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

Nicole Y. Choi

University of Wyoming - Department of Economics and Finance

Richard W. Sias

University of Arizona - Department of Finance

Date Written: October 6, 2011

Abstract

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

Choi, Nicole Y. and Sias, Richard W., Why Does Financial Strength Forecast Future Stock Returns? Evidence from Subsequent Demand by Institutional Investors (October 6, 2011). Available at SSRN: https://ssrn.com/abstract=1510784 or http://dx.doi.org/10.2139/ssrn.1510784

Nicole Y. Choi

University of Wyoming - Department of Economics and Finance ( email )

P.O. Box 3985
Laramie, WY 82071-3985
United States

Richard W. Sias (Contact Author)

University of Arizona - Department of Finance ( email )

McClelland Hall
P.O. Box 210108
Tucson, AZ 85721-0108
United States

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