What Makes Stock Prices Move? Fundamentals vs. Investor Recognition

Abstract

The authors synthesized and extended recent research demonstrating that investor recognition is a distinct, significant determinant of stock price movements. Realized stock returns are strongly positively related to changes in investor recognition, and expected returns are strongly negatively related to the level of investor recognition. Moreover, companies time their financing and investing decisions to exploit changes in investor recognition. Investor recognition dominates stock price movements over short horizons, whereas fundamentals dominate over longer horizons.

A basic tenet of security valuation is that the intrinsic value of a security is equal to the discounted value of its expected future cash distributions. Yet, it is well established that variability in cash distributions and expectations thereof account for less than half the variation in realized security returns. The remaining “nonfundamental” variation in security returns remains the subject of intense debate. Efficient market aficionados attribute it to time-varying risk. Value investors attribute it to irrational “animal spirits.” But neither camp has made much progress in elucidating its respective explanation. As such, much of the variation in stock prices remains poorly understood.

Our objective in this article was to synthesize and extend research on the importance of investor recognition in explaining variation in stock prices. Investor recognition of a security is defined as the number of investors who know about the security. The investor recognition hypothesis posits that some securities are known to many investors. These securities are, therefore, in high demand, leaving other securities relatively neglected. In order for security markets to clear, neglected securities must offer higher expected returns to induce the remaining investors to overweight them. This situation leads to a negative relationship between the level of investor recognition and expected security returns and a positive relationship between changes in investor recognition and realized stock returns.

Using a crude measure of investor recognition, we showed that investor recognition is of the same order of importance as fundamentals in explaining annual stock returns. Our results indicate that expected stock returns are strongly negatively related to the level of investor recognition and realized stock returns are strongly positively related to changes in investor recognition. Moreover, investor recognition dominates stock price movements over short horizons (e.g., one quarter), and fundamentals dominate over longer horizons (e.g., five years).

We also showed that investor recognition is an important determinant of resource allocation. Companies time their financing and investing decisions to exploit changes in investor recognition. Specifically, we showed that companies’ security issuances and capital expenditures increase significantly following increases in investor recognition. These findings vindicate the significant resources that corporations allocate to investor relations and investment banking services. To the extent that such services increase investor recognition, they result in significantly higher stock prices and lower costs of capital.

Finally, our findings provide a rationale for the existence of “growth” investors, who select securities with a primary focus on product innovation and growth potential and a secondary focus on price. To the extent that such investors are able to identify securities that will experience increases in investor recognition, they should generate superior investment performance.