Cost Behavior and Stock Returns

Abstract

This paper shows that investors do not fully incorporate cost behavior information into valuation. Firms with higher growth in operating costs generate substantially lower future stock returns and operating performance. An equal-weighted long-short spread portfolio earns an average return of 82 basis points per month that is robust to a number of specifications. The negative cost growth-return relation is much stronger around earnings announcement days and among firms with lower investor attention, higher idiosyncratic volatility, and higher transaction costs, suggesting that investor underreaction and limits to arbitrage mainly drive the effect.

Keywords: Cost behavior; sticky costs; operating costs; investor underreaction; limits to arbitrage

JEL Classification: M41, D21, G12, G14