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Journal of Money, Investment and Banking ISSN 1450-288X Issue 21 (2011) EuroJournals Publishing, Inc. 2011 http://www.eurojournals.com/JMIB.

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A Study on Abnormal Stock Returns and Information Transfer Following R&D Increases
Yih-Bey Lin PhD student, Department of Finance, National Taiwan University and Department of Finance Chaoyang University of Technology, Taiwan Jian-Fa Li Corresponding Author, Department of Finance, Chaoyang University of Technology, Taiwan Address: 168 Jifong E. Rd., Wufong District, Taichung, 41349, Taiwan, R.O.C Tel: 886-4-23323000#4283; Fax: 886-4-23742333 E-mail: jfli@cyut.edu.tw Cheng-Yih Hong Department of Finance, Chaoyang University of Technology, Taiwan Abstract In order to better understand the informational contents of prices and the speed of the information revealed, this study examined the effects of R&D increases on stock returns and information transfer. Accordingly, by modifying Kyles model (Kyle, 1985), an asset pricing model was constructed, related hypotheses were proposed and the calendar-time approach was employed to investigate the information-related content of sudden unusually large increases in R&D expenditures. The empirical evidence shows that firms experience insignificantly negative abnormal returns on stocks following such R&D increases. It suggests that R&D increases might not be beneficial investments. The volatility of the value of R&D increases decline. It implied the fact that information is gradually incorporated into price system. It suggests that the stock market might still be informationally efficient. Additionally, in Taiwan we found that larger firms in contrast to smaller ones experienced better effects following R&D increases before year 2000 while smaller firms have done better after year 2000.

Keywords: R&D increases, Stock returns, Information transfer Calendar-time approach JEL Classification Codes: G11, G14, O32

I. Introduction
It is documented that the asset price is subject to all available information in an efficient market. Accordingly, it fails to generate abnormal stock returns that investors trade on publicly available information (Fama, 1970). Once market news (information) is released, a price adjustment would be made rapidly and accurately. It is important to note that the efficient market hypothesis (EMH hereafter) does not rule out small abnormal stock returns. Analysts and investors could still have an incentive to obtain and act on valuable information. Prior studies have developed various mechanisms to explore the effects of

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information on asset prices. They attempt to capture more complicated market responses and more complicated investors behavior. Bagehot (1971) provides an insight into the way in which information is incorporated into securities price through investment. Grossman and Stiglitz (1980) document that with costly information it is impossible for a market to be efficient. They also indicate that the equilibrium of a feasible model (namely rational expectation equilibrium) with noise must leave some incentives for investing in securities. Kyle (1985) finds that informed traders gain at the expense of noise traders. Some researchers have reported that the equities market slowly absorbs publicly available information. Loughran and Ritter (1995), for example, find that firms issuing new stocks significantly underperform non-issuing firms within five years. Baker and Wurgler (2000) document that equities issuers would issue stocks when the stock is overvalued and buy them back when the stock is undervalued. The strategy leads to the total gain with market timing being even bigger than loss with the adverse announcement effect. Eberhart et al. (2004) indicate that the stock market slowly realizes information-related value of research and development (R&D hereafter) increases. Motivated by the prior empirical evidences summarized above, the present study examines the impacts of R&D increases on stock returns and information transfer. The results might help us better understand the informational contents of stock price and the speed of the information revealed in a stock market. The reasons focusing on the effects of the R&D activities of firms on stock returns are as follows: (i) the R&D investments differ from other capital expenditures. First, R&D increases are firmspecific activities, whereas most capital investments share generic characteristics across firms within an industry. Second, there are currently few well-organized trading markets for R&D activities. Consequently, there is no price mechanism to convey the information-related value of R&D increases. Third, in both accounting treatment and practice R&D expenditures are different from other investments since R&D increases are recorded as expense in financial statements. There is, therefore, no information about gains and changes in productivity accompanied with R&D increases to report to investors (Aboody and Lev, 2000). As a result, the insiders or the well-informed traders might fail to evaluate the value of R&D investments. (ii) R&D increases accounts for the intangible assets of a firm and bring a potential benefit to cash flow in the future. However, Daniel and Titman (2006) argue that investors are liable to misevaluate those. Therefore, R&D increases provide an experiment to examine whether the stock market is capable to correctly incorporate the benefit of an intangible long-term investment. The literature on the evaluation of R&D investments has been primarily focused on the effects of changes in R&D expenditures on stock returns.1 Eberhart et al. (2004) claim that the market is slow to recognize the extent of benefit in R&D increases and EMH might not be satisfied. Hence, in the present study, we explore the information-related content and the speed at which information is updated as revealed by the behavior of long-term stock returns following changes in R&D investments and investigate whether R&D increases are beneficial investments for firms in Taiwan and if EMH remains valid following R&D increases. Considering the characteristics of R&D investments as intangible assets and referring to the conjectures of Grossman and Stiglitz (1980), we assume that the information-related value of R&D increases consists of two random parts: One is that the informed might capture true value but the uninformed merely obtain the expected value. The other is that the true value cannot be observed by either informed or uninformed traders and is revealed gradually over time. Accordingly, we construct a model of insider trading to examine the information-related content of R&D increases. The present
1

Chan et al. (1990), for example, investigate the response of stock prices for firms on the announcement of changes in R&D expenditures. Kelm et al. (1995) examine the impacts of the announcements about R&D projects on the market value of firms stocks. Sundaram et al. (1996) examine the hypothesis of competition matters. Furthermore, Aboody and Lev (2000) corroborate the hypothesis by providing evidence that insider gains in R&D intensive companies are significantly larger than those in firms that do not engage in R&D. In addition, Chan et al. (2001) examine whether stock price fully values the intangible assets of firms, specifically in R&D.

