Investor recognition and disagreement: pricing effects among Australian equities

Purpose: To determine whether there is a premium for lack of recognition, as theorised by Mertron ( 1987, A Simple Model of Capital Market Equilibrium with Incomplete Information. Journal of Finance 42, 483-510) among Australian-listed equities in the light of potential opposing pricing effects where short sale constraints are binding. Originality: First Australian study to examine cross-sectional pricing effects of recognition and to consider the possible confounding effects of binding short sale constraints. Uses a unique database, CHESS, in the measure of ‘recognition’. Key literature / theoretical perspective: Merton (1987) suggests that where we do not know of all securities, less-recognised firms pay a premium return to compensate for the idiosyncratic risk borne in under- diversified portfolios. The return is predicted to be increasing in idiosyncratic risk. However, evidence of negative returns to idiosyncratic risk suggest that binding short sale constraints may cause stocks that are typically less recognised, to be overvalued where differences of opinion are significant (Miller, 1977). Empirical evidence is mixed. Design/methodology/approach: Utilises portfolio sort and regression techniques. Choice of recognition proxy allows determination of effect by investor type (eg individuals as opposed to institutions). Research limitations/implications: Recognition-enhancing strategies reduce a firm’s cost of capital and provide a competitive advantage.