The short-term reversal in stock returns is already a well known and well-established anomaly that appears to contradict the weak-form market efficiency. Strategy based on this anomaly buys past winners and sells past losers. A possible and sensible explanation of the short-term reversal phenomenon is the overreaction of investors. Research in the past focused primarily on noise trading and ignored the important role of fundamental information. Curiously, new research suggests that there is a need to study the impact of fundamental news on short-term return reversals where a nonparametric metric of fundamental strength (FSCORE) is used to measure the impact from fundamental information. The need to measure the impact mentioned above is clear – there is overwhelming evidence that investors underreact to fundamental news. Moreover, fundamental information metric has a persistent predictive effect on stock returns, which is consistent with the hypothesis of the slow diffusion of information and investor underreaction. Simply said, high FSCORE firms tend to earn much higher returns than low FSCORE firms. The paper has found significant evidence that recent losers with strong fundamental strength and recent winners with weak fundamental strength experience stronger reversals than other reversal portfolio strategies. A fundamental-anchored reversal strategy exploits this finding, and this reversal strategy could generate a high significant average monthly returns that outperform the profit from the unconditional and traditional reversal strategy. The paper primarily studies all common stocks; however, we present the data about large stocks since the small stocks bear their own unique features.

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There are three reasons to use FSCORE. Firstly, FSCORE is a comprehensive metric of a firm’s fundamental strength, because this score synthesizes information from nine signals along three dimensions of a firm’s financial performance (profitability, change in financial leverage and liquidity, and change in operational efficiency). Secondly, the fundamental information is gathered directly from the financial statements, which obviates the measurement error problem. And lastly, FSCORE is a nonparametric measure, compared with a parametric approach, FSCORE is more robust and helps to reduce concerns over potential estimation biases. Results support the hypothesis that short-term reversals are influenced by both noise trading and investor underreaction to fundamental information. Also results from regression analysis suggest that both noise trading and fundamental information significantly influence stock returns on the short horizon. No doubt, there is a conclusion that investor underreaction to fundamental information coupled with noise trading can explain the observed empirical patterns in short-term reversals. Moreover, results indicate that the bid-ask spread cannot be the main source of the profitability for short-term reversals, and the results are not particularly sensitive to alternative definitions of fundamental strength. Last but not least, simple short-term reversal and industry-adjusted reversal strategies fail to be profitable in the presence of transaction costs; however, fundamental anchored reversal strategies are economically profitable even in the presence of transaction costs.