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study employs the calendar-time approach to examine the abnormal returns on stocks and the information value of price volatility, and then to evaluate the speed of the information revealed of R&D increases. All of the data used in the present study are collected from the database of the Taiwan Economic Journal. The sample set consists of 1197 cases of firms that unexpectedly increased their R&D expenditures by a significant amount over the period 1988 to 2007. To verify whether our findings vary across different groups of firms, the sample classified into two sets of two subgroups: high-tech and low-tech, as well as high-growth and low-growth firms. We found no evidence of significant abnormal returns in either the short term or the long term following R&D increases. This result suggests that abnormal R&D increases might not be beneficial activities. Moreover, the volatility of the value of R&D increases decline reflecting the fact that information is gradually incorporated into price system. It suggests that the stock market might still be informationally efficient. The remainder of this paper is organized as follows. In section 2, we construct an asset pricing model, and propose related hypotheses. The empirical methodology is discussed in section 3. Section 4 describes the data and the sample construction, and presents the empirical results. Finally, we conclude in section 5.

II. Theoretical Models


In this section, the theoretical model is constructed by adding the intangible characteristics of R&D investments and Grossman and Stiglitzs conjectures (Grossman and Stiglitz, 1980) into Kyles model (Kyle, 1985) in which there is an asset market with relatively few insiders or informed traders and many uninformed traders. The information-related value of R&D increases consists of two random components. One is that the insiders or the informed recognize the true value but the uninformed merely know the expected value. The other is that the true value cannot observed by either the informed or the uninformed. However, it would be gradually revealed over time. Accordingly, there are two main differences between Kyle (1985) and our model. First, Kyle (1985) assumes the insiders could observe the ex post liquidation value of the risky assets, whereas in the present study we assume the insiders could merely recognize the partial value of them. Second, Kyle (1985) illustrates clearly that the error variance of assets price converges to zero as the ex post liquidation value becomes fully revealed. Nevertheless, the error variance in our model might converge to a non-degenerate normal distribution which admits us to conduct some empirical studies about R&D increases of the firms. One-shot Trading

~ % % % % Assume that the information-related value of R&D increases is denoted as v , v = + , where is ~ normally distributed with mean 0 and variance 2 ; is normally distributed with zero mean and ~ ~ variance 2 . Therefore, we have v ~ N ( , 2 ), where 2 = 2 + 2 . Suppose the informed know .

0 v
v

% % The quantity traded by the informed is denoted as x and the price is denoted as p . The uninformed ~ which is normally distributed are noisy traders, they know only 0, the quantity traded is denoted as u
2 with zero mean and constant variance u . The trading structure consists of two steps as follows: % % % % % Step 1: v , u and x are realized and x = X .

( )

% % % % Step 2: market clearing determines the price p and p = P ( x + u ) . % % where x is the trading strategy function of the informed and p is the market price function.

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Equilibrium 1 % % The equilibrium is defined as a pair functions of x and p , which satisfies the following two % % % % conditions: (i) the profit maximization condition E[ ( x, p ) % = ] E[ ( x ', p ) % = ] ; and (ii) the ~~ ~ % % % % x p x market efficiency condition P ( ~, ~ ) = E[v + u ] . Let the profits of the informed be = ( v p ) x , The
equilibrium exists in which both X( ) and P( ) are linear functions: X ( ) = ( 0 ) (1) (2)
1

% % % % P ( x + u ) = 0 + ( x + u )
2 2 1 2 2 where = u2 , = u2 2 According to the equilibrium above, we have the following property: Property 1
1

1 ~p Define v2 = Var{v~} , we obtain v2 = 2 + u2 . That is, half of the insiders private information is 2 incorporated into price function.2

Sequential Trading
This subsection generalize the model of one-shot trading in which a number of trading rounds take place sequentially. Let trading take place continually during a period, which begins at time t = 0 and ends at time t = 1. There are N+1 episodes of trading, the time at which the nth episode occurs is denoted by tn , 0 = t0 < t1 < L < t N = 1 ~ % % Let u (t ) be a Brownian motion process with an instantaneous variance 2 . u = u ( t ) and
u
n n

% % % % un = un un 1 , where un ~ N (0, tn ) and. tn = tn tn 1 Assume ~ 2 ~ ~ N (0, 2 ) , ~ ~ N ( , 2 ) . ~ N ( 0 , ) and and Accordingly, 0


2 u

% % % v = +
2 v

where

where = 2 + 2

2 % % % % and n = v2 (tn ) . Let xn = xn xn 1 and pn represent the market clearing price at the nth trading. % Therefore, the measurable functions of the nth trading for trading volume ~ and the price p are x

written as % % % xn = X n ( p1 ,L , pn 1 , ) ,

% % % % % pn = Pn ( x1 + u1 ,L , xn + un ) where the vectors of function ~ and ~ are defined as x p ~ = ( ~ , , ~ ) x x1 xN ~ = ( ~ , , ~ ) p p1 pN % We refer to ~ as the informed traders trading strategy and ~ as the pricing rule. Let n x p th denote the profits of the insiders on positions acquired at the n trading
% % % % n = ( v pk ) xk
N k =n

Equilibrium 2 The equilibrium of a sequential trading is defined as a pair ( ~, ~ ). The following profit maximization x p and market efficiency conditions could be satisfied simultaneously.

