Financial
constraints and stock returns, (with Owen Lamont and Jesus Saa-Requejo), 2001, The Review of Financial Studies, 14,
529-554.
ABSTRACT: We test whether
the impact of financial constraints on firm value is observable in stock
returns. We form portfolios of firms based on observable characteristics
related to financial constraints, and test for common variation in stock
returns. Financially constrained firms stock returns move together over time,
suggesting that constrained firms are subject to common shocks. Constrained
firms have low average stock returns in our 1968-1997 sample
of growing manufacturing firms. We find no evidence that the relative
performance of constrained firms reflects monetary policy, credit conditions,
or business cycles.
The
diversification discount: cash flows vs. returns (with Owen Lamont), 2001, The Journal of Finance 56,
1693-1721.
ABSTRACT: Diversified firms
have different values than comparable portfolios of single-segment firms. These
value differences must be due to differences in either future cash flows or
future returns. Expected security returns on diversified firms vary
systematically with relative value. Discount firms have significantly higher
subsequent returns than premium firms. Slightly more than half of the
cross-sectional variation in excess values is attributable to variation in
expected future cash flows, with the remainder attributable to variation in
expected future returns and to covariation between
cash flows and returns.
Does
diversification destroy value?: Evidence from industry
shocks, (with Owen Lamont), 2002, The
Journal of Financial Economics, 63, 51-77. Winner of the
2002 Jensen prize for best corporate finance paper in The Journal of Financial Economics.
ABSTRACT: Does corporate
diversification reduce shareholder value? Since firms endogenously choose to
diversify, exogenous variation in diversification is necessary in order to draw
inferences about the causal effect. We examine changes in the within-firm
dispersion of characteristics, or "diversity." Following the
inefficient internal capital markets hypothesis, we examine investment
diversity. We find that exogenous changes in diversity, due to changes in
industry investment, are negatively related to changes in firm value. Thus
diversification destroys value. This finding is not caused by measurement
error. We also find that exogenous changes in industry cash flow diversity are
negatively related to changes in firm value.
The
value spread (with Randy
Cohen and Tuomo
Vuolteenaho), 2003, The
Journal of Finance, 58, 609-641.
ABSTRACT: We decompose the
cross-sectional variance of firms book-to-market
ratios using both a long U.S. panel and a shorter international panel. In
contrast to typical aggregate time-series results, transitory cross-sectional
variation in expected 15-year stock returns causes only a relatively small
fraction (20-25 percent) of the total cross-sectional variance. The remaining
dispersion can be explained by expected 15-year profitability and persistence
of valuation levels. Furthermore, this fraction appears stable across time and
across types of stocks. We also show that the expected return on
value-minus-growth strategies is atypically high at times when the value spread
(the difference between the book-to-market ratio of a typical value stock and a
typical growth stock) is wide.
Money
illusion in the stock market: The Modigliani-Cohn hypothesis, (with Randy
Cohen and Tuomo
Vuolteenaho), 2005, Quarterly
Journal of Economics, CXX, 639-668.
Note: This paper was
previously circulated as How inflation
illusion killed the CAPM.
ABSTRACT: Modigliani and
Cohn [1979] hypothesize that the stock market suffers from money illusion,
discounting real cash flows at nominal discount rates. While previous research
has focused on the pricing of the aggregate stock market relative to Treasury
bills, the money-illusion hypothesis also has implications for the pricing of
risky stocks relative to safe stocks. Simultaneously examining the pricing of
Treasury bills, safe stocks, and risky stocks allows us to distinguish money
illusion from any change in the attitudes of investors towards risk. Our
empirical results support the hypothesis that the stock market suffers from
money illusion.
Cross-sectional forecasts of the equity premium (with Sam
Thompson and Tuomo
Vuolteenaho), 2006, The Journal of Financial Economics 81,
101-141.
