Retail Investor Recognition and the Cross Section of Stock Returns

Abstract

We test and offer support to Merton’s (1987) theory that difference in a stock’s investor recognition affects its cost of capital. In the U.S. market, using the breadth of ownership among retail investors as a proxy for investor recognition, we show that a long-short portfolio based on the annual change of shareholder base earns a compounded annual abnormal return of 6.42% after controlling for the Fama-French three factors. These results are more pronounced among young, low visibility and high idiosyncratic volatility stocks. Moreover, we present evidence that the investor recognition effect can explain approximately 20% of the puzzling net equity issuance effect documented by Pontiff and Woodgate (2008).

Keywords: Retail investor recognition, Ownership breadth, Net equity issuance

JEL Classification: D83, G11, G12