The detailed proofs of equilibrium 1 and property 1 are available from the from Appendix.

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~ ~ E[ ( ~, ~ ) ~1 , , ~n 1 , ] E[ ( ~ ' , ~ ) ~1 , , ~n 1 , ] x p p p x p p p ~ = E[v + u , , ~ + u ] ~~ ~ p x x ~
n

There is a recursive linear equilibrium such that % % % xn = n pn 1 tn

(3) (4)

% % % pn = n ( xn + un )
E n p1 ,L , pn 1 , = n 1 ( pn 1 ) + n 1 %
2

(5)

where n 1 =

1 2 n n 1 , n 1 = n + n n2 u2 tn , n tn = 4 n (1 n n ) 2n (1 n n )
2 n n 2 2 and n = (1 n n tn ) n 1 u2

n =

Property 2 2 The parameter n which measures the informativeness of prices declines monotonically. It reflects the fact that information-related value is gradually incorporated into prices. Property 3 The extent of R&D benefit is slowly recognized in the market owing to that information-related value is gradually incorporated into prices, which causes positive (negative) long-term performances as R&D investments are beneficial (harmful), but the market might be still efficient.3

III. Empirical Methodology


Hypotheses Development
Recalling the conditions of equilibriums above, we find that even if the positive long-term performance exists after R&D increases, the market might still be efficient. According to the properties above, two hypotheses can be established as follows:

Hypothesis 1 There are positively or negatively abnormal returns on stock following R&D increases. Hypothesis 2 The value of R&D increases is gradually incorporated into prices, which causes (positive or negative) abnormal returns on stock following R&D increases while the market might be still efficient. The present study tests these hypotheses to explore whether R&D increase is a beneficial investment, and whether the stock market could precisely and promptly recognize information-related value of R&D increases. Abnormal stock returns following R&D Increases
Most prior studies form portfolio by employing event-time approach to explore the abnormal stock returns. However, Fama (1998) argues that event-time approach might raise the probability of type error owing to high cross-sectional correlation problem. Accordingly, this paper employs calendar-time approach and Fama-French there factor model to examine the effects of R&D increase on stock returns. The calendar-time portfolio and Fama-French there factor model are established as follows.

The detailed proofs of equilibrium 2 and properties 2 and 3 are available from the Appendix.

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Calendar-time Portfolio A calendar-time portfolio is composed of the firms which have ever increased in R&D expenditure within the past five years. For example, in April, nth year, we select the firms which have ever increased in R&D during April in (n-5)th year to March in nth year, form a calendar-time portfolio. Next month, we elect the firms which have ever increased in R&D during May in (n-5)th year to April in nth year, form the another calendar-time portfolio, and so forth. Fama-French there factor model To examine the sensitivity of stock returns to R&D investments, the Fama-French three-factor model (FF3 model hereafter) and No-R&D model (NOR model hereafter) are constructed, respectively. The FF3 model states that the expected returns on a risky portfolio p at the period t in excess of the risk-free rate are explained by the sensitivity of the returns on the portfolios to three factors: a market factor, a size factor, and a book-to-market factor. To investigate the difference between the stock returns of R&D expenditures and No-R&D expenditures firms (R(t)-NOR(t)), a modified three-factor model is presented as NOR model. The No-R&D expenses firms represent the firms with no unexpectedly and economically significant R&D increases during the year. Both the testable FF3 and NOR models for the long-term abnormal stock returns are written as R(p, t) - R(f, t) = a1 + b1[R(m, t) R(f, t)] + s1SMB(t) + h1HML(t) + e1(t) (6) R(p, t) - NOR(p, t) = a2 + b2[R(m, t) R(f, t)] + s2SMB(t) + h2HML(t) + e2(t) (7) where R(p, t) is the raw stock return for firms with economically significant R&D increases in period t, R(f ,t) is the 3-month T-bill returns, R(m, t) is the market index returns, SMB(t) (small minus big) is the returns on a portfolio of small stocks minus the return on a portfolio of large stocks, and HML(t) (high minus low) is the return on a portfolio of stocks with a high book-to-market ratio minus the returns on a portfolio of common stocks with low book-to-market ratios. NOR(p,t) represents the stock return of firms with no unexpectedly and economically significant R&D increases in period t. The terms e1(t) and e2(t) are error terms assumed to have zero mean and to be uncorrelated with all other variables. The intercepts (a1, a2) are the measures of abnormal returns. The factor sensitivities, b1, b2, s1, s2, h1, h2 are slope coefficients in the regression, respectively. We expect that the estimated parameters b1, b2 and s1, s2 are positive and significant, and h1, h2 are negative. These are generally consistent with those reported in previous studies. Information Transfer effect of the value of R&D Increases
Different from Kyle(1985), the theoretical model in the present study documented that since the insiders could merely recognize the partial value of R&D increase, the error variance in our model might converge to a non-degenerate normal distribution4. We calculated the t-th returns on portfolio of R&D increase (Rp,t) and no unexpectedly significant R&D increases (NORp,t), respectively. Then we estimated the changes in variances of the differences between Rp,t and NORp,t ,in order to measure the informativeness of stock market on the value of R&D increase. The term t2 denoted the variances of the differences between Rp,t and NORp,t , and was specified as follows: t2 = Var (Rp,t NORp,t) We employed two indices ( V1 = (t - 1 ) / 1 and V2 = (t - t-1 ) / t-1 , respectively, to estimate the responses of stock market on the information of increasing in R&D.

