Retail investor recognition and the cross section of stock returns

Abstract

We test and offer support to Merton’s (1987) theory that difference in a stock’s investor recognition affects its cost of capital. In the U.S. market, using the breadth of ownership among retail investors as a proxy for investor recognition, we show that a long-short portfolio based on the annual change of shareholder base earns a compounded annual abnormal return of 6.42% after controlling for the Fama-French three factors. These results are more pronounced among young, low visibility and high idiosyncratic volatility stocks, and are robust to various controls such as momentum, breadth of institutional ownership, analyst coverage, liquidity, idiosyncratic volatility, trading volume, accruals, capital investment, probability of informed trading (PIN), and retail investor sentiment. Moreover, we present evidence that the investor recognition effect can explain approximately 20% of the net equity issuance effect documented by Pontiff and Woodgate (2008).