Knowledge that Transforms

We show that a simple, intuitive variable, Goliath versus David (GVD), reflects time variation in discount rates related to changes in aggregate business conditions. GVD is the annual change in the weight of the largest 250 firms in the aggregate stock market and is motivated by research that shows that small firms are more severely impacted than large firms by economic shocks due to differences in access to external finance. We find that GVD is the best single predictor of out-of-sample market returns among traditional predictors, predicting quarterly market returns with an out-of-sample R 2 of 6.3% in the 1976–2011 evaluation period.

We examine the effect of foreign institutional investors on firm innovation. Using firm-level data across 26 non-U.S. economies between 2000 and 2010, we show that foreign institutional ownership has a positive, causal effect on firm innovation. We further explore three possible underlying mechanisms through which foreign institutions affect firm innovation: Foreign institutions act as active monitors, provide insurance for firm managers against innovation failures, and promote knowledge spillovers from high-innovation economies. Our article sheds new light on the real effects of foreign institutions on firm innovation.

We model the pricing implications of screens adopted by socially responsible investors. The model reproduces the empirically observed abnormal return to sin stock and implies a premium for systematic investor boycott risk that affects targeted as well as nontargeted firms. The investor boycott premium is not displaced by litigation risk, measures of neglect effect, illiquidity, industry momentum, or concentration. The investor boycott risk factor is useful in explaining mean returns across industries, and its premium varies with the relative wealth of socially responsible investors and the business cycle.

Short sellers trade more on days with qualitative news, that is, news containing fewer numbers. We show that this behavior is not informationally motivated but can be explained by short sellers exploiting higher liquidity on such days. We document that liquidity and noise trading increase in the presence of qualitative news, enabling short sellers to better disguise their informed trades. Natural experiments support our findings. Qualitative news has a bigger effect on short sellers’ trading after a decrease in liquidity following the stock’s deletion from the Standard & Poor’s 500 index and a smaller effect when investor attention is distracted by the Olympic Games.

We construct a model to illustrate the dynamics of cash-flow volatility (CFV) and firm valuation. As a firm progressively invests in its growth opportunities, its book value increases and catches up with its market value, reducing the valuation multiple (Q). CFV decreases because of the diversification effect of investing in more market segments. We document a positive CFV–Q association, which varies with firm size, investment opportunities, and the correlation across market segments. Empirical findings strongly support the model’s predictions and are robust to alternative explanations offered by extant studies on firm growth, volatility, and valuation.

Can the degree of predictability found in data be explained by existing asset pricing models? We provide two theoretical upper bounds on the R 2 of predictive regressions. Using data on the market portfolio and component portfolios, we find that the empirical R 2 s are significantly greater than the theoretical upper bounds. Our results suggest that the most promising direction for future research should aim to identify new state variables that are highly correlated with stock returns instead of seeking more elaborate stochastic discount factors.

We study the impact of the enforcement of financial regulation by the United Kingdom’s regulatory authorities on the market price of penalized firms. Existing studies rely on analyses of multiple events that may distort the measurement of reputational losses. In the United Kingdom, the entire enforcement process involves only one public announcement and is accompanied by complete information on legal penalties. We find that reputational losses are nearly nine times the size of fines and are associated with misconduct harming customers or investors but not third parties.

We develop an estimation approach based on a modified expectation-maximization (EM) algorithm and a mixture of normal distributions associated with skill groups to assess performance in hedge funds. By allowing luck to affect both skilled and unskilled funds, we estimate the number of skill groups, the fraction of funds from each group, and the mean and variability of skill within each group. For each individual fund, we propose a performance measure combining the fund’s estimated alpha with the cross-sectional distribution of fund skill. In out-of-sample tests, an investment strategy using our performance measure outperforms those using estimated alpha and t -statistic.

We investigate whether incentives to join the Fortune 500 affect corporate decisions. Firms closer to the cutoff appear to take actions to join the list by engaging in more mergers and acquisitions activity, bidding for larger targets, and paying higher takeover premia. Further, the relation is stronger for firms with more-entrenched chief executive officers, and the stock market reaction to bids is worse when bidders are close to the Fortune 500’s cutoff. A 1994 methodological change by Fortune acts as an exogenous shock for identification. Our results suggest that firms try to increase revenues to join the Fortune 500 but that such actions adversely affect shareholders.

We study data from an organization in which fund managers privately share and discuss detailed investment recommendations. Buy recommendations generate positive abnormal returns, and sell recommendations result in negative abnormal returns. In the context of these results, we explore an important economic question: Why do skilled investors share profitable ideas with others? Evidence suggests that the managers in our sample share to receive feedback on their ideas and to attract additional arbitrageur capital to the securities they recommend in order to correct mispricings.