Kyle (1985) assumes the insiders could observe the ex post liquidation value of the risky assets and illustrates clearly that the error variance of assets price converges to zero as the ex post liquidation value becomes fully revealed.

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IV. Empirical Results


Data and Sample Construction
All the data used in this study are collected from the Taiwan Economic Journal databases. The data set contains 1197 observations (464 firms) listed on the Taiwan Stock Exchange over the period 1988 to 2007. In order to construct the final sample set, some selection criteria were imposed. First, following Eberhart et al. (2004), we select the firms with the ratio of R&D expenditures to sales above 3% or with increases in R&D expenditures over 5 percentage change of those in the prior year. Second, to directly address any possible problems associated with overlapping data, we also demonstrate the overlapping-adjusted sample in which a firm could only be included once every 5 years. To verify whether our findings differ across various groups of firms, according to Chan et al. (1990) and Eberhart et al. (2004), the firms are then further classified into two groups: high-tech and low-tech firms. The firms are also classified into high-growth and low-growth firms. The firms are assigned into high-tech or low-tech based on their R&D intensity, where R&D intensity is computed as a ratio of R&D expenditures to sales. The high-tech subgroups are the top 75% of the sample firms. The lowtech subgroups are the remaining 25% of the firms. The firms are sorted into high-growth or lowgrowth based on their MB ratio, where MB ratio is the sum of market value of common stocks and book value of debt, divided by book value of total assets. The high-growth subgroups are the top 75% of the sample firms and the low-growth subgroups are the bottom 25% of the firms. Besides, to avoid the cross-sectional correlation in event-time measurement which might cause possible downward biases, we make use of calendar-time approach to sort for the portfolios. The descriptive statistics for 1197 observations (464 firms) with unexpectedly and economically significant R&D increases, those observations are the firms with the ratio of R&D expenditures to sales above 3% or with increases in R&D expenditures over 5 percentage change of those in the prior year (following Eberhart et al. (2004). The market capitalization (i.e. equity market value) was measured as the sample firms R&D increases year and adjusted by the Consumer Price Index (CPI) to reflect the monetary value in year 2003. MB ratio and R&D intensity are also measured as the sample firms R&D increases year. No-R&D firms represent the firms do not unexpectedly increase their R&D expenditures with an economically significant amount during the sample firms R&D increases year. On average, the total assets of our sample firms with R&D increases is NT$ 11.57 billion, the sales is NT$ 6.36 billion, market capitalization is NT$ 21.36 billion, MB ratio is 1.50, and the yearly average percentage change in R&D expenditures is 39.59%. It should be noted that the monthly average stock returns of both full sample and sub-groups are negative. It shows that the percentage changes in stock returns rate range from -1.48% to -0.12%. Therefore, R&D investments might not be beneficial activities. The result shows that it is not similar to those documented in prior studies.

Regression Results on Abnormal Stock Returns for full Sample


Table 1 reports the regression results for the full sample and overlapping- adjusted sample under the FF3 and the NOR models, respectively. The 40 estimated intercepts (a1, a2) of the abnormal returns on the portfolios are all insignificant with the p-value from 0.11 to 0.99 under the FF3 and the NOR models. Accordingly, the firms do not experience abnormal returns following R&D increases. In fact, it is not an unexpected result since there are more than 70% of investors in the Taiwan stock market are individual investors. With short-term investments, they seldom care about R&D investments. The benefits from the R&D increases might require time to become realized. Additionally, there are conservation and pessimism in the securities market after the R&D increases of the firms. Consequently, no clear relationship between R&D increases and future stock returns have been found in Taiwan stock market. However, under the FF3 model, the 20 market betas (b1) are all significantly positive and range from 0.638 to 0.967. They are close to one except for over 1 and 2 months (0.638 and 0.808). That is,

