Why do Predicted Stock Issuers Earn Low Returns?

Abstract

Predicted stock issuers (PSIs) are firms with expected “high-investment and low-profit” (HILP) profiles that earn extremely low returns. We evaluate alternative explanations for this empirical phenomenon. Our results show top-PSI firms are cash-strapped, have lottery-like payoffs, high-volatility, high-beta, low-liquidity, and high shorting-costs. Over the next two years, top-PSIs earn return-on-assets of -30% per year, report disappointing earnings, and experience strongly negative forecast revisions. They perform poorly in down markets and are six times more likely to delist for performance-related reasons. Overall, we find substantial support for mispricing, some support for nonstandard-preferences, and virtually no support for the risk explanation.

Keywords: profitability, investment, market efficiency, mispricing, asset pricing models, stock issuance, external financing, investor sentiment

JEL Classification: G12, G14, G32, G40, G41