Why Does Financial Strength Forecast Stock Returns?
Evidence from Subsequent Demand by Institutional Investors
Measures of a company’s financial strength forecast stock returns. For instance, companies that have high return on assets this year tend to have higher stock returns next year. There are two possible interpretations of this pattern. First, investors require higher future expected stock returns for holding riskier companies in their portfolios and riskier companies need greater profitability to sell for the same valuation levels as a safer company.
As a result, greater risk is associated with both higher future expected returns and higher profitability today. Second, perhaps investors are slow to fully incorporate the profitability information. That is, one would expect, given information today that a company is more profitable, the price should increase today—there is no reason that investors should wait to drive up the price. A smart investor could simply buy more profitable companies today and earn “abnormal returns” at the expense of the investor selling the company today (recall there’s a seller for every buyer). Disentangling these explanations is complicated because it is not clear how to correctly and fully measure a company’s riskiness and fair expected return given that riskiness.
In this study, the authors take a different approach by recognizing that the gradual incorporation of information explanation requires that over time, investors who recognize (i.e., have revised their expectations) that strong financial condition stocks are undervalued will initiate purchases of these stocks and drive prices higher. And, analogously, investors who realize that weak financial condition stocks are overvalued will initiate sales of these stocks and drive prices lower. Assuming institutional investors—and especially those institutional investors who trade a lot—are more sophisticated than retail investors, the authors attempt to differentiate these explanations by testing whether financial strength predicts not only returns but also subsequent demand by institutional investors. In other words, if the relation between financial strength and subsequent returns arises from risk, then financial strength will forecast returns, but not trading between more and less sophisticated investors. In contrast, if the relation between financial strength and returns arises from the gradual incorporation of public information, then financial strength will forecast both subsequent return and subsequent demand by more sophisticated investors (or, equivalently, subsequent supply by less sophisticated investors).Their empirical results reveal that, consistent with gradual incorporation of information explanation, financial strength predicts both returns and subsequent demand by institutional investors. Moreover, the most sophisticated high-turnover institutions respond first to the information, followed by less sophisticated low-turnover institutions and both exploit individual investors.
Nicole Choi is an assistant professor of finance and economics at the University of Wyoming. Richard Sias is Finance Department Head, Professor of Finance, and Tyler Family Endowed Chair in Finance at the Eller College of Management, University of Arizona.
Forthcoming in The Review of Financial Studies.