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the market risk premium could capture the systematic risk in the Taiwan stock market. Only for the period of 5 to 7 months and 24 to 48 months, the coefficients (s1) on SMB range from 0.170 to 0.224 are positive and significant. The rest of the coefficients are not significant. It shows there is weak small firm effect in the Taiwan stock market. The range of the coefficients (h1) on HML is from -0.232 to 0.041. While the 12 coefficients (h1) of HML are significantly negative for the period of 5 to 60 months, 4 out of 16 are not significantly different from zero. As most of them are statistically significant, the HML factor, to some extent, appears to have statistical ability to explain the returns variation on stocks. That is, the larger the ratio of book-to-market is, the lower the stock returns are. In short, we document that the returns on Taiwan stocks with R&D increases are significantly related to market premium (Rm-Rf) and book to market equity ratio (B/M). Under the NOR model, the estimated coefficients (b2) of market-factor are less significant. Although the results indicate that both the stock returns on R&D firms (firms with R&D increases) and No-R&D firms could be explained by the market-factor, respectively, the differences of them might cancelled out each other. It follows that the explanatory power might drop off. Most of the estimated coefficients (s2) are significantly negative at the 1% significance level. Comparing the results under the NOR model with those under the FF3 model in Panel A, the results indicate that the returns on stocks for the larger firms are higher than those for the small firms, this is evidence that the R&D increases in the large firms are more beneficial than those of the small firms.
Table 1: Abnormal stock returns following R&D increases
FF3 model s1

NOR model h1 a2 b2 s2 h2 Panel A : Full sample 1 0.263 0.638** -0.046 0.041 0.966 -0.152 0.075 -0.788** 2 -0.171 0.808*** 0.171 -0.049 0.518 -0.291** -0.234 -0.455** 3 -0.286 0.893*** 0.221 -0.044 0.632 -0.220** -0.452** -0.402** 4 -0.203 0.911*** 0.188 -0.126 0.094 -0.145 -0.640*** -0.342** 5 -0.235 0.901*** 0.224* -0.181** -0.005 -0.147** -0.558*** -0.384*** 6 -0.464 0.913*** 0.218* -0.187** -0.483 -0.111* -0.584*** -0.381*** 7 -0.803 0.913*** 0.186* -0.232*** -0.702 -0.122** -0.606*** -0.446*** 8 -0.769 0.923*** 0.060 -0.187** -0.501 -0.102* -0.688*** -0.440*** 9 -0.584 0.967*** 0.050 -0.147** -0.213 -0.024 -0.777*** -0.375*** 10 -0.474 0.959*** 0.035 -0.151** -0.186 -0.052 -0.759*** -0.383*** 11 -0.372 0.934*** 0.091 -0.152** -0.159 -0.067 -0.718*** -0.389*** 12 0.038 0.940*** 0.122 -0.152** 0.200 -0.064 -0.690*** -0.402*** 24 -0.060 0.939*** 0.170* -0.143** 0.102 -0.066 -0.642*** -0.393*** 36 -0.074 0.956*** 0.172* -0.126** 0.088 -0.049 -0.640*** -0.376*** 48 -0.065 0.951*** 0.173** -0.118* 0.097 -0.053 -0.639*** -0.368*** 60 -0.142 0.953*** 0.147* -0.100* 0.260 0.998*** 0.769*** 0.256*** Panel B : Overlapping-adjusted sample 24 -0.087 0.951*** 0.172* -0.155** 0.075 -0.054 -0.641*** -0.405*** 36 -0.065 0.955*** 0.168* -0.132** 0.097 -0.049 -0.645*** -0.382*** 48 -0.095 0.945*** 0.190** -0.132** 0.067 -0.060 -0.622*** -0.382*** 60 -0.064 0.953*** 0.141 -0.112* 0.144 -0.047 -0.623*** -0.371*** Note: Full Sample contains all sample firms; the overlapping-adjusted sample takes once every five year. The FF3 and NOR models are expressed as R(p, t) - R(f, t) = a1 + b1[R(m, t) R(f, t)] + s1SMB(t) + h1HML(t) + e1(t) (FF3 model) R(p, t) - NOR(p, t) = a2 + b2[R(m, t) R(f, t)] + s2SMB(t) + h2HML(t) + e2(t) (NOR model) Month a1 b1
where the FF3 model represents the Fama-French three-factor model, the NOR model represents the R&D versus No-R&D model, R(p, t) is the raw returns on portfolio at month t, R(f, t) is the riskless interest rate, R(m, t) is the returns on Taiwan stock market index, SMB(t) is the return on a portfolio of small stock minus the returns on a portfolio of large stock, and HML(t) is the returns on a portfolio of stocks with high book-to-market ratios (B/M) minus the returns on a portfolio of stocks with low book-to-market ratios. The intercept a1 anda2 are the abnormal return measures, and b1, b2, s1, s2, h1, h2 are the corresponding coefficients, respectively.***, **, and *denote significance at the 1 %, 5%, and 10% levels, respectively. The data covers 1,197 observations (464 firms) over the period 1988 to 2007.

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To avoid any possible problems associated with overlapping data, a firm can only be included in the sample one time in every 5 year period. The results of the regression using the overlappingadjusted sample are reported in Panel B of Table 1. Because the results for the periods of 1 to 12 months for the overlapping-adjusted sample are the same as those for the full sample shown in Panel A, they are not reported in Panel B. Again, our finding provides evidence that firms do not experience abnormal returns following R&D increases. As Taiwan has experienced political instability and an economic recession since year 2000, and the stock price volatility contrast have changed. To uncover the sensitivity of the abnormal stock returns with R&D increases after year 2000, the regressions are run in which the sample set covers over the period 2000 to 2007 (The results of the regressions are not tabulated here). Except for 5-8 months under the FF3 model and 5-7 months under the NOR model, the intercepts (a1, a2) are not significant under either model. Overall, the results for both the full sample and the overlappingadjusted sample consistently evidence that the corporate events with R&D increases do not have longterm effects for stock returns.

