Transcription

• Speaker #0

  Hello, welcome back to Papers with Backtest podcast. Today, we dive into another Algo Trading research paper.

• Speaker #1

  Today, we're unpacking a paper titled Advertising Effect Within Stocks by Thomas Cheminor and Ann Yan. The version we're looking at is from February 2009.

• Speaker #0

  Okay, Advertising Effect Within Stocks. So at its heart, what were these researchers trying to understand? What was the, you know, the puzzle?

• Speaker #1

  Yeah, the central question was really about how a company's advertising spending actually impacts its stock returns. They were digging into whether there's a real connection, not just like immediately, but also what happens down the line, the longer term consequences for investors.

• Speaker #0

  Right. And for you tuning in, maybe you're looking to get a quick handle on what matters in this kind of research. Get those aha moments without wading through loads of dense text. This deep dive is really focused on pulling out the crucial bits from this paper.

• Speaker #1

  Especially anything that looks like a potential trading rule or insight from their back test.

• Speaker #0

  Exactly. We want those practical takeaways.

• Speaker #1

  And just as a quick preview, what we found interesting is how the paper suggests this interplay between advertising, investor attention, and then the stock's performance.

• Speaker #0

  It sounds like there are some surprising twists.

• Speaker #1

  Definitely. Could have some real implications for how you might think about trading strategies based on, say, advertising spend.

• Speaker #0

  All right. Let's get into it then. Yeah. The core finding, what was the main discovery connecting advertising and stock returns?

• Speaker #1

  Okay, so the primary finding is, well, it's quite neat, actually. They found that when a company spends more on advertising in a particular year, its stock tends to perform better in that same year.

• Speaker #0

  Okay, like a spotlight effect, maybe.

• Speaker #1

  Sort of, yeah. But here's the twist. In the year after that big advertising push, those same stocks tend to deliver lower returns.

• Speaker #0

  Ah, okay, so it's short-term gain. but maybe long term pain.

• Speaker #1

  That's a good way to put it, like a sugar rush followed by a bit of a slowdown.

• Speaker #0

  Can we put some numbers on that? How big is this effect they found?

• Speaker #1

  Sure. They use Fama-McBeth's regressions. It's a pretty standard, robust way to look at this stuff across lots of stocks in time. Right. And they found that a one standard deviation increase in advertising spend in a year was linked to about a 3.35% higher stock return during that year.

• Speaker #0

  3.35%. That's not insignificant.

• Speaker #1

  No, it's noticeable. But here's the interesting part for traders. That same increase in advertising was associated with a decrease of about 2.92% in the stock's return, specifically in the second half of the following year.

• Speaker #0

  Wow. Okay. So that initial boost really seems to, well, reverse later on.

• Speaker #1

  Pretty significantly,

• Speaker #0

  yeah. Now, a key question is always, is this just random noise, or is it really about the advertising itself? Did they check if other known factors like company size or value? Explain this.

• Speaker #1

  Absolutely. Critical point. And yes, they did. They controlled for things like size, book-to-market ratio, the value measure and momentum. Factors we already know predict returns. And even after accounting for those, this advertising effect, both the up and the down, it remains statistically significant.

• Speaker #0

  So that suggests advertising has its own sort of independent impact here.

• Speaker #1

  That's what the evidence points to. Yeah. It's not just a proxy for being a certain size or type of company.

• Speaker #0

  Okay. So we have this pattern. Advertising up. Short-term return up, longer-term return down. Why? What's the theory behind this?

• Speaker #1

  The authors put forward what they called the investor attention hypothesis. Okay. The basic idea is pretty straightforward. When a company advertises more, it simply grabs more attention from investors. It becomes more visible.

• Speaker #0

  That makes sense. You see the ads, you think about the company, maybe look up the stock.

• Speaker #1

  Exactly. And they suggest this increased attention can push prices up short-term in a couple of ways. First, just more eyeballs might mean more buying pressure as people notice it.

• Speaker #0

  Simple awareness.

• Speaker #1

  Right. Second, more attention might lead to more disagreement or heterogeneity in beliefs about the stock's future. And if it's hard to short the stock, the price tends to reflect the more optimistic views pushing it up.

