Why Does Financial Strength Forecast Future Stock Returns? Evidence from Subsequent Demand by Institutional Investors
54 Pages Posted: 22 Nov 2009 Last revised: 7 Oct 2011
Date Written: October 6, 2011
Measures of a firm’s financial strength forecast stock returns. The relation between financial condition and future returns, however, is consistent with two explanations: (1) changes in investors’ expectations are impounded gradually over time and, (2) riskier firms - with higher discount rates - require greater profitability to generate the same valuation ratios and changes in investors’ expectations are quickly impounded into prices. Using net demand by institutional investors as a proxy for the incorporation of information driven by revisions in sophisticated investors’ expectations, we test whether changes in investors’ expectations are immediately or gradually impounded over time. Consistent with the gradual incorporation of information explanation, financial strength predicts both future returns and future institutional investor demand.
Keywords: Financial reporting, Fundamental analysis, Capital markets, Market efficiency, Behavioral finance
JEL Classification: M41, G14
Suggested Citation: Suggested Citation