Regression Results for Dichotomies


In this subsection, we further examine the abnormal returns on stocks for subgroups with the R&D increases over the period 1988 to 2007. To check whether our findings vary across firms, the firms are classified into high-tech, low-tech, high-growth, and low-growth subgroups. As shown in Panels A, B, C and D of Table 2, all the intercepts (a1, a2) ranging from -0.779 to 0.389 are not significantly different from zero at the 10% significance level. The evidence suggests that there are no long-term abnormal returns following R&D increases, and no significant difference between sample firms and firms without R&D increases. Therefore, this still does not support a direct link between R&D increases and their future stock returns across all the categories. It, however, is consistent all the estimated coefficients (b1, b2) are significantly positive at the 1% significance level, except for the NOR model for high-tech and high-growth firms, where the low-tech and low-growth firms have higher systematic risk. Additionally, we find that estimated coefficients (s2) and (h2) are significantly negative at the 1% significance level under the NOR model except for low-tech firms. Furthermore, the size effect under the NOR model are more obvious than those under the FF3 model for high-tech and highgrowth firms. To observe the differences of R&D effects on stock returns after year 2000, we also run the regression in which the sample set covers the period 2000 to 2007 for four subgroups (They are not tabulated). We find that (a)s are still insignificant in both of two models above. Similarly, we do not find the R&D-related effects on stock returns.
Table 2: Abnormal stock returns for subgroups (1988-2007)
FF3 model s1 h1 a2 Panel A : High-tech subgroups 0.948*** 0.098 -0.155** 0.269 0.923*** 0.179** -0.149** 0.101 0.952*** 0.166* -0.145** 0.162 0.950*** 0.164* -0.140** 0.159 0.963*** 0.146 -0.137** 0.154 Panel B : Low-tech subgroups 1.071*** 0.325** -0.265*** 0.398 1.122*** 0.365** -0.283*** 0.372 1.104*** 0.384*** -0.231*** 0.285 1.080*** 0.356** -0.212*** 0.361 1.047*** 0.375*** -0.173** 0.314 b1 NOR model b2 s2 -0.056 -0.082* -0.053 -0.054 -0.041 0.146** 0.197*** 0.179*** 0.155*** 0.122** -0.715*** -0.633*** -0.646*** -0.648*** -0.666*** -0.272* -0.232 -0.213 -0.241* -0.221*

Month 12 24 36 48 60 12 24 36 48 60

a1 0.107 -0.061 0.000 -0.003 -0.008 0.160 0.134 0.047 0.123 0.076

h2 -0.405*** -0.399*** -0.395*** -0.390*** -0.387*** -0.612*** -0.630*** -0.578*** -0.559*** -0.520***

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Table 2: Abnormal stock returns for subgroups (1988-2007) - continued

82

Panel C : High-growth subgroups 0.082 -0.213*** 0.253 -0.072* -0.730*** -0.463*** 0.144 -0.183*** 0.133 -0.068 -0.668*** -0.433*** 0.152* -0.161*** 0.103 -0.051 -0.660*** -0.411*** 0.156* -0.155** 0.116 -0.056 -0.656*** -0.405*** 0.168* -0.132** 0.056 -0.054 -0.644*** -0.382*** Panel D : Low-growth subgroups 12 -0.521 1.188*** 1.047*** -0.150 -0.381 0.271*** 0.821*** -0.645*** 24 -0.779 1.193*** 1.034*** -0.178 -0.639 0.275*** 0.808*** -0.672*** 36 -0.708 1.206*** 1.034*** -0.159 -0.567 0.288*** 0.808*** -0.654*** 48 -0.569 1.171*** 0.984*** -0.117 -0.428 0.254*** 0.758*** -0.611*** 60 -0.727 1.211*** 0.996*** -0.108 -0.587 0.293*** 0.771*** -0.603*** Note: The FF3 model represents the Fama-French 3-factor model, The NOR model represents the R&D versus No-R&D model, High-tech subgroups are the firms whose R&D intensities rank at the top 75% of all sample firms, where R&D intensity is equal to R&D expenditures divided by sales. High-growth subgroups are the firms whose MB ratios ranks at the top 75% of all sample firms, where MB ratio is equal to sum of market value of common stocks and book value of debt, divided by book of assets. The intercepts (a1, a2) are the abnormal returns measure, and b1, b2, s1, s2, h1, h2 are the corresponding coefficients, respectively. ***, **, and *denote significance at the 1%, 5%, and 10% levels, respectively. The data covers 1,197 observations (464 firms) over the period 1988 to 2007 12 24 36 48 60 0.091 -0.029 -0.059 -0.046 -0.106 0.933*** 0.936*** 0.954*** 0.949*** 0.951***