• Speaker #0

  Gotcha. So the buzz builds, optimists drive the price. But why the later reversal? Why does it come back down? Well,

• Speaker #1

  the hypothesis suggests that this attention spike is often temporary. The ad campaigns end, the news cycle moves on.

• Speaker #0

  The novelty wears off.

• Speaker #1

  Precisely. And as that initial surge of attention fades, the stock price tends to correct downwards, closer to maybe what the fundamentals justify. The temporary boost wasn't sustainable.

• Speaker #0

  Okay. The market sort of recalibrates. So how do they actually try to measure this investor attention? Sounds a bit fuzzy.

• Speaker #1

  Yeah, you can't just ask everyone. They used a couple of common proxies, things we can measure that likely correlate with attention. First was trading volume.

• Speaker #0

  How much the stock trades.

• Speaker #1

  Exactly. Specifically, exchange-adjusted turnover. The idea being more attention equals more trading activity. The second was the number of financial analysts covering the firm using IBES data.

• Speaker #0

  Right. More analysts covering it usually means more visibility.

• Speaker #1

  That's the thinking. And they found a clear link. Higher ad spending in a year did lead to higher trading volume and more analyst coverage that same year.

• Speaker #0

  OK, so advertising does seem to attract attention by these measures.

• Speaker #1

  Looks like it.

• Speaker #0

  But the key thing for us, thinking about trading, is whether attention itself, however it's generated, causes this up-then-down pattern in returns.

• Speaker #1

  Right. And their analysis showed just that. Increased attention, whether from ads or something else, was linked to higher returns now but lower returns later.

• Speaker #0

  Which strengthens the whole attention-based explanation for the advertising effect.

• Speaker #1

  Exactly. It suggests the rise and fall of attention is a major driver here.

• Speaker #0

  Okay, let's get to the really practical stuff. This is Papers with Backtest, after all. What did they actually do in terms of backtesting or simulating trading strategies based on this?

• Speaker #1

  So they used portfolio sorts, standard approach. Each year, they ranked all the stocks based on the change in their advertising spending compared to the previous year.

• Speaker #0

  Okay, so add VT, the change. Right.

• Speaker #1

  They grouped them into 10 buckets, deciles. Decile 10 had the biggest increase in advertising. Decile 1 had the biggest decrease or smallest increase.

• Speaker #0

  Got it. Top group ramped up spending, bottom group. Hmm. Did.

• Speaker #1

  Precisely. And when they looked at the raw returns in the advertising change happened the advertising year, the difference was stark. The top decile, the big increasers, outperformed the bottom decile by about 16.8% on average.

• Speaker #0

  Wow. 16.8%. That's huge. Definitely catches the eye.

• Speaker #1

  It absolutely does. But, and this is crucial for trading rules, look what happened next. The reversal. Yep. In the six months immediately after that advertising year, the top decile, the previous winners, actually underperformed the bottom decile by around 9.2%.

• Speaker #0

  Ouch. Okay.

• Speaker #1

  And it continued. In the next six months, so months 7 to 12 after the advertising year, they underperformed again by about

• Speaker #0

  9.4%. So that massive initial outperformance. just completely reverses and turns into significant underperformance over the next year.

• Speaker #1

  That's what the raw portfolio sorts show, a really clear reversal pattern.

• Speaker #0

  That's a massive takeaway for anyone thinking, oh, big ad spend, let's buy.

• Speaker #1

  Absolutely. Now, they also checked if this was just because the high advertising firms were different in size or value, controlled for size and book to market.

• Speaker #0

  Did the effect disappear?

• Speaker #1

  No. The size of the effect got a bit smaller, as you'd expect, but the pattern held. Even after adjusting, the top ad increase groups still outperformed in the advertising year, by about 9.6 percent, but then underperformed significantly in the next two six-month periods by around 8.4 percent and 8.9 percent.

• Speaker #0

  Still substantial underperformance later on. Definitely. What about more advanced models, like Fama French? Did those confirm the reversal?

• Speaker #1

  Yes, they ran Fama French three-factor and Carhartt four-factor models on these portfolios. The results were consistent. The high advertising increase portfolio showed significant negative abnormal returns alpha in the six months and the full year after the advertising year.

