Investor recognition and stock returns: evidence from China

Abstract

Purpose

Merton’s model of capital market equilibrium under incomplete information predicts that contemporaneous stock returns are positively related to investor recognition and that future stock returns are negatively related to investor recognition. The purpose of this paper is to empirically investigate whether Merton’s theory holds true for the Chinese stock market.

Design/methodology/approach

This paper proposes the degree of shareholder base growth (SBG) as a proxy for investor recognition and examines the relationship between investor recognition and stock returns through a univariate analysis and Fama-Macbeth cross-sectional regressions based on A-Share listed firms.

Findings

The results show that investor recognition is nonlinearly and positively related to contemporaneous stock returns and is negatively related to future stock returns in contrast to the conclusions of Merton’s theory. A long-short trading strategy that involves buying stocks with the lowest SBG rate and that sells stocks with the highest SBG rate will earn an average monthly return of 3.615 percent.

Research limitations/implications

Though Merton’s theory is not fully reflected in the Chinese stock market, investor recognition is considered an important risk factor in the Chinese stock market.

Originality/value

No works have yet investigated the validity of Merton’s “investor cognition hypothesis” in relation to the Chinese stock market. This paper strives to fill this gap.

Citation

Zhu, H. and Jiang, L. (2018), "Investor recognition and stock returns: evidence from China", China Finance Review International, Vol. 8 No. 2, pp. 199-215. https://doi.org/10.1108/CFRI-11-2016-0127