REVISION: Reading the Tea Leaves: Model Uncertainty, Robust Forecasts, and the Autocorrelation of Analysts' Forecast Errors
We put forward a model in which analysts are uncertain about a firm's earnings process. Faced with the possibility of using a misspecified model, analysts issue forecasts that are robust to model misspecification. We estimate that this mechanism explains approximately 60% of the observed autocorrelation in analysts' forecast errors. The remainder of the observed autocorrelation stems from the cross-sectional variation in mean forecast errors and analysts' estimation errors of the persistence of earnings growth shocks. Consistent with our model, we find that analysts learn about some features of the earnings process but not others, and this learning reduces, but does not eliminate, the autocorrelation of forecast errors as firms age. Other potential explanations for the observed autocorrelation of analyst's forecast errors are rejected. Our model of robust forecasting applies not only to analysts' forecasts but to all model-based forecasts.
REVISION: Accruals, Cash Flows, and Operating Profitability in the Cross Section of Stock Returns
Accruals are the non-cash component of earnings. They represent adjustments made to cash flows to generate a profit measure largely unaffected by the timing of receipts and payments of cash. Prior research finds that expected returns increase in firm profitability. However, firms with high accruals generate lower returns than firms with low accruals, and this "accrual anomaly" strengthens when evaluated using asset pricing models that include a profitability factor. We show that a cash-based operating profitability measure (that excludes accruals) outperforms other measures of profitability (that include accruals) and subsumes accruals in predicting the cross section of average returns. Surprisingly, an investor can increase a strategy's Sharpe ratio more by adding just a cash-based operating profitability factor to his investment opportunity set than by adding both an accruals factor and a profitability factor that includes accruals.
REVISION: Common Factors in Return Seasonalities
A strategy that selects stocks based on their historical same-calendar-month returns earns an average return of 13% per year. We document similar return seasonalities in anomalies, commodities, international stock market indices, and at the daily frequency. The seasonalities overwhelm unconditional differences in expected returns. The correlations between different seasonality strategies are modest, suggesting that they emanate from different common factors. Our results suggest that seasonalities are not a distinct class of anomalies that requires an explanation of its own – rather, they are intertwined with other return anomalies through shared common factors. A theory that is able to explain the risks behind any common factor is thus likely able to explain a part of the seasonalities.
REVISION: Retail Financial Advice: Does One Size Fit All?
Using unique data on Canadian households, we assess the impact of financial advisors on their clients' portfolios. We find that advisors induce their clients to take more risk, thereby raising expected returns. On the other hand, we find limited evidence of customization: advisors direct clients into similar portfolios independent of their clients' risk preferences and stage in the life cycle. An advisor's own portfolio is a good predictor of the client's portfolio even after controlling for the client's characteristics. This one-size-fits-all advice does not come cheap. The average client pays more than 2.7% each year in fees and thus gives up all of the equity premium gained through increased risk-taking.
REVISION: Deflating 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 bottom-line net income, cash flows, and dividends. 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 they have consistent deflators. Deflating profit by the book value of total assets results in a variable that is the product of profitability and the ratio of the market value of equity to the book value of total assets, which is priced. We then construct an alternative measure of profitability, operating profitability, which better matches current expenses with 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 in- tangible information. They therefore decompose five-year changes in firms' book-to-market ratios into stock returns and a residual that is a proxy for tangible information based on accounting performance ("book returns"). Consistent with investors overreacting to intangible information, they find that only stock returns orthogonal 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. Empirically, two-fifths of the variation in book returns is due to these factors. In addition, the Daniel and Titman (2006) result is sensitive to methodological choices. When we use the change in the book value of equity as a proxy for tangible information, only the tangible component of stock returns reverses. Moreover, current book-to-market subsumes the intangible return's power to predict the ...
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: 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: 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