Examination of the Asset Growth Anomaly

A related paper has been added to:

#52 – Asset Growth Effect

Authors: Prombutr, Phengpis, Lam

Title: Anatomy of the Mispricing Theory: Evidence from Growth Anomalies

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2746998


This paper investigates corporate growth anomalies in asset pricing from behavioral perspectives. Cross-sectional analyses indicate that a long-term 3-year investment growth is statistically significant in explaining subsequent stock returns, but the first 1-year growth that is closest to the formation is priced by investors the most, followed by the second and third ones, monotonically. We find that the evidence is driven by myopic mispricing in that investors tend to put more weights on recent information since the evolution of the firm’s prospects around the formation year consistently shows that the growth closest (farthest) to the formation has the most (least) severe mispricing. Further investigations show that the mispricing evolution is directly amplified by limits to arbitrage and that benchmark-adjusted returns on short positions are affected more than those on long positions. However, the farther growth is less sensitive to the limit-to-arbitrage because of the extrapolation is myopic. The asset growth anomaly also shows the same pattern as the investment growth anomaly.

Notable quotations from the academic research paper:

"With respect to the extrapolative mispricing theory, we hypothesize that the growth effect cannot happen without mispricing. The growth premium coincides with the disappointment from extrapolating the firm’s prospects into the future. Along with the extrapolative mispricing theory, we investigate two additional behavioral theories: limits to arbitrage and arbitrage asymmetry. We realize that rational and behavioral theories cannot be differentiated (See Lin and Zhang, (2013)) because the characteristic-based factor models are linear approximations of investment returns. Hence, if the three behavioral theories (extrapolative mispricing, limits to arbitrage and arbitrage asymmetry) are connected and contemporaneously supported by the data, our paper will strengthen the validity of behavioral explanations without disapproving the rational q-theory.

Importantly, in this paper, we expand an investigation into the growth anomaly by decomposing the growth measures. We decompose a long-term 3-year growth measure into three consecutive short-term 1-year growth measures based on the concept of term structure. With this decomposition, we can do several anatomy tests on the corporate growth anomaly. The anatomy tests along with the evolution of mispricing and returns should be able to show more clearly if predictions of the above three behavioral theories are consistent with empirical evidence. Prior studies have not decomposed long-term growth measures into short-term components or investigated the three behavioral theories concurrently.

We find, based on cross-sectional regressions, that the explanatory power of the 3-year long-term growth (IG13) on stock returns is statistically significant and actually comes from its most recent 1-year growth component (IG1, one year closest to the formation period). The farther 1-year growth components (IG2 and IG3, two and three years away from the formation period, respectively) show monotonically diminishing explanatory power. These results indicate short memory of investors which are consistent with the myopic theory from the behavioral perspective. Cognitive biases such as representativeness state that investors tend to put too much weight on recent information (Kahneman and Tversky, 1974). Combining the myopic theory with the mispricing theory that investors extrapolate too much into the future about firms’ prospects and valuations for high and low growth firms, more severe extrapolative mispricing should exist closer to the portfolio formation year than farther distant years.

We empirically find that (1) long-term growth (IG13) demonstrates less extrapolative mispricing around the formation year than short-term growth that is measured right before the formation year (IG1), (2) compared to the IG1, the farther 1-year growth measures (IG2 and IG3, two and three years away from the formation period) show monotonic decreases in mispricing around the formation year, and (3) return performances associated with these growth measures show patterns that are consistent with the degrees of mispricing described in (1) and (2). Combined with the above cross-sectional regression findings, these results strongly suggest that the investment growth anomaly can be explained by the extrapolative myopic mispricing theory.

All of the above tests are redone using asset growth measures instead of investment growth measures. The results are similar and in fact even more pronounced. In sum, we conclude that the investment or asset growth effect is associated with mispricing. The mispricing is short-lived, so a long-term 3-year growth has the most severe mispricing near the formation year. Additionally, limits to arbitrage lead to more severe mispricing and a short position is affected more than a long position. However, the mispricing evolution tends to be less pronounced when the farther growth measures are used since investors are myopic."

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