Commonality In Misvaluation, Equity Financing, And The Cross Section Of Stock Returns
Source: University of California
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.