Evidences for Information transfer Effect of the value R&D Increases This subsection estimated the changes in variances of the differences between Rp,t and NORp,t (t2 = Var (Rp,t NORp,t)) to explore the informativeness of stock market on the value of R&D increase. We employed V1 and V2 to examine the responses of stock market on the information of increasing in R&D. where V1 =(t - 1 ) / 1 , V2 = (t - t-1 ) / t-1, respectively. As shown in figure 1, the change in volatility ( V1) of tth month t is decreasing in time relative to the volatility in the first month (1). It represents that the value of R&D increases is gradually incorporated into prices. The volatility(t2) is gradually decreasing. It shows that the uncertain information of R&D-related reduces gradually relative to the first month. Accordingly, Hypothesis 2 is verified.
Figure 1: Change in the volatility based on the first period variance

1 0.8 0.6 0.4 0.2 0 -0.2 1 -0.4 -0.6 Number of month after R&D increase 4 7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58

Figure 2 reports that the changes in volatility ( V2) relative to the preceding period 12 are weak in the first 30 months following R&D increases. It exhibits that R&D-related information is gradually transferred in stock market. The changes in volatility ( V2) enhance in latter 30 months, which shows that the information of R&D increases has been revealed completely, so that V2 go back

V1= (t 1 ) /1

83

Journal of Money, Investment and Banking - Issue 21 (2011)

the conditions with no R&D increase. This is inconsistent with Kyle(1985). It implies that the changes in volatility ( V2) of return on stocks will be flatted out gradually through information transfer.
Figure 2: Change in the volatility based on the (t-1)th period variance
0.8 0.6 0.4 0.2 0 -0.2 1 -0.4 -0.6 -0.8 Number of month after R&D increase

V. Conclusions
This paper investigates the linkage between the stock returns and R&D increases, and information transfer effects of R&D increases. The primarily empirical findings are as follows: first, under the FF3 and NOR models with calendar-time approaches, we find that there are no insignificant abnormal returns for firms. The evidence confirms that R&D increases might not be beneficial investment activities. Second, the volatility of the value of R&D increases decline reflecting the fact that information is gradually incorporated into price system. In addition, the return on stock for firms with conducting R&D investments has a significant increase. It could be explained by FF3 model as well as NOR model. The result shows that long-term stock returns have a downward trend for low-tech and low-growth firms; the systematic risk of low-tech firms is higher than that of high-tech firms. In the same vein, the systematic risk of low-growth firms is higher than that of high-growth firms.

References
[1] [2] [3] [4] [5] [6] [7] Aboody, D. and Lev, B. (2000) Information asymmetry, R&D, and insider gains, Journal of Finance, 55, 2747-66. Bagehot W. (1971) The only game in town, Financial Analysts Journal, 27, 12-14 Baker, M., and Wurgler, J. (2002) Market timing and capital structure, Journal of Finance, 57, 1-32. Chan, L. K. C., Lakonishok, J. and Sougiannis, T. (2001) The stock market valuation of research and development expenditures, Journal of Finance, 56, 2431-56. Chan, S. H., Martin, J. and Kensinger, J. (1990) Corporate research and development expenditures and share value, Journal of Financial Economic, 26, 255-76. Daniel, K. and Titman, S. (2006) Market reactions to tangible and intangible information, Journal of Finance, 61, 1605-43. Eberhart, A. C., Maxwell, W. F. and Siddique, A. R. (2004) An examination of long-term abnormal stock returns and operating performance following R&D increases, Journal of Finance, 59, 623-50. Fama, E. F. (1970) Efficient capital markets: a review of theory and empirical work, Journal of Finance, 25, 383-417.

[8]

V2= (t t-1 ) /t-1

7 10 13 16 19 22 25 28 31 34 37 40 43 46 49 52 55 58

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84

[9] [10] [11] [12] [13] [14]

Fama, E. F. and French, K. R. (1993) Common risk factors in the returns on stocks and bonds, Journal of Financial Economics, 33, 3-56. Grossman, S. J. and Stiglitz, J. E. (1980) On the impossible of informationally efficient markets, American Economic Review, 70, 393-408. Kelm, K. M., Narayanan, V. K. and Pinches, G. E. (1995) Shareholder value creation during R&D innovation and commercialization stages, Academy of Management Journal, 38, 770-86. Kyle, A. S. (1985) Continuous auctions and insider trading, Econometrica, 53, 1315-35. Loughran, T. and Ritter, J. (1995) The new issues puzzle, Journal of Finance, 50, 23-51. Sundaram, A. K., John, T. A. and John, K. (1996) An empirical analysis of strategic competition and firm values: the case of R&D competition, Journal of Financial Economics, 40, 459-86.

Appendix
Proof of Equilibrium 1
Suppose that P ( y ) = + y , X ( ) = + , then
% % E v P ( x + u ) x = = ( x ) x % By first order condition 2 x = 0 x ( ) = 2 By second order condition 2 < 0 > 0 Therefore 1 = , = 2 Given linear X and P , the market efficiency condition: % + y = E v + + u = y %

(A1)

Apply Normality and the Projection theorem, we obtain % % Cov ( + + u , v ) 2 = 2 2 2 = % Var ( + + u ) + u

% + y = 0 + ( + + u 0 )

0 = ( + 0 )
From (A1) and (B2), we have = 0 , = 0
2 2 2 1 2 2 + u2 = = = u2 , = u 2 2 2 2
1

(A2)
1 2

Q.E.D.

