A growing literature investigates how investors’ gambling behavior affects their investment decisions and asset returns. This literature shows that investors with a taste for gambling concentrate their trading in stocks with lottery-like payoffs, such as stocks with high volatility. In addition, prior studies show that in sports betting, such as racetrack gambling, bettors consistently over bet longshots and under bet favorites relative to their observed frequency of winning. Misperceptions of probability is likely to drive the favorite-longshot bias. In a recent project, we investigate investors’ behavioral bias in the setting of mergers and acquisitions (M&A). Specifically, we examine how the earnings performance of bidding firms affects investor reactions to acquisition announcements.
Pursuing fast business growth is one of the most common motives for companies transacting in the M&A market. Typically, high growth acquirers seek investment opportunities from target firms in the M&A market. However, it is not uncommon for firms with substantial earnings declines to make acquisitions. Moreover, anecdotal evidence suggests that investors are often enthusiastic about these acquisitions announced by companies suffering significant earnings decline. In our recent paper, we ask two questions. First, do investors systematically overreact to acquisitions announced by bidders suffering earnings declines? Second, if they do overreact, what behavior bias is most likely contributing to this irrationality?
We focus on the bidders’ recent earnings growth (i.e., the change in net income during the most recent two years prior to the merger) because investors consider earnings the single most important item in the financial reports. As a result, bidders’ recent earnings performance may significantly influence how investors perceive the M&A deal.
We consider two alternative hypotheses. The rational expectation hypothesis assumes that investors are unbiased and that the market, on average, is efficient in evaluating deal quality. Under the assumption that bidders with strong earnings growth are in a better position to identify ideal target firms that allow them to transfer their superior management skills or productive opportunities, acquisitions announced by bidders with high earnings growth are potentially more value-creating, when compared with acquisitions announced by bidders with low earnings growth. Furthermore, under rational expectations, the market incorporates new information rapidly and efficiently. Therefore, no price drift or reversal should follow the acquisition announcement.
In contrast, the mispricing hypothesis, or investor gambling hypothesis, suggests that investors may systematically overweight the probability of high synergies and underweight the riskiness associated with an acquisition, particularly for acquiring firms that had recently experienced significant earnings declines. In the M&A context, acquisitions made by bidders with significant earnings declines provide attractive opportunities to investors with a taste for gambling. Acquisitions have risky payoffs, especially when they are made by acquirers that have already been experiencing deteriorating operating performance. An unsuccessful acquisition can have a more detrimental effect on these bidders. However, there is a small probability that the acquisition will create high synergistic gains, which may quickly turn around the sinking ship. Betting on poorly performing firms to make good acquisitions is similar to the well-documented favorite-longshot bias in racetrack gambling in which bettors consistently over bet longshots and under bet favorites. If investors overweight the probability of deal success and underweight the probability of deal failure for bidders with earnings decline, we expect price overreaction to acquisition announcements which leads to temporary mispricing and subsequent post-announcement price reversals.
Using more than 37,000 M&A deals that involve public bidders from 1981 to 2017, we first compute bidders’ cumulative abnormal returns in a five-day window surrounding the merger announcement. We document a strong positive initial market reaction to merger announcements from bidders with either large earnings growth or significant earnings decline, relative to those with neutral earnings change, reflecting a U-shaped pattern between bidders’ earnings growth and stock price reactions.
To test whether the initial positive returns to acquisition announcements are due to investor overreaction, we examine bidders’ short-term post-announcement returns in one to two months following the acquisition announcements. We find that higher initial returns for bidders with earnings decline subsequently reverse, while higher returns for bidders with high growth do not.
To investigate whether investor gambling behavior can explain the initial overreaction and subsequent price reversal of bidders with earnings declines, we examine whether our results are concentrated among bidders with high retail holdings. Consistent with this expectation, we find that the mispricing results are concentrated in the subsample of bidders with high retail holdings. To provide further evidence on the gambling channel, we conduct cross-sectional analyses by comparing subsamples based on stock lottery-type characteristics and find that the results are concentrated among bidders with lottery-like payoffs.
We also investigate the distribution of ex-post returns to M&A announcements to identify whether there are a few winners among bidders with negative earnings growth. Although we document that, on average, these bidders underperform in the post M&A period, gambling may be rational if the payoffs are sufficiently large and not too improbable. Our results support this explanation. We find that bidders with negative earnings growth have a higher return volatility and a fatter right tail in the post-merger return distribution. The top 10% of returns (i.e., returns higher than 90% of the estimates) are almost always larger for bidders with negative earnings growth compared to those with positive growth. This analysis provides further support that bidder stocks with negative growth indeed exhibit lottery-like features that attract individual investors with the propensity to gamble. However, the significant average return underperformance for the bidders with negative earnings growth persist for up to three years.
Taken together, our results indicate that investor behavior biases significantly affect acquisition returns, particularly for bidders with negative earnings growth. The propensity of individual investors to gamble on poorly performing bidder’s stock causes a price overreaction to acquisition announcements which is followed by significant post-merger underperformance. Our findings add to the growing literature documenting how investors’ gambling behavior affects their investment decisions. Moreover, our results challenge the common practice that uses bidder returns over a short window surrounding the merger announcement to measure the wealth effect of a merger, especially when considering bidders with significant earnings decline.
Tingting Liu is an Associate Professor of Finance and John and Connie Stafford Professor in Finance at Iowa State University
Danni Tu is a Ph.D. candidate in Finance at Iowa State University
This post is adapted from their paper, “Earnings growth and acquisition returns: Do investors gamble in the takeover market?” available on SSRN.