Note: This paper was
previously circulated as New forecasts of the equity premium
ABSTRACT: If investors are
myopic mean-variance optimizers, a stock's expected return is linearly related
to its beta in the cross section. The slope of the relation is the
cross-sectional price of risk, which should equal the expected equity premium.
We use this simple observation to forecast the equity-premium time series with
the cross-sectional price of risk. We also introduce novel statistical methods
for testing stock-return predictability based on endogenous variables whose
shocks are potentially correlated with return shocks. Our empirical tests show
that the cross-sectional price of risk (1) is strongly correlated with the
market's yield measures and (2) predicts equity-premium realizations,
especially in the first half of our 1927-2002 sample.
Click here for a Matlab
function implementing our conditional tests, here
for a Matlab program testing this function, and here for some instructions.
The
stock market and corporate investment: a test of catering theory (with Paola Sapienza), 2009, The Review of Financial Studies, 22,
187-217.
Note: This paper was
previously circulated as The real effects of investor sentiment
ABSTRACT: We test a
catering theory describing how stock market mispricing might influence
individual firms' investment decisions. We use discretionary accruals as our
proxy for mispricing. We find a positive relation between abnormal investment
and discretionary accruals; that abnormal investment is more sensitive to
discretionary accruals for firms with higher R&D intensity (opaque firms)
or share turnover (firms with shorter shareholder horizons); that firms with
relatively high abnormal investment subsequently have relatively low (high)
stock returns; and that the larger the relative price premium, the stronger the
abnormal return predictability. We show that patterns in abnormal returns are
stronger for firms with higher R\&D intensity or higher share turnover.
The
price is (almost) right (with Randy
Cohen and Tuomo
Vuolteenaho), 2009, The
Journal of Finance, 64, 2739-2782.
Note: This paper was
previously circulated as Does risk or mispricing explain the cross-section of stock prices?
ABSTRACT:
Most previous research tests market efficiency using average abnormal trading
profits on dynamic trading strategies, and typically rejects the joint
hypothesis of market efficiency and an asset-pricing model. In contrast, we
adopt the perspective of a buy-and-hold investor and examine stock price levels.
For such an investor, the level of price is more relevant than the
short-horizon expected return, and betas of cash-flow fundamentals are more
important than high-frequency stock return betas. Our cross-sectional tests
suggest that there exist specifications in which differences in relative price
levels of individual stocks can be largely explained by their fundamental
betas.
Growth or Glamour? Fundamentals and Systematic Risk in Stock
Returns (with John
Campbell and Tuomo
Vuolteenaho), 2010, The Review of Financial Studies 23, 305-344. Online Appendix to Growth or Glamour
ABSTRACT: The cash flows of
growth stocks are particularly sensitive to temporary movements in aggregate
stock prices (driven by movements in the equity risk premium), while the cash flows
of value stocks are particularly sensitive to permanent movements in aggregate
stock prices (driven by market-wide shocks to cash flows.) Thus the high betas of growth stocks with the market's discount-rate shocks,
and of value stocks with the market's cash-flow shocks, are determined by the
cash-flow fundamentals of growth and value companies. Growth stocks are not
merely glamour stocks whose systematic risks are purely driven by investor
sentiment. More generally, accounting measures of firm-level risk have
predictive power for firms' betas with market-wide cash flows, and this
predictive power arises from the behavior of firms' cash flows. The systematic
risks of stocks with similar accounting characteristics are primarily driven by
the systematic risks of their fundamentals.
Click here for a spreadsheet containing the aggregate
and portfolio-level data used in the paper.
Working Papers
An Intertemporal
CAPM with Stochastic Volatility (with John Campbell, Stefano
Giglio, and Robert
Turley), London School of Economics working paper, October 2011.
ABSTRACT:
This paper extends the approximate closed-form intertemporal
capital asset pricing model of Campbell (1993) to allow for stochastic
volatility. The return on the aggregate stock market is modelled
as one element of a vector autoregressive (VAR) system, and the volatility of
all shocks to the VAR is another element of the system. The paper presents
evidence that growth stocks underperform value stocks because they hedge two
types of deterioration in investment opportunities: declining expected stock
returns, and increasing volatility.
