Unfortunately, even if firm size is in fact a useful measure of the rate of information diffusion, it is likely to capture other things as well, potentially confounding our inferences. For example, it is probably also the case that market-making or arbitrage capacity is less in small-cap stocks. On the one hand, if there are supply shocks, this couid lead to a greater tendency towards reversals (i.e., negatively correlated returns) in small stocks, which would obscure the gradual-information-flow effect we are interested in. On the other hand, one might argue that whatever behavioral phenomenon is driving positive serial correlation in returns, less arbitrage means that it will have a bigger impact in small stocks, leading us to overstate the importance of gradual information flow as the specific mechanism at work. The bottom line is that while it is certainly interesting to see how momentum profits vary with firm size, this probably does not by itself constitute a clean test of our central hypothesis. Electronic Payday Loans Online
As an alternative proxy for the rate of information flow, we consider analyst coverage. The idea here is that stocks with lower analyst coverage should, all else equal, be ones where firm-specific information moves more slowly across the investing public. Thus our second set of tests boils down to checking whether momentum strategies work better in low-analyst-coverage stocks. The one important caveat is that analyst coverage is very strongly correlated with firm size (Bhushan 1989). So in this second set of tests, we control for the influence of size on analyst coverage, by sorting stocks into groups according to their residual analyst coverage, where the residual comes from a regression of coverage on firm size.
To preview, we obtain the predicted results for both firm size and residual analyst coverage. First, with respect to size, once one moves past the very smallest-capitalization stocks (where thin market-making capacity does indeed appear to be an issue) the profitability of momentum strategies declines sharply with market capitalization. Second, holding size fixed, momentum strategies work particularly well among stocks which have low analyst coverage.