperformingthe market while at six months, losers continue underperformance.

We found evidence of continuation for the small winner and low PE winner portfolios 3 and 6 months after portfolio formation. There was no significant difference in returns of past losers and winners in big size stocks and high PE stocks. The returns of these stocks are essentially similar to market returns.

The findings of this study support the proposition ofunderreaction (Jegadeesh and Titman, 1993) among small size and low PE stocks. The source of this underreaction may be investor conservatismwhereby investors adjust their beliefs about changing fundamentals gradually.

In the study, different portfolios were formed and their performances over the holding period ~ evaluated.It used the excess returns over the market rather than the absolute returns so that the

portfolio performance could be gauged against the market's performance as well. This has an intuitiveappeal especially in markets without short selling opportunities like the NSE.