REVISION: Deflating Gross Profitability
Gross profit scaled by book value of total assets predicts the cross-section of average returns. Novy-Marx (2013) concludes that it outperforms other measures of profitability such as earnings, cash flows, and dividends and is negatively correlated with the value premium. One potential explanation for the measure's predictive ability is that its numerator - gross profit - is a "cleaner" measure of economic profitability. An alternative explanation lies in the measure's deflator. We find that net income equals gross profit in predictive power when both measures are constructed using consistent deflators. We then construct an alternative measure of profitability, operating profitability, based on economic intuition about which expenses most closely relate to current revenue. This measure exhibits a far stronger link with expected returns than either net income or gross profit.
REVISION: Market Reactions to Tangible and Intangible Information Revisited
Daniel and Titman (2006) propose that the value premium is due to investors overreacting to intangible information. They therefore decompose changes in firms’ book-to-market ratios into stock returns and a proxy for tangible information based on accounting performance ("book returns"). Consistent with investors overreacting to intangible information, they find that only stock returns unrelated to book returns reverse. We show that their decomposition creates a book return polluted by past book-to-market ratios, stock returns, net issuances, and dividends. One-third of the variation in book returns is due to these factors. The Daniel and Titman (2006) result is fragile — a plausible alternative definition of tangible information reverses their conclusions.
REVISION: Dissecting Factors
Size and book-to-market split into two components, one correlated with changes in market value and the other with everything else. Only the market value components have positive risk premia. Average returns are flat across portfolios based on the other parts, but their loadings on SMB and HML differ significantly. This mismatch between covariances and average returns generates significant alphas for high-minus-low portfolios. The estimated fraction of skilled fund managers increases from 4% to 18% when we control for the other parts. Also, the other part of value drives the negative correlation between gross profitability and value.
REVISION: Common Factors in Stock Market Seasonalities
A strategy that selects stocks based on their historical same-calendar month returns earns an average return of 13% per year. We develop and test two models to evaluate the source of these profits. In the first model the seasonalities arise from seasonal variation in the risk premia of common factors; in the second they are stock-specific. Our empirical results are consistent with the first model: common factors account for at least three-quarters of the seasonalities in individual stock returns, exposing seasonal investment strategies to systematic risk. The factors are largely the same as those driving the differences in average returns.
REVISION: Do Investors Buy What They Know? Product Market Choices and Investment Decisions
This paper shows individuals’ product market choices influence their investment decisions. Using microdata from the brokerage and automotive industries, we find a strong positive relation between customer relationship, ownership of a company, and size of the ownership stake. Investors also are more likely to purchase and less likely to sell shares of companies they frequent as customers. These effects are stronger for individuals with longer customer relationships. A merger-based natural experim
REVISION: Reverse Survivorship Bias
Mutual funds often disappear following poor performance. When this poor performance is partly attributable to negative idiosyncratic shocks, funds' estimated alphas understate their true alphas. This paper estimates a structural model to correct for this bias. Although most funds still have negative alphas, they are not nearly as low as those suggested by the fund-by-fund regressions. Approximately 12% of funds have net four-factor model alphas greater than 2% per year. All studies that run fund
REVISION: Lack of Anonymity and the Inference from Order Flow
This paper investigates the information content of signals about the identity of investors and whether they affect price formation. We use a dataset from Finland that combines information about the identity of investors with complete order flow records. While we document that investors use multiple brokers, our study demonstrates that broker identity can nonetheless be used as a powerful signal about the identity of investors who initiate trades. This finding testifies to the existence of fricti
REVISION: IQ and Stock Market Participation
Stock market participation is monotonically related to IQ, controlling for wealth, income, age, and other demographic and occupational information. The high correlation between IQ, measured early in adult life, and participation, exists even among the affluent. Supplemental data from siblings, studied with an instrumental variables approach and regressions that control for family effects, demonstrate that IQ’s influence on participation extends to females and does not arise from omitted familial
REVISION: Reading the Tea Leaves: Why Serial Correlation Patterns in Analysts' Forecast Errors are not Evidenc
This paper argues that an absence of serial correlation in forecast errors is not the appropriate benchmark for rational analyst behavior. We put forward a model that confronts analysts with two layers of uncertainty. An initial layer of uncertainty about firm-specific parameters leads analysts to underreact to signals from some firms and overreact to signals from others. A subsequent layer of uncertainty about the distributions from which these firm-specific parameters are drawn causes the null
REVISION: Jensen's Inequality, Parameter Uncertainty, and Multi-Period Investment
Classical approaches to estimation and decisions requiring estimation often are at odds. When values critical to the decision are convex or concave functions of unknown parameters, the statistician’s estimation error adjustments are the opposite of what is appropriate for the decision. We illustrate the conflict by studying multi-period investment problems. The proper application of Jensen’s inequality to the decision turns finance intuition on its head. For example, multi-period investments wit
REVISION: Do Limit Orders Alter Inferences About Investor Performance and Behavior?
Individual investors lose money around earnings announcements, experience poor post-trade returns, exhibit the disposition effect, and make contrarian trades. Using simulations and trading records of all individuals in Finland, I find that investors’ use of limit orders is largely responsible for these trading patterns. These patterns arise mechanically because limit orders are price-contingent and face the adverse selection problem. Reverse causality from behavioral biases to order choices does
The Anatomy of Day Traders
This paper examines the complete trading records of all day traders in Finland. A typical day trader is a male in his late 30s, who lives in the metropolitan area and trades in larger quantities than an investor in a size-matched control group even after ignoring day trades. These traders day-trade stocks that grab their attention, that they own, or that they have day-traded before. They pay close attention to the state of the limit order book, are very active near the end of the trading session