Stock
Prices Under Pressure: How Tax and Interest Rates
Drive Returns at the Turn of the Tax Year (with Johnny Kang, Tapio Pekkala,
and Ruy Ribeiro), London School of Economics working paper, October 2011. Internet Appendix to Stock Prices Under
Pressure
second revise and resubmit The Journal of Finance
ABSTRACT:
We show that the level of interest rates determines the magnitude of mispricing
at the turn of the tax year, as investors face the trade-off between selling a
temporarily-depressed stock this year and selling next year, but delaying tax
implications by one year. Interest rates do explain the predictable variation
in US returns and selling behavior around the turn of the year. Similar results
in the UK provide out-of-sample confirmation, as tax and calendar years differ.
Moreover, part of the variation in the risks and abnormal returns of size,
value, and momentum factors can be linked to tax-motivated trading.
Hard Times (with John Campbell and
Stefano
Giglio), London School of Economics working paper, October 2011. Internet Appendix to Hard Times
ABSTRACT: We show that the
stock market downturns of 2000-2002 and 2007-2009 have very different proximate
causes. The early 2000's saw a large increase in the discount rates applied to
profits by rational investors, while the late 2000's saw a decrease in rational
expectations of future profits. We reach these conclusions using a VAR model of
aggregate stock returns and valuations, estimated both freely and imposing the
cross-sectional restrictions of the ICAPM. Our findings imply that the
2007-2009 downturn was particularly serious for
rational long-term investors, whose losses were not offset by improving stock
return forecasts as in the previous recession.
Connected Stocks (with Miguel Anton), London School of
Economics working paper, May 2010
revise and resubmit
The Journal of Finance
ABSTRACT: By connecting stocks through common active mutual fund ownership, we forecast cross-sectional variation in return covariance, controlling for similarity in style (industry, size, value, and momentum), the extent of common analyst coverage, and other pair characteristics. We argue this covariance is due to contagion based on return decomposition evidence, cross-sectional heterogeneity in the extent of the effect, and the magnitude of average abnormal returns to a cross-stock reversal trading strategy exploiting information in these connections. We show that the typical long/short hedge fund covaries negatively with this strategy suggesting that hedge funds may potentially exacerbate the price dislocation we document.
Best
Ideas (with Randy
Cohen and Bernhard Silli), London School of Economics working paper, May
2010
ABSTRACT: We find that the stocks that active managers display the most conviction towards ex-ante, their best ideas, outperform the market, as well as the other stocks in those managers portfolios, by approximately 1 to 2.5 percent per quarter depending on the benchmark employed. The other stocks managers hold do not exhibit significant outperformance. Consistent with the view of Berk and Green (2004), the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would benefit if managers held more concentrated portfolios.
New in Town: Demographics, Immigration,
and the Price of Real Estate (with Dragana Cvijanovic and Jack Favilukis),
London School of Economics working paper, April 2010
ABSTRACT: We link cross-sectional
variation in both realized and expected state-level house price appreciation to
cross-sectional variation in demographic changes. In particular, we extract two
components of expected population growth: 1) a natural component due to
predictable demographic changes related to fertility and mortality rates and 2)
a non-natural component due to immigration. Our analysis shows that only the
second component forecasts cross-sectional variation in state-level house price
appreciation. We find that the sensitivity of both realized and expected
returns to these demographic changes is stronger for states with greater
population density, consistent with population growth actually causing the
price appreciation rather than merely being correlated with some other
phenomenon. We also document that building permits anticipate a portion of
future population growth and house price appreciation. However, lagged measures
of building activity do not subsume the ability of our expected immigration
proxy to forecast price appreciation. Our findings are consistent with
fundamentals driving an economically important portion of cross-sectional
variation in state-level housing returns. However, markets appear to
significantly underreact to the component of fundamentals that is arguably more
difficult for market participants to anticipate.
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