Information Quality and the Cross-Section of Expected Returns∗

When investors learn about both systematic risk factors and firm-specific factor loadings, we show that information quality can generate cross-sectional variation in expected returns not captured by factor loadings. Firms with higher firm-specific information quality earn higher expected returns after controlling for average factor loadings, and this difference in expected returns decreases with aggregate information quality. Using proxies based on analyst forecasts, idiosyncratic volatility, and standard errors of beta estimates, we find that stocks in the highest information quality decile earn an average of 89 to 191 basis points per month more than stocks in the lowest decile after controlling for the Fama-French-Carhart risk factors and the Pastor-Stambaugh liquidity factor, and that these average returns are negatively related to aggregate information quality (as proxied for by the VIX). ∗We have benefited from comments from Andres Almazan, Ryan Ball, John Core, Lorenzo Garlappi, Mike Faulkender, Mike Fishman, Yaniv Konchitchki, Bob Korajczyk, Arvind Krishnamurthy, Christian Leuz, Dimitris Papanikolaou, Jonathan Parker, Lubos Pástor, Mitchell Petersen, Ernst Schaumburg, Viktor Todorov, Laura Veldkamp, Pietro Veronesi and seminar participants at the University of Toronto, Loyola University, the 2009 Financial Economics and Accounting Conference, and the 2010 Annual AFA Meetings. All errors are our own. A previous version of this paper was circulated under the title “Information Quality, Systematic Risk and the Cost of Capital. ” †The Wharton School, University of Pennsylvania, carms@wharton.upenn. edu ‡Kellogg School of Management, Northwestern University, snehal-banerjee@kellogg.northwestern. edu §McCombs School of Business, University of Texas, Carlos.Corona@mccombs.utexas. edu Does the quality of firm-specific information affect the cross-section of expected returns? In a model where investors are uncertain about both the aggregate risk-factors in the economy and firm-specific factor loadings, we show that firm-specific information quality can affect the cross-section of expected returns, even after controlling for the average level of factor loadings. Moreover, the effect of firm-specific information quality depends on the quality of the aggregate information about the systematic risk-factors. In particular, we show that after controlling for average loadings, firms with higher firm-specific information quality have higher expected returns and that the difference in expected returns decreases with aggregate information quality. We test the model’s predictions using hedge portfolios formed by sorting stocks on various proxies for firm-specific information quality based on analyst forecasts, idiosyncratic volatility, and the standard errors of beta estimates. In our sample from January 1986 through December 2008, we find that high information quality firms have higher returns on average than low information quality firms, and that this return difference is negatively related to aggregate information quality (measured using a proxy based on the VIX). These results persist even after controlling for standard equity risk-factors (i.e., the Fama-French-Carhart factors) and liquidity risk (using the Pastor-Stambaugh liquidity factor), and are economically significant. When sorted on our proxies for firm-specific information quality, the average return for the highest decile portfolio is 89 to 191 basis points per month higher than the average return for the lowest decile portfolio, even after controlling for the previously mentioned risk factors. The setup of our model is fairly standard. We assume an exogenously specified stochastic discount factor, or pricing kernel, that is log-normally distributed. Each firm generates cashflows that grow stochastically, and the growth rate is correlated with the risk-factor driving the pricing kernel. Hence, the expected return on a firm’s stock depends on investors’ beliefs about the risk-factor and the factor-loading of the firm’s cash-flows. In contrast to much of the prior literature, however, we assume that investors are uncertain not only about future realizations of the aggregate risk-factor, but also about each firm’s future factor loadings. As a result, investors use information to update their beliefs about the factor-loadings of cash-flows. This implies that firm-specific information is not idiosyncratic and cannot be diversified away. The intuition for our results relies on the fact that the price of a stock’s stream of cashflows is a convex function of its growth rate adjusted for its covariance with the aggregate riskfactor. This implies that after controlling for the average level of factor loadings, prices are increasing in, and expected returns are decreasing in, the uncertainty about these loadings.