Who Underreacts to Cash Flow News?

"When news about expected cash flows is good, institutional investors buy stock from individuals. When it is bad, they sell to individuals."

The extent to which stock prices in organized markets reflect all available information is of perennial interest to those who buy and sell stocks, those who regulate their sale, and those with a general interest in detailing the functioning of market systems. If buyers or sellers know something that the market fails to include in a particular stock's price, they stand to make tidy profits by exploiting their informational advantage. Past studies of the reaction of firm-level stock prices to changes in a firm's expected cash flows generally have concluded that the stock price "underreacts." When news suggests that expected future cash flows will increase, stock prices typically go up by less than the expected future gains.

The existence of irrational individual investors who buy and sell stocks in booms and busts without paying sufficient attention to news about changes in cash flow fundamentals could explain such underreactions. In Who Underreacts to Cash-Flow News? Evidence from Trading Between Individuals and Institutions (NBER Working Paper No. 8793), authors Randolph Cohen, Paul Gompers, and Tuomo Vuolteenaho review the evidence that stock prices underreact, show that underreaction is larger for the stock of smaller firms, and discuss the fact that prices react more rapidly when the cash flow news is good. The authors estimate that a $1.00 increase in cash flow news increased an average share price by just 41 cents.

Covering 1983 to 1998, their data include all stocks on the NYSE, AMEX, and NASDAQ. They define institutional investors as those who must file a form 13F with the Securities and Exchange Commission, generally all entities with more than $100 million of securities under discretionary management.

Underreaction implies that savvy investors can make profits by buying undervalued stocks, and the authors find that institutions do exploit the profit opportunities implicit in market underreaction. When news about expected cash flows is good, institutional investors buy stock from individuals. When it is bad, they sell to individuals. On average, institutions hold about 36 percent of a typical stock, and a one standard deviation improvement in cash flow news causes the average institution to buy an additional 4 percent of outstanding shares.

On average, banks appear to have done a better job of exploiting cash flow news than insurance companies, mutual funds, investment advisors, and other institutions. In general, the authors conclude that institutional investors do a better job than individuals of discriminating "between stock price movements that are justified and those that are unjustified by cash flow fundamentals."

While institutional activity reduces the amount of underreaction it does not eliminate it. Although institutional trades do reduce underreaction, institutional deviations from the value-weighted market index are relatively small. As a group, institutions outperform individuals by only 1.4 percent per year before transactions and other costs. The authors attribute this conservative performance to a number of factors, including the cost of lost diversification, transactions, and the written and unwritten rules that limit the actions of institutional investment managers.

-- Linda Gorman

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