A Financing-Based Misvaluation Factor and the Cross-Section of Expected Returns

Several recent behavioral models predict commonality in the misvaluation of firms. In the style investing approach of Barberis and Shleifer (2003), commonality in misvaluation arises when irrational investor enthusiasm for stock characteristics shifts, inducing positive comovement among stocks with similar characteristics and negative comovement in stocks with dissimilar characteristics. In the overconfidence approach of Daniel, Hirshleifer, and Subrahmanyam (2001), investors misinterpret what they perceive to be private information about the genuine economic factors influencing firms’ profits. Thus, sets of stocks with similar loadings move together as information about factors arrives, is misinterpreted, and is later corrected. Characteristics such as book-to-market can reflect both firm-specific mispricing or misvaluation of systematic economic factors. Thus, evidence that stock characteristics such as size, book-to-market, or momentum predict the cross-section of future returns does not resolve whether there is systematic or
merely firm-specific mispricing. On theoretical grounds, either idiosyncratic or common mispricing could be predominant. There is less incentive to study an idiosyncratic payoff component than a common one such as the market, which suggests more mispricing in idiosyncratic corners of the market.2 On the other hand, in the model of Daniel, Hirshleifer, and Subrahmanyam (2001), in a frictionless market idiosyncratic mispricing can be arbitraged away using low-risk hedge portfolios; the mispricing of common factors remains. Style investors and overconfident investors may trade in ways that cause either idiosyncratic or common mispricing. Since there are arguments on both sides, it is useful to test whether mispriced stocks comove, and whether measures of sensitivity to factor mispricing can be used to predict the cross-section of stock returns.

From “A Financing-Based Misvaluation Factor and the Cross-Section of Expected Returns” by David Hirshleifer and Danling Jiang

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