• Speaker #0

  Meaning even after accounting for market risk, size, value, and momentum.

• Speaker #1

  There was still this extra underperformance linked to the prior advertising surge. For instance, the long-short portfolio, P10 minus P1, had a three-factor alpha of menacing at 8.4% over the next six months and amicable 11.3% over the next year.

• Speaker #0

  Okay, so the backtests really drive home that this isn't a simple buy-on-add-spend signal. The reversal seems very real and robust.

• Speaker #1

  The data strongly suggests any gains are temporary and likely followed by a payback period.

• Speaker #0

  Now, you mentioned attention earlier. The paper looked at whether the persistence of that attention mattered,

• Speaker #1

  right? Yes, that was another interesting layer. They found the initial positive kick in the advertising year was stronger for stocks that got more attention, more volume, more analysts that year. Makes sense. But crucially, the negative reversal later on was also stronger for these high attention stocks, unless that high attention persisted.

• Speaker #0

  Ah. So if the trading volume and analyst coverage stayed high into the next year...

• Speaker #1

  Then the negative reversal was weaker. The underperformance wasn't as bad if the buzz stuck around.

• Speaker #0

  That adds a lot of nuance. Maybe a potential trading rule isn't just fade the ad spike but feed the ad spike unless the attention seems sticky.

• Speaker #1

  It certainly suggests a more sophisticated approach might be needed. You might want to monitor not just the ad change but the subsequent sustained change in volume or analyst coverage.

• Speaker #0

  Fascinating. What about things that make it harder for smart traders to correct mispricing? Like arbitrage costs. Did that play a role?

• Speaker #1

  It did. They used proxies for arbitrage costs like illiquidity and idiosyncratic risk, basically, how hard or risky it is to trade against potential mispricing. OK. And they found the whole advertising effect, both the initial boost and the subsequent reversal, was stronger for stocks with higher arbitrage costs.

• Speaker #0

  Meaning where it's harder for arbitragers to step in and correct the price quickly.

• Speaker #1

  The advertising driven attention effect has a. bigger, longer lasting impact, both positive and negative.

• Speaker #0

  That makes sense. Any differences based on the type of company?

• Speaker #1

  Yeah. A few interesting points there, too. The effect, particularly the negative long run reversal, was more pronounced for small firms. OK. And also for value stocks. And interestingly, for firms that had poor prior stock performance or poor prior operating performance.

• Speaker #0

  Hmm. So maybe companies that aren't doing so well use advertising as a way to get some temporary attention. But the reversal hits harder.

• Speaker #1

  That's one interpretation the findings seem to support, yes. It might be a tactic used more effectively or perhaps more desperately by firms needing a boost.

• Speaker #0

  And did they do robustness checks, just briefly?

• Speaker #1

  They did. They looked at percentage changes in advertising, controlled for things like sales growth, checked different time periods, though, with some data caveats earlier on. Generally, the main results held up.

• Speaker #0

  Okay, good to know. So wrapping this up, what's the key takeaway for our listener?

• Speaker #1

  I think the main point is that while a big jump in advertising can give a stock a short-term lift, you really need to be wary of the potential for underperformance later on. It seems less about fundamental value changing overnight and more about this temporary wave of investor attention.

• Speaker #0

  And focusing on those trading rules and backtest results we discussed, simply chasing high advertising spend looks like a losing strategy long-term.

• Speaker #1

  Yeah, the reversal is pretty clear in their tests. Any strategy would need to account for that fade and maybe consider things like how sustainable the attention spike looks or the arbitrage costs involved or the type of company.

• Speaker #0

  It definitely adds complexity. So maybe a final thought for you listening. How might you use these insights? Could tracking changes in advertising alongside subsequent shifts in training volume or analyst coverage give you an edge? Maybe helping anticipate that fade or... Identify when it might be less severe. Something to think about.

• Speaker #1

  Food for thought. Definitely.

• Speaker #0

  Thank you for tuning in to Papers with Backtests podcast. We hope today's episode gave you useful insights, particularly regarding the potential pitfalls of chasing short-term gains linked to advertising expenditure. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktests.com. Happy trading.