A financing-based misvaluation factor and the cross-section of expected returns. Review of Financial Studies 23:3401–36

Behavioral theories suggest that investor misperceptions and market mispricing will be correlated across firms. We use equity and debt financing to identify common misval-uation across firms. A zero-investment portfolio (UMO, undervalued minus overvalued) built from repurchase and issue firms captures comovement in returns beyond that in some standard multifactor models, and substantially improves the Sharpe ratio of the tangency portfolio. Loadings on UMO incrementally predict the cross-section of returns on both portfolios and individual stocks, even among firms not recently involved in external fi-nancing activities. Further evidence suggests that UMO loadings proxy for the common component of a stock’s misvaluation. (JEL G12, G14) Several recent behavioral models predict commonality in the misvaluation of firms. In the style investing approach of Barberis and Shleifer (2003), com-monality in misvaluation arises when irrational investor enthusiasm for stock characteristics shifts, inducing positive comovement among stocks with similar characteristics and negative comovement in stocks with dissimilar characteris-tics. In the overconfidence approach of Daniel, Hirshleifer, and Subrahmanyam (2001), investors misinterpret what they perceive to be private information The article was previously entitled “Equity Financing, Commonality in Misvaluation, and the Cross-Sectio