Proof of Property 1 Since Var ( ~ ) = Var ( + y ) p ~ = Var ( + ( + + u ))


2 = 2 ( 22 + u )

~ p ~ Cov(v , ~ ) = Cov(v , ( + y )) ~ ~ ~ = Cov( + , ( + + u )) = ( 2 )

85 then

Journal of Money, Investment and Banking - Issue 21 (2011)

~p v2 = Var{v ~}

~ ~ 2 ~ [Cov(v , p )] = Var (v ) Var ( ~ ) p


2 = ( + ) 2 2 2 2 ( + u )
2 2 2

= ( 2 + 2 )

2 2 (Q u = 2 2 ) 2 ( 2 2 + 2 2 )

1 = ( 2 + 2 ) 2 2 1 = 2 + 2 2

Proof of Equilibrium 2
A sequential trading equilibrium is defined as a pair X, P. Such that the following two conditions hold: % % % % % % 1. E ( X , P ) p1 ,L , pn 1 , E ( X , P ) p1 ,L , pn 1 , (Profit Maximization) % %
2.

% % % pn = E v x1 + u1 ,L , xn + un (Market Efficiency) % % %
There exists a recursive linear equilibrium such that for % % % xn = n pn 1 tn

(A3) (A4) (A5)

2 % % % % % n = Var ( v x1 + u1 ,L , xn + un )

% % % pn = n ( xn + un )

E n p1 ,L , pn 1 , = n 1 ( pn 1 ) + n 1 %
2

(A6)

% % % % % % Q E n = E pn 1 xn and xn = n pn 1tn , n = 1,L , N % Where,

n1 =

1 4 n (1 n n )

(A7) (A8) (A9) (A10) (A11)

n 1 = n + n n2 u2 tn 1 2 n n n tn = 2n (1 n n )
2 n n u2 2 2 n = (1 n n tn ) n 1

n =

n (1 n n ) > 0 , (Second Order Condition), n = 1,L , N (A12) proof By backward induction, N = N = 0 , Because that no profits on new positions are made after
trade is completed. We have 2 E n +1 ( X , P ) p1 ,L , pn , = n ( pn ) + n 1 , %
% % % % % Since n = ( v pn ) xn + n+1 , we obtain
E n p1 ,L , pn 1 , %

(A13)

Journal of Money, Investment and Banking - Issue 21 (2011)


2 % % = max E ( v pn ) x + n pn + n p1 ,L , pn 1 , In a linear equilibrium, pn = pn 1 + n ( xn + un ) Substitute (A13) into (A12), we have E n p1 ,L , pn 1 , %
2 = max ( pn 1 n x ) x + n ( pn 1 n x ) + n n2 u2 tn + n By first order condition pn 1 2n x + 2 n ( pn 1 n x )( n ) = 0

86 (A14) (A15)

(A16)

x =

( pn 1 )(1 2 n n ) = % p t % n 1 ) n n( 2n (1 n n )
1 2 n n 2n (1 n n ) ( A9)

( A3)

n tn =

SOC : n (1 n n ) > 0 ( A12) By (A15) and (A3), (A1) and (A2) are obtained. Furthermore, from (A16), n 1 and % % n 1 are given by (A7) and (A8). Because v pn 1 is independent from

% % % % x1 + u1 ,L , xn 1 + un 1 , from market efficiency condition, we obtain % % % % pn pn 1 = E v pn 1 xn + un % %


Using (1) and (2), applying the projection theorem and normality, that yields (A17)

u2 n21 2 n2 n 1tn + u n2 n21tn + u2 2 2 Where n 1 = 2 ( n 1) + 2 , n 1 v2 ( n 1) = 2 ( n 1) + 2 n =


2 , n = 2

n n21

(A18)

Cov ( x, y ) Var ( x )

2 n n 1tn 2 = 2 2 n n 1 2 n2 2 (tn ) 2 + u2 tn n (tn ) + u

Var ( x * y* = y ) = Var ( x *) % % % = Var ( v x1 + u1 ,L , )


2 n

cov ( x *, y *= y )
Var ( y *)

2 n 1

(
n

2 n 1

tn )

n2 n21 ( tn ) + u2 ( tn )
2

n21 u2 n2 n21tn + u2 u2 n21 2 n

(A19)

From (A18)
2 n2 n 1tn + u2 2 2 n = 2 n2 n 1 2 = n 2 n u n 1 / n u 2 Let u2 = n n substitute into (A19) ( A11) Q.E.D. n

n =

n n21

2 n2 n 1tn + u2 =

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Journal of Money, Investment and Banking - Issue 21 (2011)

Proof of Property 2
2 n = 2 (n) + 2 = (1 nn tn ) 2 (n 1) + 2 = 2 (n 1) n n tn 2 (n 1) + 2 2 = n 1 nn tn 2 (n 1) 2 2 Q n n t n (n 1) > 0 , it follows the informativeness of prices n declines monotonically.

Proof of Property 3
In equilibrium 2, if R&D increases are beneficial activities, then % % % > Pn 1 xn > 0 (Information received from R&D investments is gradually divulged.) ~ >0 p
n

Stock returns are greater than zero (at tn ) . There are positively abnormal long-term stock returns.

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