Commonality In Misvaluation, Equity Financing, And The Cross Section Of Stock Returns

Behavioral theories suggest that investor misperceptions and market mispricing will be correlated across firms. This paper tests how equity financing identifies commonality in stock misvaluation. A zero-investment portfolio (UMO, Undervalued Minus Overvalued) built from repurchase and new issue stocks captures comovement in returns beyond that captured by the 3- or 4-factor models. The covariances of stocks or portfolios with this mispricing factor predict the cross section of future returns, and the inclusion of UMO reduces the pricing errors of the 4-factor model. Further evidence suggests that these findings are not explained by a rational frictionless asset pricing model.